Oil Firm Poised to Deliver 20% Returns

Following is a sampling of stocks that recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.

To get a  complete tally of stocks that have recently jumped to 5 stars--as well as our  full list of 5-star stocks--including our consider buying and selling prices, risk ratings, and moat ratings--simply take Morningstar Premium Membership for a test spin. Click here to sign up for a free trial.

Apache
Moat: Narrow  |  Risk: Average  |  Price/Fair Value Ratio*: 0.77  |  Three-Year Expected Annual Return*: 20.5%

What It Does:  Apache (APA) is one of the oil patch's largest independent exploration and production companies. Although most of its wells are in North America, Apache also has operations in the North Sea, Argentina, Australia, and Egypt. The company has about 2.4 billion barrels of oil equivalent in its proven reserves, a little more than half of which is in natural gas. It produces more than 500,000 barrels of oil equivalents a day.

What Gives It an Edge: Morningstar analyst Justin Perucki has awarded Apache (and many of its peers) a narrow economic moat rating, mainly because of OPEC. By limiting its members' production, OPEC manipulates oil prices higher. This lifts profitability in what would otherwise be a brutally competitive commodity market. Apache also benefits from the stranded nature of natural gas, which keeps prices artificially high. If oil or natural-gas prices were to drop in the near term due to a slowdown in economic activity, Apache's strong balance sheet and relatively low-cost asset base should allow it to weather the down cycle with ease. Moreover, the firm should be in good position to grow shareholder value by snapping up assets at distressed prices from less fortunate peers.

What the Risks Are: Perucki thinks that Apache courts average business risk, meaning that he'd be an enthusiastic investor in the shares at a moderate discount to his fair value estimate. With profits heavily dependent on commodity oil and gas prices, a sustained downturn in prices would crimp Apache's results. Spills, terrorism, and higher taxes are ever-present risks, as well.

What the Market Is Missing: With oil prices still hovering around $70 per barrel, it appears the market is overly concerned about near-term natural-gas prices. Relatively mild weather over the past two years, coupled with strong domestic production growth, has pushed spot prices to around $5 per thousand cubic feet (mcf). However, Perucki believes natural-gas prices will average just shy of $7.50 per mcf over the next five years. North American finding and development costs have increased dramatically over the past few years, and Perucki thinks the price required to induce new marginal producers to invest in new supply is around $7-$8 per mcf over this time period. On the low end, Perucki thinks the large installed base of gas-fired power plants should help support prices above $5 per mcf. Although liquefied natural gas should displace some high-cost domestic production over the next five years, Perucki doesn't see it as a significant threat.

Darden Restaurants
Moat: Narrow  |  Risk: Below Avg  |  Price/Fair Value Ratio*: 0.81  |  Three-Year Expected Annual Return*: 17.9%

What It Does: In 1968, Bill Darden opened the first Red Lobster, which eventually grew into  Darden Restaurants (DRI), a portfolio of 1,323 casual dining restaurants in the United States and Canada. Chains include the flagship Red Lobster (680 units) and Olive Garden (614 units), as well as newer concepts Bahama Breeze (23 units) and Season 52 (seven units). With the planned acquisition, Darden portfolio will also include LongHorn Steakhouse (287 units) and The Capital Grille (28 units).

What Gives It an Edge: Olive Garden and Red Lobster delivered total annual sales of $2.8 billion and $2.6 billion, respectively, last fiscal year. In Morningstar analyst John Owens' view, this scale affords Darden tremendous buying power and allows its brands to leverage the efficiency of national advertising. As evidence of its narrow moat, Owens notes that Olive Garden, which is the leading Italian dining chain, has delivered positive same-restaurant sales growth for 51 consecutive quarters. Meanwhile Red Lobster, which has been recognized as the nation's best seafood restaurant 18 years in a row by Restaurants & Institutions magazine, has delivered positive growth in nine of the past 11 quarters. Owens thinks Darden's performance has been especially impressive in the last few years, as many other casual dining chains have suffered continual declines in same-restaurant sales in the face of soaring gas prices, rising interest rates, and waning consumer confidence. Despite these challenges, Darden has consistently delivered returns on invested capital that comfortably exceed Owens' estimate of its cost of capital.

What the Risks Are: Owens thinks that Darden courts below-average business risk. As such, he wouldn't demand an especially wide margin of safety to invest in the shares. That said, there are salient risks to consider. To wit, with the Red Lobster and Olive Garden chains approaching saturation, Darden's long-term growth will depend more on its recently acquired brands, as well as its two other concepts that have not yet proved their long-term viability. A challenging consumer environment could lead some of Darden's customers to scale back their spending at its restaurants. A rise in food, labor, energy, and/or occupancy costs could also drag on profitability.

What the Market Is Missing: With concerns about a slowdown in consumer spending, the market has been indiscriminately selling a number of retail stocks recently, including shares of restaurant companies. Nevertheless, Owens doesn't think the recent sell-off in Darden shares is warranted when one considers the firm's resilient performance. Further, Owens does not believe that the challenging macroeconomic environment will persist indefinitely. As it currently stands, Darden shares are trading at a 19% discount to Owens' fair value estimate (which is based on a discounted cash-flow analysis) and at just 13.6 times forward earnings, versus a market multiple of 15.5 times. This is the first time that Darden's stock has traded in five-star territory since Morningstar began covering the company more than four years ago.

Other New 5-Star Stocks
 Chesapeake Energy 
 Infinity Property and Casualty 
 Toll Brothers  (TOL)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, August 24, 2007.