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Stock Analyst Update

10 New Stocks in 5-Star Territory

Get our take on these mispriced names.

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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.

CarMax
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.72*  |  Trailing 1-Year Return: 43.6%

What It Does:  CarMax (KMX) sells, finances, and services used and new cars through a chain of retail stores. The company was formed in 1993 as a unit of  Circuit City (CC) and was spun off into an independent company in late 2002. Used-car sales account for about four fifths of revenue, while new-car sales, financing, maintenance, and repair services provide the remaining one fifth of sales.

What Gives It an Edge: Morningstar analyst John Novak thinks that CarMax merits a narrow economic moat for a few reasons. CarMax's simple, no-haggle pricing strategy poses challenges for traditional new and used-car dealers who can't easily replicate that model without hurting their existing profits. CarMax's business model also helps it turn inventories more effectively than most traditional dealers, resulting in higher returns on capital. CarMax's nationwide inventory and extensive vehicle pricing databases also give the company an advantage over local and less-sophisticated competitors.

What the Risks Are: Novak believes that CarMax poses average business risk. Because this is a growth stock, the share price could be volatile in the short run. The heavy new-car discounting employed by Detroit's Big Three could hurt CarMax's sales as new cars become less expensive relative to used cars. In addition, a broad economic slowdown could hurt consumer spending and used-car sales. CarMax's success could attract imitators.

What the Market Is Missing: CarMax's stock has stumbled in recent weeks over concerns that high gas prices, a downturn in the housing market, and increasingly leveraged consumers could lead to a slowdown in auto sales. While we agree those factors could dent results in the short term, we think CarMax's long-term prospects remain bright. With about 80 stores, the company has plenty of room to expand in new and existing geographies. In addition, we think CarMax will continue to steal market share from traditional car dealers in the markets where it competes. Finally, CarMax's operating margins should continue to expand as its store base matures and it further leverages its fixed costs.

Great Plains Energy
Moat: Narrow  |  Risk: Below Avg  |  Price/Fair Value Ratio: 0.81*  |  Trailing 1-Year Return: 21.0%

What It Does:  Great Plains Energy (GXP) is a holding company for a regulated utility and a wholesale energy supply company. Kansas City Power & Light generates, transmits, and distributes electricity to 490,000 customers in Missouri and Kansas. Acquiring Aquila's electric assets will add some 300,000 customers in Missouri. Strategic Energy purchases and manages electricity for large commercial and industrial clients in nine states where customers are allowed to choose their energy supplier.

What Gives It an Edge: As a natural monopoly, KCP&L--the integrated utility that supplies virtually all of Great Plains' earnings--generates steady, regulated returns. KCP&L's moat is further widened, in Morningstar analyst Ryan McLean's opinion, by its low-cost fleet of coal and nuclear generation assets. A low-cost structure helps keep electricity bills in check and, in turn, regulators happy. Excess capacity, meanwhile, can be sold profitably into the wholesale market. Great Plains' competitive advantages can be plainly seen in its returns on invested capital, which have generally exceeded the firm's cost of capital--an achievement not always seen across our utilities universe. McLean thinks Great Plains' upcoming acquisition of Aquila's electric assets will further strengthen its competitive position. Because these assets lie in an adjacent concession area, McLean believes Great Plains should be able to integrate them more effectively than any other purchaser could have.

What the Risks Are: McLean thinks that Great Plains poses below-average business risk. Unlike many of its regulated peers, KCP&L's rate structure does not contain a fuel-adjustment clause. This price exposure hurts earnings when input prices rise (as they have over the past two years). However, the company expects new rate structures in 2007 to include fuel-adjustment provisions for its Kansas service territory. KCP&L's generation capacity is heavily weighted toward coal. With 98% of its supply originating in the Powder River Basin, the firm is vulnerable to supply disruptions. On the unregulated side, Strategic Energy operates in an industry with low barriers to entry and exposure to rising wholesale electricity prices.

What the Market Is Missing: At first glance, growth prospects in Great Plains' service territories would appear ordinary. But Great Plains' rate base--those investments on which it earns a regulated return--is set to outpace load growth by two-to-one as the firm invests in new generation and upgrades. Though equity issuances will dilute this growth somewhat, McLean expects solid per-share earnings expansion. Moreover, as a greater proportion of Great Plains' business comes under the regulated fold, the overall riskiness of future cash flows should decline. On another note, McLean thinks the market has penalized Great Plains for the weak performance at its unregulated power marketer, Strategic Energy. This segment accounts for only a small fraction of its parent's business, however. Great Plains' value, in McLean's view, lies in the expansion of its regulated operations.

Texas Instruments
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.76*  |  Trailing 1-Year Return: 9.8%

What It Does: Founded in 1930 and based in Dallas,  Texas Instruments  (TXN) generates 95% of revenues from digital signal processors (DSPs), analog chips, and other semiconductors and 5% from its high-margin calculator business. Its exposure to the communications market is large, and about 15% of its sales are made to one client-- Nokia (NOK). TI has the number-one revenue share in both of its target semiconductor markets--DSP and analog--and both markets are forecast to enjoy high growth rates over the next few years.

What Gives It an Edge: In Morningstar analyst Erik Kobayashi-Solomon's opinion, Texas Instruments is well-positioned to gain share in the fractured high-performance analog (HPA) chip market, where it's the largest player by far. TI has several times the number of salespeople and engineers available to work with clients on designing TI chips into end products. Coupled with TI's robust product portfolio, which is broader and deeper than any rival's, Kobayashi-Solomon thinks the firm has a very good opportunity to cross-sell to existing clients. On the digital chip side, TI has developed single-chip solutions for mobile handsets, which Kobayashi-Solomon thinks will be the standard technology in five years. Only one other company,  Infineon Technologies (IFX), is as far along in developing single-chip solutions, and TI has better customer relationships with key handset makers.

What the Risks Are: Kobayashi-Solomon thinks that TI poses average business risk. TI's consumer base is diverse (roughly 50,000 end customers), but its exposure to the communications business--primarily through DSP sales--is large, representing 50% of its annual revenues. While its rationalized, "fab-lite" manufacturing strategy has allowed it to better weather temporary downturns in demand, a prolonged or severe shakeup in the communications market could have a significant negative effect on TI's growth and profitability, in our opinion.

What the Market Is Missing: Texas Instruments is a company in transition, and Kobayashi-Solomon believes the market in general has trouble valuing firms in such a state. Over the last few years, TI's bread-and-butter business has been selling DSPs to Nokia and other mobile phone handset makers. Kobayashi-Solomon believes that most market observers are attempting to price TI's shares by making projections about handset sales growth. But he thinks that's just part of the TI story. Kobayashi-Solomon believes that the future TI will have a more balanced portfolio, with sales of analog chips driving growth and profitability. In addition, considering trends in digital media, Kobayashi-Solomon thinks that demand for DSPs in non-handset applications will allow TI to diversify its DSP customer base and retain healthy growth in this area.

Other New 5-Star Stocks

* Price/fair value ratios calculated using fair value estimates and closing prices as of Friday, May 25, 2007.

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