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Stock Analyst Update

Nine Wide-Moat Stocks on Sale

High-quality names hit 5 stars as the market retreats.

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With the stock market retreating last week, an unusually high number of stocks jumped to 5 stars. All in all, there were more than 60 stocks that crossed the 5-star threshold (for the complete list, click  here), including many high-quality names, such as  Pfizer (PFE) and  Walt Disney (DIS). These two, and a number of other firms mentioned below, carry Morningstar's wide-moat rating--a status assigned to the firms that, in our opinion, have the most durable competitive advantages over their peers. As many of these companies' stocks rarely trade at a suitably large discount (margin of safety) to our fair value estimate, we welcome the opportunity to add them to our bargain bin.

Pfizer
Moat: Wide | Risk: Avg | Price/Fair Value Ratio*: 0.74 | Three-Year Expected Annual Return*: 21.3%

What It Does:  Pfizer  (PFE) is the world's largest pharmaceutical firm, with annual sales near $50 billion. Prescription drugs account for more than 90% of the company's revenue. Top sellers include cholesterol-lowering Lipitor, Celebrex for arthritis, Viagra for impotence, and Lyrica for epilepsy and some types of neuropathic pain. Recently approved drugs with blockbuster potential include oncology drug Sutent and Chantix for smoking cessation.

What Gives It an Edge: According to Morningstar analyst Damien Conover, Pfizer's wide economic moat stems from a robust portfolio of patent-protected drugs and a massive salesforce. Furthermore, Pfizer's enormous cash flows combined with strong scientific know-how afford the firm plenty of opportunities in developing the next generations of drugs.

What the Risks Are: Pfizer faces generic competition, an increasingly stringent Food and Drug Administration, and stronger managed-care negotiating power. Several of its blockbuster drugs are nearing the end of their patent exclusivity periods. New drug development to fill these gaps has become challenging with a more risk-conscious FDA. Additionally, managed care has grown over the past two decades into a powerful entity that can negotiate lower drug prices. While more remote, litigation risks remain, as evidenced by  Merck's (MRK) ongoing cases involving Vioxx.

What the Market Is Missing: Conover believes the market has placed too much emphasis on the company's weak Phase III pipeline and patent losses on several blockbusters. While he expects Pfizer will likely generate flat to slightly down top-line growth over the next 10 years, Conover believes the company can employ external strategies to grow sales. With over $22 billion in cash, Pfizer can acquire growth opportunities through acquisitions. Through internal advancement and acquisitions, Pfizer's Phase III pipeline should grow over the next 18 months. This should increase the market's cash flow projections and boost the firm's stock.

Walt Disney
Moat: Wide | Risk: Below Avg | Price/Fair Value Ratio*: 0.82 | Three-Year Expected Annual Return*: 17.1%

What It Does:  Disney (DIS) owns the rights to some of the most famous characters ever created, including Mickey Mouse, Winnie the Pooh, and the Muppets. These characters and others are featured in several theme parks that Disney owns or licenses around the world. Disney makes live-action and animated films under several labels and owns or has a stake in several popular television networks, including ABC, ESPN, Lifetime, and A&E. Disney owns and operates dozens of TV and radio stations in the U.S.

What Gives It an Edge: Since creating Mickey Mouse in 1928, Walt Disney has developed some of the most popular and enduring animated franchises of all time. In addition to creating and exploiting great content, the company controls a large library of films and owns the powerful Disney and ESPN brands. Morningstar analyst Larry Witt believes these competitive advantages result in a wide economic moat.

What the Risks Are: New technologies are jeopardizing business models throughout the media sector and could still diminish Disney's profitability. Advertisers have been moving money out of cable television, which could cause a slowdown in Disney's important media network business. These ad-supported networks, along with the theme parks and consumer products, could also suffer in the event of an economic recession. Making movies is a hit-or-miss business, which could result in big swings in profitability.

What the Market Is Missing: In addition to creating great content, Disney has been very successful in exploiting that content through box office and home video sales, television network licensing, sequels, theme park attendance, and merchandising. As content migrates to digital platforms, Disney looks to find new ways to attract and retain customers. To that end, the firm has been very aggressively distributing its content through its own Web site and third parties such as iTunes. The market, however, is preoccupied with Disney's other major media property, ABC. The rise of cable television, the emergence of the Internet, and the proliferation of DVRs is leading to lower ratings for the major networks, including ABC. However, Witt estimates that ABC represents less than 10% of Disney's operating income and is not a significant driver for his fair value estimate.

International Business Machines
Moat: Wide | Risk: Below Avg | Price/Fair Value Ratio*: 0.84 | Three-Year Expected Annual Return*: 16.3%

What It Does:  International Business Machines (IBM) is one of the largest IT solutions providers in the world. It designs computer systems, peripherals, and software, and provides related services. The company's hardware products (25% of sales) include a wide range of servers, disk and tape storage systems, and electronic subsystems. IBM is also a leader in middleware software (20% of sales), which enables disparate computer applications to communicate. IBM also offers a broad array of services (53% of sales), including outsourcing, maintenance, and systems integration.

What Gives It an Edge: IBM gets an edge by its ability to deliver globally integrated solutions for enterprise IT. The firm is unrivaled in the breadth and depth of products and services that it can offer to its clients based on their business requirements. Strategic partnerships supplement its capabilities to ensure that it is able to supply the best solutions for clients. As a testament to its strength, IBM has gained market share versus its top rivals in services and hardware servers, and has improved profitability in each of its business segments over the last four years.

What the Risks Are: Key risks include demand fluctuations for hardware and software products, increased competition across its broad product line, lack of accuracy in accounting for revenues and profits from services engagements, and global currency fluctuations.

What the Market Is Missing: Morningstar analyst Rick Hanna thinks the market is spooked by a potential fallout from the financial industry's struggles. Financial-services companies represent approximately one fourth of IBM's total revenue and had a negative impact last quarter on the firm's results in its hardware business. However, recurring revenue (from services and software) is a far larger component of IBM's sales and profits, and Hanna believes it will help the company weather the storm more than most. Furthermore, its global operations also help it to mitigate softness from any one region.

H & R Block
Moat: Wide | Risk: Avg | Price/Fair Value Ratio*: 0.73 | Three-Year Expected Annual Return*: 23.2%

What it Does:  H&R Block (HRB) is the leader in tax preparation and IRS refund loans, which represents roughly two thirds of revenue. It also offers business consulting services through RSM McGladrey, the fifth-largest U.S. accounting firm. The consumer financial segment offers brokerage and investment planning through H&R Block Financial Advisors and full-service banking through HRB Bank. It also operates a mortgage segment, Option One, which is in the process of being sold.

What Gives It an Edge: Morningstar analyst Todd Young attributes H&R Block's success to its scale, brand recognition and market position. The company has 20.3 million U.S. clients, representing roughly 16% of all individual income tax returns. Its revenue is almost 10 times that of its closest competitor, and the firm also offers its products at a lower cost. H&R Block's wide brand recognition, along with an award-winning product, have helped its online offering gain ground on  Intuit's (INTU) TurboTax.

What the Risks Are: The sale of the Option One mortgage business may not be completed. Even if it is, it is likely that only the less-risky mortgage servicing business will be sold. H&R Block will then be left with a significant amount of subprime mortgage loans and will need to wind down its origination business, which will likely cause more impairments. Also, H&R Block faces legal and regulatory issues because of its IRS refund loan practices, which are considered by some to be predatory lending.

What the Market Is Missing: Given the current subprime mortgage market and H&R Block's trouble selling its Option One mortgage unit, investors are shying away from the stock. Young believes the low-investment, high-return tax business is being overlooked because of the current credit crisis. However, Option One represents only a fraction of Young's fair value estimate for H&R Block.

Linear Technology
Moat: Wide | Risk: Avg | Price/Fair Value Ratio*: 0.75 | Three-Year Expected Annual Return*: 20.9%

What It Does:  Linear Technology (LLTC) designs and manufactures standard high-performance analog integrated circuits to a diverse customer base spanning industrial, automotive, communications, and high-end consumer electronics. It offers more than 7,000 types of products to over 15,000 original equipment manufacturers globally. Most of its products support functions such as power management, data interface, and conversion. More than 70% of its revenue is derived from international markets.

What Gives It an Edge: According to Morningstar analyst Dan Su, Linear boasts a wide economic moat thanks to its exceptional talent pool and highly differentiated products. The company can offer complex, research-heavy designs for analog chips that few competitors can match. As a result, it has consistently commanded high premiums for its products, generating healthy gross and operating margins over the past decade.

What the Risks Are: Linear is vulnerable to a broad-based slowdown in the semiconductor industry, although its exposure to diverse end markets may help cushion some impact. As the company sets a high bar for profit margins, it may have difficulty identifying suitable new projects to expand sales. Although Linear's strategy is to compete on functionality and performance rather than price, it still may face some pricing pressure, since the high-end analog market has become more crowded in recent years.

What the Market Is Missing: Su believes some investors are under the impression that the chipmaker focuses on high-priced components that limit its market reach. Su disagrees with this sentiment, however, and believes Linear has achieved its remarkable margins by taking advantage of its massive production scale and superior product quality. As long as the company continues to woo its customers with unique designs and excellent chip performance, Su thinks it will maintain its generous margins.

Other New 5-Star Stocks
 Lloyds TSB Group (LYG)
 Comcast (CMCSA)
 Cadbury Schweppes (CSG)
 Paychex (PAYX) 

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Nov. 9, 2007.

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