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Stock Analyst Update

Five Stocks That Look Poised to Notch 20%-Plus Returns

Plus, the market dumps dozens of other stocks in the bargain bin.

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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.

Ecolab
Moat: Narrow  |  Risk: Below Average  |  Price/Fair Value Ratio*: 0.84  |  Three-Year Expected Annual Return*: 15.5%

What It Does:  Ecolab (ECL) produces and sells cleaning products and services to institutional, hospitality, and industrial customers. The company's products include detergent, vehicle-care, and pest-elimination products, among others. Ecolab's major customers are restaurants, hotels, hospitals, and schools. The firm has a strong international presence: Almost half of its revenue comes from abroad.

What Gives It an Edge: In Morningstar analyst Ben Johnson's view, Ecolab's primary advantage over rivals is its scale. In the highly fragmented global cleaning and sanitizing market, Ecolab is the only player large enough to serve big accounts like  McDonald's (MCD) and Four Seasons in all corners of the globe. Furthermore, portions of its business have a razor-and-razor-blades model, where the firm has an installed asset on its client site (such as a dispenser for dishwashing detergent) and also provides the consumable (the actual detergent). This creates substantial switching costs for Ecolab's customers and simultaneously generates a lucrative recurring revenue stream. Taken together, these advantages earn Ecolab a "narrow" economic moat.

What the Risks Are: A pronounced economic downturn could decrease the number of meals consumers purchase outside the home or the quantity and duration of hotel stays. Either of these factors would cause a substantial decrease in demand for Ecolab's products and services. Because roughly half of its sales are made overseas, Ecolab also faces significant currency risk.

What the Market Is Missing: While Ecolab's North American business is firing on all cylinders, its overseas operations have historically been a sore spot. The firm is in the midst of a massive overhaul of this business and has been investing heavily to help bring its performance in line with its North American operations. As a result of this increased level of spending, the international business' operating margin has stagnated over the past few quarters. Johnson continues to believe that these investments will pay off over time and that the international segment will perform neck-and-neck with North America over the long run.

Mexican Economic Development
Moat: Narrow  | Risk: Avg  |  Price/Fair Value Ratio*: 0.76  |  Three-Year Expected Annual Return*: 22.6%

What It Does:  Mexican Economic Development (FMX), also known as "Femsa," is made up of four holding companies: Coca-Cola Femsa is the largest Coke bottler in Latin America and the second-largest in the world; Femsa Cerveza brews beers, such as Tecate and Dos Equis; and Femsa Comercio owns the Oxxo chain of convenience stores, which is growing rapidly. Other operations include packaging and logistics. Femsa owns 53.7% of Coke Femsa and controls a majority of the voting shares. All other operations are 100%-owned by Femsa.

What Gives It an Edge: Femsa maintains strong market positions in several Latin American beverage markets and a dominant chain of convenience stores in Mexico. Although Morningstar analyst Matthew Reilly thinks the company has built a moat with these operations, his concerns regarding the long-term legality of exclusive relationships with retailers in Mexico and the general instability of several countries where Femsa operates limit the moat to narrow.

What the Risks Are: In Reilly's view, Femsa poses average business risk. Femsa's businesses had been solid and steady, but the company faces debt, foreign currency, and antitrust risk. Some of the firm's South American revenue comes from traditionally unstable currencies and governments. Raw-material costs are likely to be high in the near term. High energy costs are also likely to dent near-term profitability and pinch consumer spending. Coke Femsa has had flareups with Coke over concentrate pricing, and this does not seem to be totally resolved.

What the Market Is Missing: Femsa's share price has been very volatile lately, hurt by depressed gross margins in the company's beer business, but also getting caught up in some of the broad-market volatility we have experienced recently. Reilly thinks the market is substantially underestimating the long-term value of Oxxo, which is growing rapidly and expanding operating margins on the way to becoming a dominant force in Mexican retailing.

International Speedway
Moat: Wide  |  Risk: Avg  |  Price/Fair Value Ratio*: 0.76  |  Three-Year Expected Annual Return*: 20.2%

What It Does:  International Speedway (ISCA) is a leading promoter of motor sports in the United States. It owns and operates 12 tracks, including the mecca, Daytona International Speedway in Daytona, Fla.--also the location of the firm's headquarters. Although its mainstay is a steady supply of Nextel Cup stock car races, International Speedway hosts truck, motorcycle, and other competitions as well. The France family has controlled both Nascar and International Speedway since inception.

What Gives It an Edge: Morningstar analyst Joel Bloomer sees two primary facets to International Speedway's wide moat: barriers to entry and intangible assets. ISC tracks range in size from 35,000 to nearly 170,000 (more than twice the size of the largest NFL stadium). There are few markets that can support stadiums of this size in different sports, and virtually none that can support two racetracks of this caliber. With the largest number of high-profile tracks in attractive markets, ISC is way ahead of the competition. Intangible assets also contribute to ISC's wide moat as fans identify with storied racetracks such as Daytona International Speedway just as they do Wrigley Field here in Chicago. However, unlike Wrigley, Daytona and other racetracks aren't restricted by historical landmark status. Thus, as demand grows, ISC can add grandstand seats, luxury suites, and merchandise points to its stadiums, making the construction of competing tracks even less attractive and strengthening ISC's intangible asset advantage.

What the Risks Are: Bloomer believes that International Speedway courts average business risk. The primary risk facing International Speedway is antitrust litigation. There have been complaints in the past that race allocation has not been competitive. Previous litigation has ended without doing much damage to ISC's operations; still, future disputes may not end favorably. In Bloomer's opinion, Nascar has consumers' best interests in mind, and he thinks there's enough demand to support more competition without damaging ISC's moat.

What the Market Is Missing: In Bloomer's view, the market is focusing too much on short-term challenges and not enough on ISC's ability to generate cash. The company failed in its attempts to gain sufficient support for the construction of two new tracks: one in the Northwest and one in the Northeast. While this diminishes growth potential, Bloomer was happy to see management nix the deals when prospective returns were depressed to unacceptable levels by the demands of local governments. In addition, the extremely difficult process in gaining approval for new track construction highlights the advantages that ISC's existing tracks currently enjoy. Also weighing on the stock is an antitrust case that's been brought against ISC and Nascar, alleging collusion in race-schedule development. It's difficult to know what the outcome of this litigation will be, but, in Bloomer's opinion, the demands (such as competitive bidding for race dates) would be detrimental to the sport and fans, making an adverse ruling unlikely. Meanwhile, ISC's solid free cash flow generation continues.

MarineMax
Moat: None  |  Risk: Avg  |  Price/Fair Value Ratio*: 0.70  |  Three-Year Expected Annual Return*: 25.3%

What It Does:  MarineMax (HZO) is the largest recreational boat dealer in the United States, 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 because 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.

Terex
Moat: None  |  Risk: Avg  |  Price/Fair Value Ratio*: 0.77  |  Three-Year Expected Annual Return*: 21.9%

What It Does:  Terex (TEX) manufactures equipment for use in construction and mining. Its construction equipment includes dump haulers and off-highway rigid and articulated haulers, scrapers, wheel loaders, mobile cranes, and aerial lift equipment. In addition, Terex produces heavy-duty trucks and related components. Approximately 60% of the company's total sales now come from outside the United States.

What Gives It an Edge: Terex was formed through the combination of several individual equipment manufacturers that formerly operated independently within a holding company structure. That arrangement effectively prevented these companies from establishing the economies of scale, strong dealer networks, or brand recognition needed to trench out defensible competitive advantages (firms like  Caterpillar (CAT) and  Deere & Co. (DE) boast these attributes in spades). However, with Terex's transition to a more operations-focused business model over the last few years, Morningstar analyst John Kearney sees a moat slowly taking shape. For instance, by outsourcing its most capital- and labor-intensive production processes and consolidating other in-house operations, Terex has been able to lower fixed costs and, thus, generate higher returns on invested capital (41.5% through 2007's first half). The next downturn will ultimately prove whether Terex is indeed digging itself a moat, rather than simply coasting on a strong cyclical tailwind. However, Kearney is inclined to lean toward the latter.

What the Risks Are: Kearney thinks that Terex courts average business risk. Terex relies heavily on commercial and government construction spending; these sectors are subject to pronounced, and in some cases, prolonged, cyclical downturns. While both end markets are in the midst of a strong investment cycle, a sharp drop-off in spending would affect our assumptions dramatically.

What the Market Is Missing: Contrary to what the market may assume, Terex has minimal exposure to the U.S. housing market (5% to 7% of revenue). As a result, Kearney does not believe that the housing downturn will negatively impact Terex to the same degree as it's likely to affect the company's rivals. Furthermore, Terex's late-cycle businesses are just starting to heat up. For instance, the company's cranes segment saw 23% revenue growth in the second quarter and backlog increased 75%--providing an ample stream of future business. With continued top-line growth opportunities over the next few years fueled by the global infrastructure construction boom and another 200-300 basis points of anticipated margin expansion from the company's supply chain improvements and lean-manufacturing initiatives, Kearney believes Terex is capable of achieving its lofty $12 billion revenue and 12% operating margin targets for 2010.

Valeant Pharmaceuticals International
Moat: None  |  Risk: Average  |  Price/Fair Value Ratio*: 0.76  |  Three-Year Expected Annual Return*: 22.2%

What It Does:  Valeant Pharmaceuticals (VRX) sells more than 400 branded products, mainly in its neurology, infectious disease, and dermatology core specialties. No single drug in the firm's portfolio contributes more than 10% of total sales or has more than $100 million in revenue. The company has worldwide operations and generates roughly 60% of its product sales outside North America. Valeant employs a salesforce of more than 1,500 people and has several products in its development pipeline.

What Gives It an Edge: Valeant may derive some benefit from its global operations, but the firm lacks a sustainable edge over rivals. The primary reason for this, in Morningstar analyst Jeff Viksjo's view, is that unlike most other specialty pharmaceutical firms, Valeant lacks a clear therapeutic focus. Although the firm explicitly targets drugs in neurology, infectious disease, and dermatology, almost half of its revenue falls outside these three areas. As a result, Valeant's salesforce is diluted across multiple other specialties. Thus, while Viksjo thinks Valeant can benefit from its international reach (it boasts an established salesforce in Latin America, Asia, and Europe), make acquisitions on a global scale, or attract profitable in-license deals with smaller domestic firms, he's not convinced that the company can trench out a formidable competitive position in any one market, explaining why it doesn't merit an economic moat.

What the Risks Are: Valeant holds about $500 million in debt due by 2011. With only $300 million in cash, the firm may need to raise additional funds to repay the principal, either by issuing shares or new debt. Also, Valeant has a high degree of fixed costs in its business, such as its salesforce and interest payments. These costs increase the volatility of earnings, as they do not rise and fall with sales. Lastly, Valeant will lose its royalty revenue by 2010, which contributes greatly to profits.

What the Market Is Missing: Viksjo thinks Valeant will become more-specialized and cost-effective in the long run. Currently, Valeant suffers from offering multiple unrelated products, which inflate costs and cannot be marketed or sold together. However, Valeant now has several late-stage drug candidates that target its core neurology and infectious disease markets. If these drugs are approved, Valeant will not need to create a new salesforce to support them, but instead can market them alongside its old ones to the same doctor groups. In so doing, Viksjo believes Valeant will produce greater profits in the future, and spend less for each new dollar of revenue it generates. Also, Viksjo thinks Valeant will repeat its success through further acquisitions and in-license deals. In total, Viksjo thinks Valeant will improve operating margins to about 20% by 2011, from an expected 8% in 2007.

WestAmerica Bancorp
Moat: Narrow  |  Risk: Below Avg  |  Price/Fair Value Ratio*: 0.83  |  Three-Year Expected Annual Return*: 16.9%

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
  3M (MMM)
 Abraxis BioScience (ABBI)
 Administaff (ASF)
 Ambac Financial Group (ABK)
 AMN Healthcare Services (AHS)
 Ann Taylor Stores (ANN)
 Bayer AG (BAY)
 CarMax (KMX)
 Cathay General Bancorp (CATY)
 Crosstex Energy (XTXI)
 Deutsche Bank (DB)
 Directed Electronics (DEIX)
 Enterprise Products Partners LP (EPD)
 First American (FAF)
 Hovnanian Enterprises (HOV)
 Infineon Technologies (IFX)
 Macy's (M)
 Moody's Corporation (MCO)
 Morgan Stanley (MS)
 Municipal Mortgage & Equity (MMA)
 Nucor (NUE)
 Orleans Homebuilders (OHB)
 RAM Holdings (RAMR)
 Ryland Group (RYL)
 Sempra Energy (SRE)
 Sonic (SONC)
 Steel Dynamics (STLD)
 Symantec (SYMC)
 Walt Disney (DIS)
 Wilmington Trust (WL)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Monday, August 13, 2007.

 

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