Four Stocks with Hefty Expected Returns
Plus several other stocks that recently hit 5 stars.
Following is a roundup 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.
Moat: Wide | Risk: Below Average | Price/Fair Value Ratio*: 0.83 | Three-Year Expected Annual Return*: 15.5%
What It Does: Anheuser-Busch (BUD) is the largest American brewer. Its domestic beer brands, which include Budweiser, Michelob, Busch, and Natural Light, are produced at 12 breweries in the United States. The company owns 50% of Grupo Modelo and has made substantial investments in Chinese breweries. It also owns a brewery in the United Kingdom and licenses its brands to various brewers worldwide. The company owns packaging companies and nine theme parks, including Sea World and Busch Gardens.
What Gives It an Edge: Morningstar analyst Ann Gilpin thinks Anheuser-Busch has a wide economic moat. The firm dominates the domestic beer market with nearly 50% share, and this scale advantage has allowed it to demand exclusivity from about 60% of its distributors, compared with 10% of its peers' volume that is distributed under exclusive arrangements. Anheuser-Busch's infrastructure for the distribution of alcoholic beverages in the U.S. is unparalleled, and the firm should be able to further leverage this system to generate improved growth by branching into faster-growth categories.
What the Risks Are: Because brewers have high fixed costs, weak volume trends significantly deteriorate profits. Wine and spirits have grown in popularity domestically at the expense of beer during the last few years, making each of the oligopolistic U.S. brewers more willing to discount to maintain volume. As a consequence, the domestic beer pricing environment, which was strong for a number of years, has become increasingly competitive.
What the Market Is Missing: Gilpin believes the market is preoccupied with near-term commodity (hops and barley) cost issues affecting all brewers, and it is discounting Anheuser-Busch's brands, unmatched scale, and its history of generating strong cash flows. Gilpin anticipates a more rational domestic pricing environment as the industry consolidates, on the heels of the recent joint venture agreement between SABMiller and Molson Coors (TAP). Although Gilpin concedes that commodity costs may take a bite out of margins in 2008, she believes Anheuser-Busch will weather the storm and provide its investors with ample returns.
Moat: Narrow | Risk: Above Average | Price/Fair Value Ratio*: 0.62 | Three-Year Expected Annual Return*: 31.2%
What It Does: SK Telecom (SKM) is the largest mobile-phone operator in South Korea, with more than 21.6 million customers (50.5% market share). The firm is a leading innovator in Korea, providing unique wireless features and using satellite to enhance services to subscribers. SK also provides wireless services through joint ventures and subsidiaries in the U.S., Vietnam, China, and Mongolia. SK Group, Korea's third-largest conglomerate, owns approximately a quarter of the company.
What Gives It an Edge: Morningstar analyst Jacqueline Zhang is a big fan of SK Telecom, and she has assigned it a narrow moat. The firm is a leading innovator in the wireless world, which, along with its early presence in South Korea's wireless market, has allowed it to capture and secure some of the nation's top-spending subscribers. As a result, Zhang estimates SK's average revenue per user is about 13% higher than that of its closest competitor. The company also enjoys significant scale advantages, thanks to its dominant size, which enables it to deliver attractive margins. With growth slowing at home, SK has boosted its investment in potentially high-growth countries, such as Vietnam and China.
What the Risks Are: SK Telecom operates in a highly regulated environment, where the government has not shied away from punishing telecom operators for unfair business practices. The firm's leading position in the wireless market also places it under stricter regulations, which Zhang believes puts the firm at a slight disadvantage. In addition, rival operators, such as KT, will likely continue offering aggressive handset subsidies to win subscribers, which could hurt the company's market share. Korea's newly elected president Lee Myung-bak has also announced his plans to cut wireless rates. Additional regulations from the new administration could hurt SK's business going forward.
What the Market Is Missing: The recent announcement by Korea's newly elected president to lower tariff rates by 20% caused SK's shares tumble nearly 25% off its highs. Although Zhang concedes that the rate reduction will have a negative impact on SK's near-term revenue growth, she thinks the firm's prospects remain attractive. Following its acquisition of Hanaro, SK will become the second-largest fully integrated telecom operator in Korea, which should allow it to provide bundled packages more efficiently and thus improve customer retention. Robust demand for data and Internet protocol television services should also, according to Zhang, lessen the impact of tariff rates reduction.
Moat: Narrow | Risk: Below Average | Price/Fair Value Ratio*: 0.81 | Three-Year Expected Annual Return*: 17.3%
What It Does: General Mills (GIS) is one of the largest packaged food companies in the United States. It produces ready-to-eat breakfast cereals, refrigerated dough and other baking items, snack and convenience foods, frozen vegetables, yogurt, and beverages. Well-known brands include Cheerios, Lucky Charms, Wheaties, Chex, Betty Crocker, Pillsbury, Gold Medal, Green Giant, Hamburger Helper, Old El Paso, Pop Secret, Colombo, and Yoplait. U.S. sales account for 85% of the firm's annual revenues.
What Gives It an Edge: With its well-known brands, General Mills has significant presence in the grocery aisles. More importantly, the company holds either the number-one or number-two market position in 12 product categories. Such strong brands allow General Mills to acquire favorable shelf space at retail and charge premium prices for its products, producing industry-leading margins and superior returns on invested capital. As a result, Morningstar analyst Greggory Warren has assigned General Mills a narrow moat.
What the Risks Are: General Mills is heavily influenced by the commodity-driven nature of its business. Input cost volatility, as well as the commodification of several of its categories, such as ready-to-eat cereals, has had an impact on profitability. General Mills faces stiff competition from branded and private-label food manufacturers in many of its product lines. Increased volatility in its foodservice segment has also been detrimental to the firm's sales and earnings growth during the last few years.
What the Market Is Missing: Warren thinks most of the packaged food firms have traded down over the past month on growing concerns over commodity cost inflation. However, he counters that the food and beverage manufacturers have in the past been able to pass much of the increase along to customers, either through straight price increases or ingenious alternatives. Although Warren believes the price hikes could negatively impact volume, the effect will differ depending on the product category involved. With below-average private-label penetration in categories such as ready-to-eat cereals (15%) and yogurt, which combined make up more than one third of the company's annual sales, Warren does not see much potential for disruption in General Mills' business. Soup sales are also not likely to be troubled, as the firm's chief competitor, Campbell Soup (CPB), needs to be rational with its pricing for a category that makes up about half of its sales and profitability.
Royal Dutch Shell
Moat: Narrow | Risk: Below Average | Price/Fair Value Ratio*: 0.83 | Three-Year Expected Annual Return*: 17.5%
What It Does: Royal Dutch Shell's (RDS.A) global integrated operations cover the spectrum in oil and gas. Shell is considered a supermajor, along with ExxonMobil (XOM) and BP (BP). Royal Dutch Shell has almost 12 billion barrels of proved oil and gas reserves, daily production of 3.5 million barrels of oil equivalent, the capacity to refine 4 million barrels a day, and about 45,000 service stations. Other businesses include chemicals and liquefied natural-gas infrastructure.
What Gives It an Edge: Shell and many of its peers carry a narrow economic moat rating mainly because of OPEC. By limiting its members' production, OPEC has control over global oil prices, and reduces the level of rivalry in an otherwise highly competitive commodity market. Shell also benefits from huge economies of scale, as few competitors can rival the firm's technology and engineering expertise, project management skills, or capital resources.
What the Risks Are: Morningstar analyst Elizabeth Collins places Shell in the below-average risk bucket, although it faces greater uncertainties and challenges than many of the other companies in this category. The largest risk is a sustained downturn in commodity prices caused by oversupply or a drastic reduction in demand brought on by recession or technology advances. Political risk in the form of war, eviction from a country, or higher taxes is rising as Shell sources more of its production in less-stable areas. The risk of spills and other environmental problems is also ever-present. Still, Shell's massive size, diversity, and century-long record of navigating through difficult challenges lead Collins to believe the firm will continue to generate solid returns.
What the Market Is Missing: Collins stipulates the market is concerned with Shell's ability to grow oil and gas production and replace its resources. Shell also has a large refining portfolio, and Collins has seen refiners' shares drop recently, perhaps on fears that a weak economy will depress demand for refined products (such as gasoline and diesel). Collins notes that Shell was earlier than some of its peers in shifting its upstream portfolio toward complex, unconventional projects such as oil sands in Canada and gas-to-liquids in Qatar, which should give it a foundation for maintaining production levels over the next several years. Further, her outlook for Shell includes lower refining earnings going forward, relative to 2005-07, because of an assumed easing in the supply/demand balance for refined products. All these factors result in an attractive entry point for potential investors.
* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Jan. 25, 2008.
Alex Morozov does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.