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Stock Analyst Update

We See Value in These Beaten-Down Stocks

These stocks offer 20%-plus expected returns.

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.

Veolia Environnement
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.68 | Three-Year Expected Annual Return*: 26.3%

What It Does: French-based Veolia Environnement (VE) is a leading global provider of environmental services. Its largest segment, water, helps provide potable water to more than 67 million people. Its other business services include environmental (waste), energy, and transportation. Veolia operates in uneconomically regulated markets across the globe, creating partnerships with municipalities.

What Gives It an Edge: According to Morningstar analyst Basili Alukos, Veolia's unique business model and its deep roots as a water provider give it an edge over its competitors. Veolia bypasses economic price-setting by operating in nonregulated markets. This gives it more flexibility to quickly pass price increases to its customers. In addition, Alukos points out that Veolia essentially has customers for life with renewal rates in excess of 90% on 10- to 15-year long-term contracts. When you combine this model with a reputation of providing quality water since the Napoleon III era, Alukos believes Veolia will remain a market leader well into the future.

What the Risks Are: In Alukos' view, contract renewal risk is Veolia's biggest threat, as customers typically reevaluate the costs and benefits of outsourcing environmental services when contracts expire. Furthermore, Veolia assumes operational risk, and any cost overruns could compress returns. Weather creates an uncontrollable risk for Veolia because of its direct effect on water and energy usage. Finally, poor selection of future acquisitions could compress returns and destroy shareholder value.

What the Market Is Missing: Alukos thinks the market has unjustly focused on Veolia's weather-related struggles recently rather than on its success in delivering above 8% annual organic revenue growth over the longer term. Also, while Alukos acknowledges that a potential downturn or recession in Europe could affect the majority of Veolia's operations, environmental services are life necessities and their demand is relatively stable regardless of economic output. Furthermore, Alukos believes the market is missing Veolia's ability to organically grow sales by persuading more governments to relinquish operational control of their environmental services. In Alukos' opinion, this gives Veolia the power to increase sales regardless of the overall economic environment.

Network Appliance, Inc.
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.73 | Three-Year Expected Annual Return*: 22.1%

What It Does: Network Appliance (NTAP) sells hardware, software, and services for customers to store and manage critical data across their networks. The company was an early pioneer in building storage hardware that could easily attach to a customer's existing network as a simple storage appliance. Today, NetApp supports network and storage protocols that allow customers to unify storage networks and support new applications for disaster recovery and business continuity.

What Gives It an Edge: NetApp's storage systems are installed in thousands of data centers across more than 100 countries and the company is the market leader in some of the fastest-growing segments in the storage market. Morningstar analyst Grady Burkett believes NetApp's large installed base affords the company a narrow economic moat, as IT managers find it easier and safer to reorder more storage from NetApp rather than risk switching to a different vendor. Storage management and data protection are now top priorities among corporations, and Burkett thinks NetApp will further entrench its customers through its management software tools and service arrangements.

What the Risks Are: Many of NetApp's competitors have far greater resources, putting the firm at a disadvantage. In addition, newer upstarts could develop storage networks that are technically superior to NetApp's offerings. Also, NetApp could have difficulty selling its storage systems to small businesses.

What the Market Is Missing: With the U.S. economy on shaky ground, Burkett believes the market fears a repeat of 2002, when NetApp's 20% revenue decline led to a precipitous drop in operating profits. Although growth should slow considerably from 2007, Burkett thinks NetApp is in a much better position to weather a recession this time around. The company has more than doubled revenues from software and services since 2005, and these areas continue to grow faster than hardware sales. This is important, as IT managers typically cut hardware spending first when budgets are tight but are more reluctant to cut services and software spending. Also, Burkett likes that NetApp has taken steps to diversify its revenue base. The company now derives a greater portion of revenues from non-U.S. sources than it did in 2002, and it is expanding its presence in the small and medium-sized business market. According to Burkett, an increased focus on software and service offerings and a more diverse revenue stream should help insulate NetApp from a slowdown in technology spending.

More New 5 Star Stocks
Luxottica Group S.p.A. 

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Thursday, March 20, 2008.

Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.