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Stock Analyst Update

Wide-Moat Retailer Looks Cheap after Earnings Miss

Plus several other stocks that recently 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.

Walgreen Company
Moat: Wide |  Risk: Average  |  Price/Fair Value Ratio*: 0.70  |  Three-Year Expected Annual Return*: 22.7%

What It Does:  Walgreen Company  (WAG) operates more than 5,700 drugstores in 48 states and Puerto Rico. Prescription drugs account for 64% of total sales. The remainder of sales includes nonprescription drugs, consumables, and general merchandise. Walgreen also provides health-care services beyond traditional pharmacy services through Walgreens Health Services, its managed-care division, and Take Care Health Systems, a wholly owned subsidiary that manages convenient care clinics inside drugstores.

What Gives It an Edge: According to Morningstar analyst Mitchell Corwin, a consistent approach in building larger, free-standing stores on convenient high-traffic corners has given Walgreen the best collection of real estate in the drugstore industry, and has enabled the firm to prosper. The store statistics bear out the firm's success at finding the best corners. Corwin estimates that a Walgreen store, on average, fills about 275 prescriptions per store per day, compared with less than 200 for the average drugstore chain. More productive stores equate to better earnings per store, robust free cash flow, and the highest returns on invested capital of any drugstore chain. 

What the Risks Are: Walgreen faces no shortage of competition, and recent merger activity from peers,  Wal-Mart's (WMT) $4 generic prescription offering, and ongoing efforts by other retailers like supermarkets to boost pharmacy sales are all threats. Ratcheting up acquisition activity might prove to be a more expensive way to grow and pressure returns on invested capital in the longer term. Reimbursement rates for prescription drugs continue to be at risk as health-care sponsors try to find ways to reduce costs.

What the Market Is Missing: In Corwin's opinion, Walgreen's earnings miss was margin-related, and had nothing to do with any softness in store traffic. Although weak margins may persist for the next two or three quarters, the company should be able to rein in expenses while not missing a beat on store growth. Walgreen's store-growth trajectory remains compelling, with room for the firm to double its existing store base over the long run. Corwin believes the recent sell-off has given investors a great opportunity to acquire shares of one of the best retailers with strong multiyear growth prospects at a very reasonable price.

For more on Walgreen, see Pat Dorsey's recent video report.

Other New 5-Star Stocks
 Buckeye GP Holdings  (BGH)
 Zebra Technologies Corporation  (ZBRA)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Oct. 5, 2007.

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