Two Firms with Hefty Expected 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.

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Global Cash Access Holdings
Moat: Narrow | Risk: Above Avg | Price/Fair Value Ratio*: 0.63 | Three-Year Expected Annual Return*: 28.8%

What It Does:  Global Cash Access Holdings  (GCA) provides casino patrons with access to cash in establishments in the United States, Canada, the United Kingdom, and the Caribbean. It operates machines that allow users to access cash in bank accounts through ATM transactions, and it facilitates point-of-sale debit card withdrawals and credit card cash advances. The company also provides consumer credit data to casinos for use in credit decisions and provides check-cashing services to casino patrons.

What Gives It an Edge: According to Morningstar analyst Sumit Desai, GCA's narrow moat stems from its dominance in serving the casino industry. GCA's leading market share gives the company scale advantages over competitors and its close integration with casino operators raises switching costs for customers. GCA locks its customers up for three- to five-year contracts and installs its own cash-dispensing machines and systems directly into the casino, making it difficult for rivals to steal business. As a result, GCA enjoys customer retention rates near 97% and earns returns on invested capital well above 30%.

What the Risks Are: Desai believes GCA's greatest long-term risk is that casinos will continue to extract higher commissions from the firm, given its heavy dependence on a few large operators. Finally, given that the company's business is related to both gambling and to expensive financial transactions, there is a certain amount of regulatory risk.

What the Market Is Missing: Desai believes the market is currently extrapolating recent weak results into the future, and he doesn't think that's accurate. GCA has seen gross margin degradation over the past four years, as renewed contracts have included higher payments to casinos. The casino industry has seen significant consolidation recently, which has given operators increased negotiating power over GCA. However, most of the firm's large customers are now signed under new long-term contracts, which should help stop margin compression. Desai stipulates that to arrive at today's stock price, one would have to assume about 400 basis points of further gross margin consolidation and a meager 5% average annual sales growth through 2011 (well below the firm's average sales growth of 15% since 2004). As a result, Desai believes the bar is set too low for GCA and long-term investors should be rewarded with ample returns.

Credence Systems Corporation
Moat: None |  Risk: Above Avg  |  Price/Fair Value Ratio*: 0.62  |  Three-Year Expected Annual Return*: 33.9%

What It Does:  Credence Systems   manufactures semiconductor-testing equipment with a broad product portfolio. Its systems are used to test digital, analog, mixed-signal, radio frequency, and system-on-a-chip integrated circuits. Credence's systems are used in different stages of testing, ranging from engineering validation of prototypes to automated testing of production chips.

What Gives It an Edge: Morningstar analyst Andy Ng does not think Credence enjoys competitive advantage over rival equipment-makers. Ng supports his assessment by pointing to the highly competitive nature of the market where Credence operates and its concentrated customer base. According to Ng, product capabilities/functionalities of the various automated-test-equipment (ATE) providers are rather similar, hence chipmakers hold substantial purchasing power over Credence.

What the Risks Are: Ng thinks Credence faces a number of risks. The ATE industry is highly competitive and includes a number of sizable players. The firm must also successfully integrate its recent acquisitions. Finally, Credence operates in a highly volatile segment of the semiconductor-equipment industry. Long product lead times result in customers ordering beyond their business visibility during industry upturns, only to cancel their orders during sudden downturns, which results in large losses for Credence.

What the Market Is Missing: Ng stipulates the stock has not performed well recently because of perceptions that Credence's market share at its major customer,  Advanced Micro Devices (AMD), may be at risk. However, Ng thinks revenue assumptions in his valuation model are conservative, and he accounts for the customer loss risk with an appropriate margin of safety. As a result, Ng believes that Credence presents an attractive risk-reward opportunity for investors willing to dive into an above-average risk stock.

Other New 5-Star Stocks
 Basic Energy Services  (BAS)
 MarineMax (HZO) 

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Sept. 28, 2007.