New 5-Star Health-Care Pick: Bend It Like Becton

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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Becton, Dickinson and Company
Moat: Narrow | FV Uncertainty: Low | Price/Fair Value Ratio*: 0.86 | Three-Year Expected Annual Return*: 15.2%

What It Does: Becton, Dickinson (BDX) is the world's largest manufacturer and distributor of medical surgical products, such as needles, syringes, and sharps-disposal units. The company also manufactures diagnostic instruments and reagents, as well as flow cytometry and cell imaging systems. International revenues account for 52% of the company's business.

What Gives It an Edge: According to Morningstar analyst Alex Morozov, Becton, Dickinson's narrow economic moat stems from its dominant position in surgical instruments, particularly sharps, and its growing presence in the rapidly expanding fields of molecular and genetic diagnostics. In addition, Morozov points to the company's vast economies of scale, derived from its sizable infrastructure of global manufacturing facilities that produce billions of needles and syringes, which preclude potential rivals from entering the business and allow the company to generate returns on capital well above its cost. In Morozov's view, the robust and predictable nature of cash flows generated by the sharps business also affords Becton, Dickinson flexibility in capital deployment: The firm is plowing cash into research and development at levels unmatched by its peers, and the firm's commitment to expanding its presence in diagnostics has already resulted in a slew of promising products.

What the Risks Are: Becton's surgical products are commoditylike, which makes differentiation virtually nonexistent and forces the firm to compete on price. In the fields of diagnostics and bioscience, Becton has a number of rivals that possess greater marketing reach and larger R&D budgets. Finally, the overheated environment for acquisitions increases the risk of overpaying for potential targets.

What the Market Is Missing: Morozov believes that Becton, Dickinson, like many other medical instrument manufacturers, has traded down as of late on concerns of a broad capital spending slowdown and peak oil prices, as the firm's raw material requirements include oil-based resin. While valid, Morozov thinks the macroeconomic concerns shouldn't have a prolonged and significant impact on the company's business given that the bulk of Becton, Dickinson's surgical instruments are of a disposable nature and by and large are not affected by capital spending cycles. Morozov acknowledges that high oil prices are slightly more concerning, but he counters that the company, being the largest sharps maker, has some pricing power over its customers and should be able to pass up price hikes if rising raw material costs persist. In addition, the company is enjoying rapid widespread adoption of its new-generation higher-margin safety-engineered needles, which should also offset margin pressure. Further, Morozov points out that Becton, Dickinson is starting to see some meaningful returns from its investment in diagnostics, which, coupled with its massive sharps business, should push its cash flow close to $2 billion in 2008.