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Stock Analyst Update

Market Dip Spells Opportunity for Bargain-Hunters

Dozens of stocks hit 5 stars during last week's swoon.

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.

BioMed Realty
Moat: Narrow  | Risk: Avg  |  Price/Fair Value Ratio: 0.71  |  Trailing 1-Year Return: -24.1%

What It Does:  BioMed Realty  is a real estate investment trust that owns and develops laboratory and office space for the life science industry. The company's tenants include biotech and pharmaceutical firms, research institutions, and government agencies. The firm's nearly 100 buildings constitute almost 9 million square feet and are located in markets recognized for life science research. BioMed also has a development pipeline and land bank that comprise about 2.4 million square feet internationally.

What Gives It an Edge: In Morningstar analyst Heather Smith's estimation, BioMed has carved out a narrow moat by focusing on an under-penetrated niche in the commercial real estate market--laboratory space in the life sciences. The firm has built a collection of premiere facilities in life sciences cluster markets such as San Francisco, Boston, and San Diego, and also possesses a large network of contacts in order to make wise leasing decisions. Tenants are also extremely sticky given their substantial investments in customizing lab space, and sign multiyear leases that cover most property operating expenses. As a result, BioMed's return on real estate assets is solid at 10%.

What the Risks Are: Smith believes that BioMed courts average business risk, meaning that she'd invest in the shares at a moderate discount to her fair value estimate. Because BioMed is focused exclusively on life sciences, it is vulnerable to any slump in the sector. A decline in research and development spending at pharmaceutical companies, or a drop in government funding for research, would adversely affect cash flows and the company's ability to fully cover the dividend.

What the Market Is Missing: Shares of real estate investment trusts have taken a tumble year-to-date, falling nearly 15% on worries about rising interest rates and pricey stock valuations. BioMed itself has seen its stock plunge 26% despite strong earnings reports and promising new development projects. Given its conservative capital structure and business strategy, Smith believes the company has little exposure to rising interest rates and, thus, thinks the shares are attractively valued at current levels. In Smith's view, the firm's growth prospects remain bright as more pharmaceutical companies sell their real estate and as funding for life sciences research climbs.

Deerfield Triarc Capital
Moat: None  |  Risk: Above Avg  |  Price/Fair Value Ratio: 0.59  |  Trailing 1-Year Return: -2.1%

What It Does:  Deerfield Triarc  is a specialty finance company with nearly $10 billion in assets. Deerfield Triarc recently announced its intentions to acquire its external manager, Deerfield Capital Management, a privately held asset manager that has $14.2 billion in assets under management. Investment-grade residential mortgage-backed securities constitute 90% of Deerfield Triarc's investment portfolio; although management expects to reduce this position to 80% in favor of alternative investments.

What Gives It an Edge: Morningstar analyst Erin Swanson doesn't think that Deerfield Triarc merits an economic moat. The firm hasn't been in the business of buying mortgage-backed securities for long. Moreover, it's particularly challenging for firms to differentiate themselves from rivals in this commodity market, where competition is already fierce and the field is only growing more crowded. In addition, Deerfield Triarc is at the mercy of the external capital markets to fund the expansion of its investment portfolio, an undesirable position, in her view.

What the Risks Are: Swanson thinks that Deerfield Triarc rates above-average business risk, meaning that she'd invest in the shares only at a significant discount to her fair value estimate. Swanson believes interest rate risk is a big stumbling block at Deerfield Triarc, as there is a disconnect between the maturities of assets and liabilities, with long-term residential mortgage-backed securities funded by short-term repurchase agreements. This scenario ultimately creates profit volatility relative to changing interest rates. In Swanson's opinion, the fact that Deerfield's profitability is highly dependent on something that is completely out of its control is a challenging proposition.

What the Market Is Missing: Swanson thinks Deerfield Triarc Capital is a compelling value right now. In a move that she believes will enhance the firm's competitive position, Deerfield Triarc announced its intentions to acquire its external manager, Deerfield Capital Management, an asset manager with about $14.2 billion in assets under management. In Swanson's estimation, this acquisition will add $5 per share of value to the overall firm, the effects of which Swanson doesn't believe the market is fully taking into account. Swanson believes that the deal will help diversify Deerfield Triarc's operations by injecting a large base of fee income into its revenue stream. Further, it should reduce Deerfield Triarc's sensitivity to interest-rate changes, which is the biggest challenge facing the firm. And while fear surrounding the mortgage market might be weighing on Deerfield Triarc's shares, it doesn't especially concern Swanson, as more than 91% of the firm's residential mortgage-backed securities are high investment-grade.

Isilon Systems
Moat: None  |  Risk: Above Avg  |  Price/Fair Value Ratio: 0.53  |  Trailing 1-Year Return: NA

What It Does:  Isilon Systems  is a high-growth storage vendor specializing in storage systems for digital assets, such as audio, video, and digital images. The solution depends on a proprietary storage operating system called OneFS, which lowers customers' management costs for a cluster of storage boxes. The overall system can scale larger than traditional storage systems by connecting multiple storage boxes that can be accessed and managed as one unit.

What Gives It an Edge: Morningstar analyst Rick Summer points out that while traditional storage systems are great at storing large numbers of small blocks of data, they perform poorly holding large files that need to be accessed simultaneously by a large number of users. However, storing large files that are not easily separated (e.g., heavy graphical images or video) is much more difficult. Isilon's proprietary storage products help customers store and manage these large files with great flexibility. In fact, storage needs are expanded almost as easily as blowing air into a balloon. As a result, Isilon's existing customer base has been a steady source of new revenues for the company, representing approximately 50% of last quarter's revenues. If Isilon can continue to grow, these existing customers may become the source of a strong competitive advantage.

What the Risks Are: Summer believe that Isilon poses above-average business risk and, thus, would demand a wide margin of safety when investing in the shares. The company faces several risks, including competition from a host of startups such as Exanet and Polyserve, as well as large companies like  EMC ,  NetApp , and  Sun Microsystems . As many companies may look to consolidate their number of storage vendors, Isilon may be shut out of future sales opportunities. Finally, the company faces execution risk as it moves into new geographies and new industries.

What the Market Is Missing: Summer thinks the market is overly focused on the uncertainty of short-term results. Because Isilon is a hyper-growth company growing in excess of 50% annually, Summer believes Isilon's long-term growth opportunity is the most important area for investors to focus on. Furthermore, due to the company's small size, Summer doesn't expect linear growth (which is why he demands a large margin of safety when investing in the shares). As Internet companies, cable companies, and medical companies continue to starve for storage capacity to hold their video and images, Summer thinks Isilon is in the sweet spot of storage.

Office Depot
Moat: None  |  Risk: Avg  |  Price/Fair Value Ratio: 0.70  |  Trailing 1-Year Return: -30.5%

What It Does:  Office Depot  supplies office products and services to consumers and businesses, directly or through affiliates, in 42 countries. It operates more than 1,160 office supply superstores in North America and about 360 stores overseas. Office Depot also sells products via the Internet and its direct salesforce. The North American retail division makes up about 45% of revenue, while the North American business solutions and international divisions make up 31% and 24%, respectively.

What Gives It an Edge: Office Depot's wide customer reach and considerable economies of scale constitute competitive advantages, in Morningstar analyst John Gabriel's opinion. However, Office Depot,  Staples , and  OfficeMax  all have similar business models and sell essentially the same products. Since there is little opportunity for differentiation among rivals, advantages stem from supply-chain efficiencies and go to the company with the lowest cost structure. While Office Depot has made considerable strides recently in improving profitability under the leadership of CEO Steve Odland, who joined the company after a successful stint at auto-parts retailer  AutoZone , it isn't the low-cost producer. Thus, Gabriel doesn't think the company warrants a moat.

What the Risks Are: Gabriel rates Office Depot average risk, meaning that he'd demand a moderate margin of safety when purchasing the shares. The main risk facing Office Depot is the intense rivalry in the industry and the aggressive store-opening plans of its two main competitors, Staples and OfficeMax. The company must also contend with increasing competition during peak selling seasons from mass merchants such as  Wal-Mart ,  Target , and  Costco . In addition, by weighting its merchandise mix toward technology (computers, printers, etc.), the company exposes itself to competition from retailers such as  Best Buy  and  Circuit City .

What the Market Is Missing: In June 2007, Office Depot warned of decelerating sales and scaled back its plans for new store openings. Though this will temper total top-line growth, Gabriel thinks it's a smart move, as it will allow the company to focus on enhancing profitability through improved supply-chain processes and store-level productivity. Prudence of that strategy notwithstanding, the company also stumbled recently in integrating Allied Office Products, which it acquired in May 2006, stoking concerns about its ability to retain Allied Office customers. Nevertheless, Gabriel views these problems as short-term setbacks rather than intractable fundamental issues and, thus, thinks Office Depot is well positioned to benefit when the tide turns. Furthermore, Gabriel thinks that there's plenty of room for Office Depot to grow anew considering the fragmented state of the office-supply market as well as the firm's potential to expand overseas.

Moat: Wide  |  Risk: Avg  |  Price/Fair Value Ratio: 0.75  |  Trailing 1-Year Return: -13.5%

What It Does:  Progressive  underwrites private and commercial auto insurance and has almost 10 million policies in force (PIF). It is the third-largest auto insurer in the United States. The company markets Drive Insurance policies through more than 30,000 independent insurance agencies in the United States and Canada. Direct-marketed policies, sold under the Progressive brand online and via telephone, represent about 36% of total PIF, while agent-marketed policies represent the remaining 64%.

What Gives It an Edge: In Morningstar analyst Jim Ryan's view, Progressive's superb underwriting and pricing model is the best in the auto insurance industry. This allows Progressive to accurately assess the consequences of rating changes and the effect on the bottom line. In Ryan's view, this capability, along with strong claims service and advanced technology, confers a wide economic moat.

What the Risks Are: Ryan thinks that Progressive courts average business risk. Progressive's key risks are a lapse in underwriting discipline that causes underwriting losses and an increasingly hostile competitive environment that is driven by firms cutting prices to steal business. Consumer groups have been lobbying state governments to outlaw the use of credit reports in underwriting decisions. If they succeed, Progressive's "financial responsibility" algorithm would need to be replaced, which might temporarily reduce the firm's underwriting margins. We think this is a low-probability risk. Progressive's wide margins are a helpful cushion.

What the Market Is Missing: With falling rates and an increasingly competitive auto insurance market, Ryan believes investors should be gravitating to the more experienced and reliable companies such as Progressive. Ryan also thinks the market is not granting full credit to Progressive's recently announced $4 billion recapitalization plan, which will pay a $2 per share dividend in September of this year. Ryan also points out that the firm is slated to repurchase about 100 million shares over the next two years.

Sealed Air
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.71  |  Trailing 1-Year Return: 19.7%

What It Does:  Sealed Air  is divided into two segments: food packaging and protective and specialty packaging. In food packaging, its Cryovac line protects various meat and vegetable products as they pass through the supply chain. In protective packaging, its Bubble Wrap, Jiffy packaging, and Instapak products (among others) are used to secure industrial and retail goods as they travel to the end user. Related equipment revenue makes up 10% of sales.

What Gives It an Edge: In Morningstar analyst Parrish Glover's view, Sealed Air's moat is built on its research spending to develop packaging products tailored to the specific needs (i.e., freshness, shelf life, protection) of various customers, the results of which are usually patentable. The company's global scale and patent protections also create an opportunity to leverage an idea globally for other customers.

What the Risks Are: Glover thinks that Sealed Air courts average business risk and, thus, would demand a moderate discount to his fair value estimate before investing in the shares. Plastic resins, which make up about one third of Sealed Air's cost structure, have escalated in price, forcing the company to pursue price increases. However, these have taken time and effort to implement, so profitability has been somewhat slow to recover. The company's fortunes are closely tied to the global economy. Recessionary effects on manufacturing or a curtailment of free-trade practices would reduce demand for Sealed Air's offerings.

What the Market Is Missing: Sealed Air's growth is being driven by ongoing trends in global manufacturing, which creates demand for protective packaging, and the resulting socioeconomic trends of a developing middle class and increased wealth among the working class, particularly in Latin America and Asia. Increasing industrialization and urbanization leads to changing dietary habits as people consume more protein, which is increasingly purchased in packaged form. The market may be underestimating this potential for international growth. Alternatively, the market may be overlooking Sealed Air's pricing power for its patented products. Costs of plastic resin have been rising for the past two years, and there is a lag effect for price increases to catch up. If resin costs remain high, ongoing operating improvements will boost margins by 2009. If resin costs fall, recent price increases will supplement the internal savings.

Sunstone Hotel Investors
Moat: None  |  Risk: Avg  |  Price/Fair Value Ratio: 0.75  | Trailing 1-Year Return: -7.5%

What It Does:  Sunstone Hotel Investors  is a real estate investment trust that owns more than 50 upscale hotels. Most of the company's assets carry Marriott brands, with the rest carrying the Hyatt, Hilton, Intercontinental, and Fairmont brands. Almost a third of the firm's hotel properties are in California. Before its 2004 initial public offering, Sunstone sold its hotel management department to Interstate Hotels & Resorts.

What Gives It an Edge: Sunstone has built an impressive collection of upscale hotels primarily in Southern California. The properties are well located in their markets, but the firm hasn't earned a moat in Morningstar analyst Jeremy Glaser's book. Sunstone is forced to take market prices for its rooms, and the business is highly sensitive to the vagaries of the larger travel market. Furthermore, Sunstone doesn't have the scale to substantially drive down operating costs.

What the Risks Are: Glaser thinks Sunstone courts average business risk. The firm's heavily concentrated upscale portfolio is vulnerable to sudden drops in overall business travel and sluggishness in California markets. Also, an earthquake in California or another large-scale terrorist attack could hurt the firm's bottom line.

What the Market Is Missing: There has been fear that growth in the hotel market is slowing after years of healthy increases in both occupancies and nightly rates. Even though growth is, in fact, slowing, Glaser doesn't think this is a huge problem for Sunstone. Almost all of the current growth is coming from increases in rates and not occupancy. This will help Sunstone become more profitable since there is little incremental cost in charging guests a higher price versus having to accommodate more guests. Glaser thinks worries about new construction bringing rates down are overblown. The bulk of new hotel openings are midscale properties in suburban markets, which are not direct competitors with Sunstone's. Glaser points out that it will be years before developers are able to build new product in the firm's core urban markets.

Warner Music Group
Moat: Narrow  |  Risk: Above Avg  |  Price/Fair Value Ratio: 0.61  |  Trailing 1-Year Return: -45.9%

What It Does: With about $3.5 billion in revenue,  Warner Music Group  is one of the largest music companies in the world. More than 80% of Warner's revenue comes from recorded music, which has a roster of almost 40,000 artists. The rest of Warner's sales come from music publishing. Warner Music was formerly a subsidiary of  Time Warner , was purchased by a consortium of private equity investors in 2004, and is now a public company trading on the NYSE.

What Gives It an Edge: As one of the largest music companies in the world, Warner owns a huge catalog of hit songs that can be monetized for many years in a variety of ways including CD sales, digital sales, and licensing to film studios and advertisers. Also, by owning some of the best labels in the music industry, Warner is able to continually attract top musical talent. Taken together, Morningstar analyst Larry Witt believes that these traits make for a narrow economic moat.

What the Risks Are: Witt thinks that Warner courts above-average business risk. Digital piracy has been a major disruption to the music industry. If Warner can't convince consumers to pay for digital music, our forecasts might be too optimistic. Another concern is Warner's debt load, a legacy of the company's buyout from Time Warner. Warner doesn't have much flexibility, and most of its cash must go to servicing debt. With more than half its revenue coming from outside the United States, Warner also faces currency risk.

What the Market Is Missing: Like its peers, Warner Music continues to suffer from the decline in physical sales as consumers increasingly rely on digital downloads and file-swapping for their music. Witt believes that piracy and the ability to digitally purchase single tracks as opposed to entire albums will lead to continued revenue declines for Warner and the industry. However, Warner seems to be suffering less than its peers. During the first quarter of 2007, CD sales slipped 17% industrywide, but only 5% for Warner. In addition, Warner has done a better job, in Witt's opinion, of distributing its content through digital sales than its peers. Witt also thinks the market is overlooking the smaller, but fast-growing ancillary markets like mobile music and licensing to video games.

Other New 5-Star Stocks

 Advance Auto Parts 
 Allied Irish Banks 
 Associated Banc-Corp 
 Atmos Energy 
 Basic Energy Services 
 Bed Bath & Beyond 
 Best Buy 
 Cadbury Schweppes 
 Charlotte Russe Holding 
 Chico's FAS 
 CIT Group 
 Devon Energy 
 EOG Resources 
 First American 
 First Horizon National 
 First Potomac Realty Trust 
 Foot Locker 
 Fulton Financial 
 Hovnanian Enterprises 
 Huntington Bancshares 
 International Coal Group 
 James River Coal Company 
 Municipal Mortgage & Equity 
 Newcastle Investment 
 Newfield Exploration 
 PG & E (PCG)
 PMI Group 
 Primus Guaranty 
 Ryland Group 
 Siemens (SI)
 St. Joe (JOE)
 Standard Pacific 
 Talisman Energy 
 Tuesday Morning 
 Universal Health Realty (UHT)
 Urban Outfitters (URBN)
 Ventas (VTR)

* Price/fair value ratios calculated using fair value estimates and closing prices as of Friday, July 27, 2007.

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