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Stock Analyst Update

Oil, Financials Firms Poised to Deliver 20% Returns

See the latest stocks to hit 5 stars.

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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.

Apache
Moat: Narrow  |  Risk: Average  |  Price/Fair Value Ratio*: 0.77  |  Three-Year Expected Annual Return*: 20.5%

What It Does:  Apache (APA) is one of the oil patch's largest independent exploration and production companies. Although most of its wells are in North America, Apache also has operations in the North Sea, Argentina, Australia, and Egypt. The company has about 2.4 billion barrels of oil equivalent in its proven reserves, a little more than half of which is in natural gas. It produces more than 500,000 barrels of oil equivalents a day.

What Gives It an Edge: Morningstar analyst Justin Perucki has awarded Apache (and many of its peers) a narrow economic moat rating, mainly because of OPEC. By limiting its members' production, OPEC manipulates oil prices higher. This lifts profitability in what would otherwise be a brutally competitive commodity market. Apache also benefits from the stranded nature of natural gas, which keeps prices artificially high. If oil or natural-gas prices were to drop in the near term due to a slowdown in economic activity, Apache's strong balance sheet and relatively low-cost asset base should allow it to weather the down cycle with ease. Moreover, the firm should be in good position to grow shareholder value by snapping up assets at distressed prices from less fortunate peers.

What the Risks Are: Perucki thinks that Apache courts average business risk, meaning that he'd be an enthusiastic investor in the shares at a moderate discount to his fair value estimate. With profits heavily dependent on commodity oil and gas prices, a sustained downturn in prices would crimp Apache's results. Spills, terrorism, and higher taxes are ever-present risks, as well.

What the Market Is Missing: With oil prices still hovering around $70 per barrel, it appears the market is overly concerned about near-term natural-gas prices. Relatively mild weather over the past two years, coupled with strong domestic production growth, has pushed spot prices to around $5 per thousand cubic feet (mcf). However, Perucki believes natural-gas prices will average just shy of $7.50 per mcf over the next five years. North American finding and development costs have increased dramatically over the past few years, and Perucki thinks the price required to induce new marginal producers to invest in new supply is around $7-$8 per mcf over this time period. On the low end, Perucki thinks the large installed base of gas-fired power plants should help support prices above $5 per mcf. Although liquefied natural gas should displace some high-cost domestic production over the next five years, Perucki doesn't see it as a significant threat.

Apollo Group
Moat: Wide  | Risk: Avg  |  Price/Fair Value Ratio*: 0.76  |  Three-Year Expected Annual Return*: 19.7%

What It Does:  Apollo (APOL) is the largest for-profit education company, with about 300,000 students. It focuses on working adults and operates 259 campuses and learning centers in 39 states as well as various international locations. Programs range from associate to doctorate degrees in areas such as business, education, health care, technology, and social and behavioral sciences.

What Gives It an Edge: Apollo's wide economic moat is driven by a few factors in Morningstar analyst Todd Young's estimation. For one, it's the largest for-profit university in the country, with the University of Phoenix boasting high brand recognition. Second, by focusing on working adults, Apollo is able to keep costs and, thus, tuition low by eliminating dorms, sports, health care, and other nonessential services. Third, strict government-imposed barriers to entry help to keep competitors at bay. Finally, since corporate- and government-aided funding limits the immediate out-of-pocket outlay that students must make in order to finance their education, Apollo enjoys breathing room with which to judiciously increase tuition rates. Consequently, the firm has been able to grow tuition well above the rate of inflation.

What the Risks Are: Young believes that Apollo poses average business risk. As younger, less financially secure students at the firm's Axia College constitute a larger portion of the student population, bad-debt expenses are likely to increase. Selling and promotional costs have also jumped as Apollo markets itself to potential students. Unless these costs stimulate top-line growth, operating margins will narrow. In addition, Apollo is vulnerable to changing perceptions of for-profit education quality. For instance, if employers come to view Apollo's curriculum more dimly, they could pull the funding they'd given any corporate-sponsored students or direct it elsewhere.

What the Market Is Missing: Young believes that the stock is trading at a hefty discount to his fair value estimate due to investor fears over slowing enrollments, declining margins, an options-backdating issue, and delayed financial filings. Yet, the SEC concluded its investigation into the options-backdating issue without levying any penalties. What's more, Apollo is now up to date on its filings. In addition, enrollment growth has started to pick up again and if the economy slows it should continue to grow even faster, as a weaker job market typically stimulates additional enrollments. And while margins have declined amid higher up-front marketing costs, Young thinks that as these investments begin to bear fruit, in the form of higher enrollments, margins should rebound.

Barclays
Moat: Wide  |  Risk: Avg  |  Price/Fair Value Ratio*: 0.76  |  Three-Year Expected Annual Return*: 22.7%

What It Does:  Barclays  (BCS) is one of the largest banks in the United Kingdom and has a collection of high-quality businesses. These include U.K. banking, which serves retail and business customers in the U.K.; Barclays Capital, a debt-focused investment bank; international banking, which serves retail and business customers in Europe, Africa, and Asia; Barclays Global Investors, an asset manager; and Barclaycard, a large credit card issuer.

What Gives It an Edge: Morningstar analyst Erin Davis believes that two factors earn Barclays a wide economic moat: the company's large market share in its main business lines (retail and business banking, credit-cards, investment banking and asset management) and its energetic, entrepreneurial management team. While market share doesn't always create a moat, it's more important in banking than in other businesses. Barclays boasts a large branch network and deep, sticky relationships with its customers, which makes it difficult for those customers to switch providers. This, in turn, has helped Barclays to earn an 18.5% average return on equity over the last five years. Davis is also a big fan of Barclays' management team, whose aggressive style has been a key ingredient to its recent successes, which have included a turnaround of the firm's retail banking franchise as well as a boom in its investment banking and international banking businesses.

What the Risks Are: In Davis' view, Barclays business risk rates average. Barclays is growing rapidly under the direction of a number of newly appointed outsiders in management positions. So far, management's strategies appear sound, but Barclays will suffer losses if the new management team fails to jell or if it misjudges risks in the bank's newer markets.

What the Market Is Missing: Two issues are chiefly responsible for the decline in Barclays' stock price. Davis concurs with the first issues--that Barclays' bid for ABN Amro is excessive given that the two banks have little overlap and limited room for cost cutting. Accordingly, she has reduced her fair value estimate for Barclays by $8 per share, notwithstanding the fact that it's far from certain that the deal will go through. Barclays' share price is also suffering because of the market's general fear of anything associated with credit, especially subprime. Barclays will certainly be affected, but Davis thinks the market's reaction is overblown. True, Barclays' investment bank is a big player in structured debt and, thus, fee income will no doubt decline amid the recent market turmoil, with significant investment losses remaining a distinct possibility. However, investment banking isn't going away. While the investment banking unit's product mix may change after all is said and done, client demand for sophisticated debt and equity products will not evaporate. In addition, Davis notes that Barclays had a very strong first half, which will help cushion any bad news in the back half of this fiscal year.

Darden Restaurants
Moat: Narrow  |  Risk: Below Avg  |  Price/Fair Value Ratio*: 0.81  |  Three-Year Expected Annual Return*: 17.9%

What It Does: In 1968, Bill Darden opened the first Red Lobster, which eventually grew into  Darden Restaurants (DRI), a portfolio of 1,323 casual dining restaurants in the United States and Canada. Chains include the flagship Red Lobster (680 units) and Olive Garden (614 units), as well as newer concepts Bahama Breeze (23 units) and Season 52 (seven units). With the planned acquisition, Darden portfolio will also include LongHorn Steakhouse (287 units) and The Capital Grille (28 units).

What Gives It an Edge: Olive Garden and Red Lobster delivered total annual sales of $2.8 billion and $2.6 billion, respectively, last fiscal year. In Morningstar analyst John Owens' view, this scale affords Darden tremendous buying power and allows its brands to leverage the efficiency of national advertising. As evidence of its narrow moat, Owens notes that Olive Garden, which is the leading Italian dining chain, has delivered positive same-restaurant sales growth for 51 consecutive quarters. Meanwhile Red Lobster, which has been recognized as the nation's best seafood restaurant 18 years in a row by Restaurants & Institutions magazine, has delivered positive growth in nine of the past 11 quarters. Owens thinks Darden's performance has been especially impressive in the last few years, as many other casual dining chains have suffered continual declines in same-restaurant sales in the face of soaring gas prices, rising interest rates, and waning consumer confidence. Despite these challenges, Darden has consistently delivered returns on invested capital that comfortably exceed Owens' estimate of its cost of capital.

What the Risks Are: Owens thinks that Darden courts below-average business risk. As such, he wouldn't demand an especially wide margin of safety to invest in the shares. That said, there are salient risks to consider. To wit, with the Red Lobster and Olive Garden chains approaching saturation, Darden's long-term growth will depend more on its recently acquired brands, as well as its two other concepts that have not yet proved their long-term viability. A challenging consumer environment could lead some of Darden's customers to scale back their spending at its restaurants. A rise in food, labor, energy, and/or occupancy costs could also drag on profitability.

What the Market Is Missing: With concerns about a slowdown in consumer spending, the market has been indiscriminately selling a number of retail stocks recently, including shares of restaurant companies. Nevertheless, Owens doesn't think the recent sell-off in Darden shares is warranted when one considers the firm's resilient performance. Further, Owens does not believe that the challenging macroeconomic environment will persist indefinitely. As it currently stands, Darden shares are trading at a 19% discount to Owens' fair value estimate (which is based on a discounted cash-flow analysis) and at just 13.6 times forward earnings, versus a market multiple of 15.5 times. This is the first time that Darden's stock has traded in five-star territory since Morningstar began covering the company more than four years ago.

Other New 5-Star Stocks
 Cathay General Bancorp (CATY)
 Chesapeake Energy (CHK)
 Digirad (DRAD)
 Infinity Property and Casualty (IPCC)
 Toll Brothers  (TOL)
 Valeant Pharmaceuticals (VRX)
 White Mountains Insurance Group (WTM)
 ZymoGenetics (ZGEN) 

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, August 24, 2007.

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