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Stock Analyst Update

Two Retailers on the Bargain Rack

Plus seven other stocks currently mispriced by the market.

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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.

Lowe's Companies
Moat: Wide  |  Risk: Below Avg  |  Price/Fair Value Ratio: 0.84*  |  Trailing 1-Year Return: 3.6%

What It Does:  Lowe's Companies (LOW) is the second-largest home-improvement retailer in the world and operates approximately 1,400 warehouse-format stores throughout the United States. The company's stores offer products and services for home decorating, maintenance, repair, and remodeling. Lowe's targets retail do-it-yourself and do-it-for-me customers, as well as commercial business clients.

What Gives It an Edge: Thanks to substantial buying power and efficient store operations, Lowe's consistently earns returns on invested capital well in excess of its cost of capital, and Morningstar analyst Brady Lemos expects that trend to continue in the future, explaining why he has awarded the company a "wide" economic moat. Lemos thinks Lowe's offers consumers a compelling reason to shop its stores rather than those of other home-improvement retailers, including  Home Depot (HD). He believes Lowe's has excelled in customer service and shopping convenience by keeping stores well staffed and designing intuitive store layouts, among other customer-focused initiatives. Not surprisingly, Lowe's routinely outshines Home Depot in customer satisfaction studies.

What the Risks Are: Lowe's sales are closely tied to the U.S. construction market. Further softening of the housing market could reduce sales and profitability. Additionally, Lowe's faces the prospect of market saturation as its domestic footprint approaches 1,500 stores and competitors like Home Depot continue to expand.

What the Market Is Missing: Near-term concerns regarding the housing market have created a good opportunity to invest in this high-quality retailer, in Lemos' opinion. While housing market worries could pressure sales over the next few quarters, Lemos likes Lowe's long-term prospects and expects the retailer to continue to gain share of the fragmented home-improvement market. In particular, Lemos believes Lowe's can leverage its industry-leading customer service, shopper-friendly stores, and proven business model to profitably expand domestically and abroad. And with just a 7% share of the U.S. home-improvement market, Lowe's still has plenty of room to expand, particularly in the quickly growing installation-services segment. Furthermore, Lowe's stores' superior shopping experience allows them to prosper even in locations where they overlap with other home-improvement retailers.

For more on Lowe's, watch our video report.

Sears Holdings
Moat: None  |  Risk: Average  |  Price/Fair Value Ratio: 0.75*  |  Trailing 1-Year Return: 13.8%

What It Does:  Sears Holdings (SHLD) is the third-largest retailer in the U.S. It operates around 3,900 full-line and specialty stores in the U.S. and Canada both in malls and off the mall, in big-box stores. It sells an assortment of consumables, apparel, appliances, tools, home furnishings, and consumer electronics. Sears Holdings' proprietary brands include Kenmore, Craftsman, Lands' End, and DieHard.

What Gives It an Edge: With little investment in its stores, declining market share, and no clearly articulated turnaround strategy, Morningstar analyst Kimberly Picciola finds it hard to believe Sears is going to stage a comeback as a retailer. But Sears is not your typical retailer. Eddie Lampert, a hedge fund manager with a stellar record of allocating capital, has a 42% stake in the company, serves as chairman of the board, and has been granted the authority to invest the company's surplus cash. While Lampert has stated his intent to turn the retail business around, Picciola thinks the value in this company is elsewhere: Lampert's ability to invest the surplus cash, the value of the firm's real estate, and the proprietary brands. Over the next 10 years, Picciola believes Lampert will milk the company's retail business for cash and eventually sell the firm's real estate. Around 45% of our fair value estimate comes from the company's real estate assets, while cash flows from the retail business, the premium for having Lampert at the helm, and the brands account for 24%, 23%, and 8%, respectively.

What the Risks Are: We think about this company's risks in terms of the four parts of the valuation. Picciola considers the risk of turning around the retail business to be above average and Lampert's ability to generate returns in the ballpark of 20% over the next 10 years to be speculative. However, Picciola views the risk associated with unlocking value in the company's real estate and its brands as average. Picciola weights the risk ratings similarly to the way the four parts contribute to the valuation. This gives an overall risk rating of average. Despite that, Picciola is making some big assumptions. First, she assumes the company will monetize its assets, but she has seen no signs since the merger that Sears Holdings intends to sell its real estate. Second, she expects the company's market share to modestly decline. Should it drop off a cliff, Lampert may be forced to liquidate the real estate at a less favorable price. Third, if consumer spending plummets or the commercial real estate market tanks, Sears will have to fall back on its underperforming retail business.

What the Market Is Missing: While Sears is focused on improving profits and sales at its Kmart and Sears stores, Picciola continues to believe this is more than just a retail turnaround story. Given the presence of Lampert, who has an exceptional record of making money, Picciola believes it is prudent for our valuation to look beyond the cash flows generated from the retail business and consider other factors, like the company's real estate assets and the cash available for investing. The market, it seems, is either overly fixated on the state of the retail business, or is discounting the value that could ultimately be attributable to the company's real estate or Lampert's investments of the firm's cash.

Countrywide Financial
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.75*  |  Trailing 1-Year Return: 1.1%

What It Does: In less than 50 years,  Countrywide (CFC) has become one of the largest players in the mortgage industry, with about $200 billion in assets. The firm primarily originates residential home loans and sells them into the secondary market, while maintaining the servicing rights on its originations. Beyond its mortgage operations, the firm has diversified its platform to include nonmortgage but complementary offerings such as banking services, insurance, and capital markets.

What Gives It an Edge: Morningstar analyst Erin Swanson believes Countrywide's competitive advantage rests in its diversified operations--mortgages, banking, insurance, and capital markets--and the strength of its balance sheet, characteristics that aren't about to be swept away in the subprime mortgage tidal wave. Taken together, those traits are a big reason why Swanson thinks Countrywide merits a "narrow" economic moat.

What the Risks Are: Countrywide poses average business risk in Swanson's view. The troubles in the subprime industry appear to be casting a wide net, and few have been able to avoid being caught up. With about 10% of its mortgages in subprime products and 40% in adjustable-rate loans, Countrywide's loan portfolio is not immune; the firm reported a 35% decline in first-quarter earnings because of rising delinquencies. Swanson has embedded further credit deterioration in her fair value estimate, as she doesn't expect the challenges in the mortgage market to improve in the near term.

What the Market Is Missing: In Swanson's opinion, the market has tunnel-vision right now, believing the weakness in housing will make it hard for Countrywide to regain its footing. To be sure, Swanson agrees that the mortgage business will drag on results, at least temporarily. But she thinks there is still significant value in the firm and contends that management is making the best of a difficult situation. She thinks Countrywide's large mortgage servicing business, as well as management's efforts to diversify its business mix following the housing slowdown in 2000-01, will enable Countrywide to weather the industry's storm.

MannKind
Moat: None  |  Risk: Speculative  |  Price/Fair Value Ratio: 0.49*  |  Trailing 1-Year Return: -39.8%

What It Does:  MannKind (MNKD) is a biopharmaceutical company focused on discovering, developing, and commercializing therapeutic products to treat diabetes and cancer. The company's Technosphere technology forms the basis of its inhaled insulin program (which is currently in Phase III trials) and is being studied to improve delivery of other metabolism-related drugs. At the end of 2006, MannKind also brought a therapeutic cancer vaccine, known as MKC1106-PP, into development.

What Gives It an Edge: In Morningstar analyst Karen Andersen's view, MannKind lacks a sustainable edge over competitors, reflecting the fact that the firm is speculative biotech concern whose fortunes hinge on the successful launch of its inhaled insulin program, Technosphere. Though Andersen believes that there's reason for highly guarded optimism (as explained further below), the firm has yet to trench out an economic moat.

What the Risks Are: Andersen believes that only those investors with a very high tolerance for risk (i.e., the risk of losing every penny invested) should consider MannKind, explaining her "speculative" risk-rating on the stock. The reason? MannKind's value rests squarely on the shoulders of its inhaled insulin product, which is still in Phase III trials and won't reach the market for another three years, assuming trials are successful. Although clinical trial data have been encouraging so far, in Andersen's view, any unexpected safety concerns or regulatory delays could have disastrous consequences for the company. Exubera has recently entered the market, and it is still difficult to foresee how well inhaled insulin will be received by doctors, patients, and payers alike. Many competitors are also vying with MannKind to enter the market and improve on Exubera's weaknesses.

What the Market Is Missing: In Andersen's opinion, there are two key reasons the stock is undervalued. First, investors equate Technosphere with Exubera, another form of inhaled insulin. And it's no secret that Exubera's launch has been a big disappointment, with physicians skeptical about the benefit over injected insulin (a direct-to-consumer advertising campaign for Exubera has yet to begin). Second, MannKind has not yet partnered Technosphere with a larger biotech or pharmaceutical firm, which is often interpreted as a sign that the product has limited potential. Nevertheless, Technosphere appears to have significant safety and efficacy advantages to Exubera, which could lead to marketing and reimbursement advantages down the road. Also, Exubera's clunky inhaler doesn't appear to have the convenience of MannKind's MedTone inhaler, which fits easily in the palm of the hand. Finally, CEO and Chairman Alfred Mann is a billionaire entrepreneur who has been more than willing to fund the development of Technosphere until the timing is right to make an attractive collaboration agreement.

Other New 5-Star Stocks

* Price/fair value ratios calculated using fair value estimates and closing prices as of Friday, June 1, 2007.

Jeffrey Ptak has a position in the following securities mentioned above: LOW. Find out about Morningstar’s editorial policies.