Bargains Sprout Up as Market Dips
20 firms hit 5 stars amid recent downturn.
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: Narrow | Risk: Below Avg | Price/Fair Value Ratio: 0.84* | Trailing 1-Year Return: 13.9%
What It Does: AGL Resources (ATG) is primarily a regulated natural-gas-distribution utility company that generates more than 95% of its revenues by servicing 2.2 million customers in Georgia, New Jersey, Virginia, Florida, and Tennessee. The company is also involved in natural-gas marketing, wholesale services, and energy investments, including LNG investments. In November 2004, the company acquired the operations of NUI Corporation for $691 million.
What Gives It an Edge: Morningstar analyst Paul Justice thinks that AGL will be a standout performer versus its natural-gas distribution peers for years to come. Regulated returns on its monopolistic infrastructure investments lay the foundation of its "narrow" economic moat, and its low operating costs and above-average customer growth give it better relative earnings growth prospects.
What the Risks Are: In Justice's opinion, AGL courts below-average business risk. The major risk for AGL is regulatory risk. Justice believes that rate design is as important, if not more so, than allowed returns on rate base, but three consecutive adverse rate cases in AGL's primary territory have illustrated how regulators can hold back growth. The benefits that regulators grant with decoupled rate structures often come at the expense of lower allowed returns. AGL must navigate the waters of its five jurisdictions carefully to achieve an attractive balance of returns versus risk.
What the Market Is Missing: AGL's regulated income stream in its largest service territory, the heart of Georgia, is among the most secure Justice has come across. AGL's revenue decoupling mechanism--a way of charging customers a standard fee regardless of how much volume is consumed--shields the company's cash flows from consumer consumption habits, including weather and price-induced conservation. Despite this income stability, regulators have still allowed the company to collect returns commensurate with its peer average. Given its strong dividend yield with above-average growth prospects, Justice thinks investors should strongly consider the shares while they're on sale.
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio: 0.75* | Trailing 1-Year Return: 30.1%
What It Does: Alleghany (Y) is an investment holding company that uses a value-oriented philosophy to acquire interests in attractive businesses. The firm purchases fractional and outright stakes and generally holds investments for long periods. Alleghany's three insurance subsidiaries--RSUI Holdings, Capitol Transamerica, and Darwin Underwriters--supply a broad range of specialty, property, and casualty protection. Subsidiary Alleghany Properties is a Sacramento, Calif., landlord.
What Gives It an Edge: In Morningstar analyst Justin Fuller's view, Alleghany merits a "narrow" economic moat for a few reasons. First, the firm's value-oriented investment structure provides a useful advantage. By sharply focusing on buying businesses it expects to own for long periods, Alleghany's team can pursue opportunities that competing investors with shorter horizons shun. Management looks to invest at a 50% discount to fair value and balances risk by looking for opportunities with $3 of upside for every $1 of downside, which Fuller considers a sensible approach to boost returns. Second, Fuller is impressed by Alleghany's wholly owned insurance subsidiaries, as the holding company can also pledge its equity investments as insurance capital, effectively using that capital twice. The largest of these firms, RSUI, seeks to develop an expertise in lines of insurance for specialty or hard-to-place risks. This information advantage helps RSUI earn small price premiums on the policies it writes. What's more, since RSUI's underwriters are compensated only for underwriting profitability, they are encouraged to refuse business that doesn't meet the firm's underwriting criteria. As such, Fuller expects RSUI--and, thus, Alleghany's--underwriting profitability to remain strong, which should boost growth in book value per share over the long haul.
What the Risks Are: Fuller rates Alleghany's business risk as average. The firm faces the risk that a large hurricane or earthquake could cause sizable losses in its insurance subsidiaries. What's more, if Alleghany doesn't buy enough reinsurance protection--as in 2005--losses of this type could diminish the firm's liquidity. However, Fuller thinks Alleghany learned from its Katrina losses and has restructured its risk portfolio to better withstand catastrophic events. In addition, since Alleghany is very acquisitive, it could possibly overpay for an acquisition, but given management's impressive track record, Fuller views this risk as minimal.
What the Market Is Missing: In Fuller's opinion, the market is missing Alleghany's long-term orientation and apparently doesn't believe the firm's insurance operations (which provide float for investments, etc.) are as valuable as he thinks they are. Specifically, the market is missing some of the value in Alleghany's RSUI subsidiary.
Moat: Narrow | Risk: Below Avg | Price/Fair Value Ratio: 0.81* | Trailing 1-Year Return: 9.5%
What It Does: Consolidated Edison (ED) is a holding company for two regulated utilities (Con Ed of New York and O&R) that provide steam, natural gas, and electricity to customers in southeastern New York--including New York City--and parts of New Jersey and Pennsylvania. The company's electric utility operations generate 77% of Con Ed's operating revenue.
What Gives It an Edge: Con Ed is a regulated "wires and pipes" utility with dependable, steadily expanding income and dividends. Regulated earnings, coupled with Con Ed's difficult-to-reproduce infrastructure, earn the firm a "narrow" economic moat. Aging assets and demand growth in New York City and neighboring areas are driving a massive capital investment program at Con Ed. Over the next three years, the company will invest nearly $4 billion--about 50% above historical levels. Given Con Ed's supportive regulatory environment, Morningstar analyst Ryan McLean is confident the company will earn an attractive risk-adjusted return well into the future.
What the Risks Are: McLean believes that Con Ed poses below-average business risk. Although it weathered the uncertainties of deregulation, Con Ed is still susceptible to regulatory risk. Investments beyond planned levels would lead the firm to seek higher rates, potentially generating political pushback--especially in light of the above-average rates that Con Ed has been granted in the past.
What the Market Is Missing: Con Ed's future hinges in part on regulators' ongoing willingness to grant the firm an appropriate return on its investments. The company has called for a material $1.2 billion rate increase to reflect its rapidly rising capital outlays. The market, in McLean's opinion, may have assigned an unduly elevated risk premium to this request. Regulators are conscious of both New York's strategic need for dependable energy (recently emphasized by the Department of Homeland Security) and Con Ed's outstanding reliability record. They are therefore likely, in McLean's view, to accommodate the bulk of Con Ed's spending program. Even if Con Ed were to suffer a regulatory setback, McLean thinks the firm's low-risk distribution model and solid dividends would help buffer long-term investors.
Moat: None | Risk: Avg | Price/Fair Value Ratio: 0.76* | Trailing 1-Year Return: -26.1%
What It Does: MarineMax (HZO) is the largest recreational boat dealer in the U.S., with 88 retail locations in 22 states. It sells new and used recreational boats, including sport, cruiser, and yachting vessels, with a focus on premium brands. MarineMax also sells related marine products, including engines, trailers, parts, and accessories. In addition, the firm arranges boat financing, insurance, and extended-service contracts and provides repair, maintenance, brokerage, and storage options.
What Gives It an Edge: In Morningstar analyst Marisa Thompson's opinion, MarineMax does not have a moat--in large part because the firm is a dealer that relies on manufacturers for floor plan financing and wholesale supply. MarineMax's wholesale price is determined by the manufacturer, and there is not a huge amount of leverage in the business (though the firm is able to negotiate some volume discounts since it's the largest dealership in the country).
What the Risks Are: Thompson believes that MarineMax poses average business risk. The company is subject to terms dictated by boat manufacturers regarding financing, rebates, allocations, and customer service. The dealership industry is highly fragmented, and the intensity of competition for customers and even dealer locations continues to escalate. Boating is seasonal in some geographic markets, and sales may also be hurt by weather, including hurricanes or drought. The company engages in the repair and resale of boats, which can expose MarineMax to liability if the repairs are faulty.
What the Market Is Missing: Thompson thinks that the boating industry is entering a cyclical downturn and, thus, MarineMax's sales will decline over the coming years. For instance, the firm has been discounting more heavily to move inventory and remain price-competitive with other dealers that are in worse financial shape. However, Thompson expects that, as with other downturns, the boating industry will eventually recover. By contrast, the market appears to be extrapolating near-term results in perpetuity, ostensibly explaining why it has pushed the firm's stock price down to a level that approximates book value (if one includes the excess market value above book for assets on the balance sheet--namely real estate). But MarineMax remains the preferred dealership to the premium boat manufacturers, which are trimming allocations to underperforming dealerships or those that lack the customer-service edge. Thus, as weaker competitors exit the industry, Thompson expects MarineMax to build on its growing market share and continue increasing its higher-margin services revenue.
Molson Coors Brewing Company
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio: 0.74* | Trailing 1-Year Return: 32.1%
What It Does: Molson Coors (TAP) is the fifth-largest brewer in the world. Major brands include Coors Light, Molson Canadian, Carling, Blue Moon, Killian's, Zima, Caffrey's, Worthington's, and Keystone. Its largest markets by volume are America (56%), the U.K. (26%), and Canada (19%). Broken down by comparable operating profit, the company's largest operations are Canada (61%), America (30%), and the U.K. (10%). The company recently sold its majority interest in Brazilian brewer Kaiser.
What Gives It an Edge: In Morningstar analyst Matthew Reilly's view, Molson Coors' Canadian operations are indicative of a wide-moat firm. It is part of a duopoly with a very rational competitor in Ambev that is unwilling to compete on price. While a tough competitive environment in Europe and Molson's sub-scale positioning to Anheuser Busch (BUD) in the U.S. keep it from a wide-moat rating overall, Canada still accounts for over 60% of companywide operating profits.
What the Risks Are: Reilly believes Molson Coors courts average business risk. The merged company faces integration risk. Prolonged pricing wars in its main markets would depress profits, as happened in 2005. The company is at a major scale disadvantage to Anheuser-Busch in the U.S. beer market in terms of production and distribution. In the beer industry, weak volume can quickly lead to declining profitability because of high fixed costs. Converting Canadian dollars and U.K. sterling into U.S. dollars entails constant foreign-exchange risk.
What the Market Is Missing: Reilly thinks that the integration of Molson and Coors is ahead of schedule, and that management's projected cost cuts are obtainable. Profitability in Europe seems to have stabilized after a couple of terrible years, and the company has right-sized the operation after suffering volume declines. Coors' U.S. operations have also been notoriously inefficient due to long shipping distances from Golden, Colo., but some of these costs should be reduced by the opening of a modern brewery in Shenandoah, Va., and continued cost synergies with Molson. While Reilly's analysis is fundamental and discounted-cash-flow-driven, Molson Coors could also be in the crosshairs of industry consolidator SABMiller, as evidenced by recent comments from SABMiller's Norman Adami and the recent adoption of a golden parachute plan for Molson Coors management. Reilly does not think that this is a growth story by any means. Rather, it is a cost-cutting story, but one that seems to be working amid a challenging commodity-cost environment.
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio*: 0.73 | Trailing 1-Year Return: 4.0%
What It Does: Thomson (TMS) offers digital media hardware, software, and distribution services to the entertainment and media industries. The company operates three divisions: services (DVD, VHS, and CD replication and distribution), systems and equipment (television broadcast cameras and set-top boxes), and technology (patent and software licenses).
What Gives It an Edge: Thomson boasts an edge over competitors in a few areas. Thanks to its new asset base, Thomson has become a centralized provider of digital media solutions and content distribution around the globe. As movie studios and networks continue to demand fast replication and secure delivery of content, Thomson has emerged as one of the few firms capable of satisfying their pressing needs. Given the company's globally integrated processing and distribution capabilities, Morningstar analyst Irina Logovinsky believes Thomson has built a "narrow" economic moat around its operations. Logovinsky also thinks Thomson's edge in the DVD replication business is helping the company to grow its content services segment (i.e., editing and special effects). The market for such services is still largely fragmented, and given Thomson's resources and existing customer relationships, it should be able to acquire a substantial market share. Furthermore, a continued migration to a digital format should benefit many of Thomson's operations, such as providing cinemas and networks with digital equipment as well as content preparation for digital distribution.
What the Risks Are: Thomson faces a multitude of risks, including its ongoing integration of multiple acquisitions and its ability to manage so many new and unfamiliar business lines. The company's DVD replication business is quickly maturing and is more susceptible to cyclical forces. The low-end nature of many of Thomson's current services and customer concentration are also concerns.
What the Market Is Missing: The market is concerned that Thomson's DVD business is going to fall off the cliff due to the proliferation of digital downloading of movies from the Internet. True, the DVD-replication business has decelerated, but that's largely because consumers have finished upgrading their home DVD collections. However, they're still buying DVDs, but now they are more selective, purchasing just their new favorite titles. Logovinsky also thinks we're likely years away from a large-scale shift away from DVDs for a few reasons. First, a lack of digital rights management standards and the slow adoption of fiber-optic cable (capable of quick high-definition movie delivery over the Internet) mean that the DVD business is here to stay, at least for the foreseeable future. Second, movie studios are still dependent on DVD sales, which constitute a large portion of their profits, and studio executives remain very committed to physical media. Third, the DVD business is hampered by a war between two high-definition standards (HD DVD and Blu-Ray), but it should recover once a single standard emerges and consumers start adopting the new technology.
Moat: Narrow | Risk: Below Avg | Price/Fair Value Ratio*: 0.84 | Trailing 1-Year Return: -6.7%
What It Does: Based in San Rafael, Calif., WestAmerica (WABC) focuses its lending activities on small business and commercial real estate. The bank offers commercial lending, mortgage banking, cash management, and other financial services. WestAmerica has more than $5 billion in assets across more than 80 branches in Northern and Central California.
What Gives It an Edge: WestAmerica carved out a very profitable niche serving small to midsize businesses and their owners. WestAmerica combines the personal attention of a community bank with the sophisticated products of a large institution to attract high-quality customers. By emphasizing the personal touch, the bank strives to form long-lasting relationships with its clients. In Morningstar analyst Michael Kon's opinion, these relationships widen the bank's economic moat and reduce its business risk.
What the Risks Are: Kon believes that WestAmerica poses below-average business risk. With the majority of its loans in commercial real estate in Northern California, WestAmerica's concentrated book of loans poses a risk. Despite its strong balance sheet, Kon believes the business would suffer if the regional economy produced an extended decline in real estate values.
What the Market Is Missing: WestAmerica trades at a discount because the market has doubts about future growth and the impact of the downturn in real estate. Kon, however, is confident that this enormously profitable bank will continue to produce good results.
Other New 5-Star Stocks
* Price/fair value ratios calculated using fair value estimates and closing prices as of Thursday, June 7, 2007.
Jeffrey Ptak has a position in the following securities mentioned above: TFC. Find out about Morningstar’s editorial policies.