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Stock Analyst Update

Two Stocks with 15%-Plus Expected Returns

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.

Crosstex Energy, Inc.
Moat: Narrow | Risk: Below Average | Price/Fair Value Ratio*: 0.83 | Three-Year Expected Annual Return*: 16.3%

What It Does:  Crosstex Energy Inc. (XTXI) is the general partner of  Crosstex Energy LP (XTEX), a midstream natural-gas master limited partnership (MLP) that gathers, transports, processes, treats, and markets natural gas and natural-gas liquids, primarily in Texas and Louisiana. The company operates gas gathering systems in the Barnett Shale, South Texas, and Louisiana, owns large processing operations in South Louisiana, and operates the largest natural-gas treating operations in the Gulf Coast region.

What Gives It an Edge: Morningstar analyst Jason Stevens believes Crosstex has dug a narrow economic moat by building a large asset base and offering producers a variety of services and market-access options. Through a string of acquisitions, Crosstex has assembled an impressive asset base of natural-gas gathering and transmission systems and treating and processing facilities, primarily in Texas and Louisiana. These assets enable the company to provide a full suite of field services to natural-gas producers, who pay Crosstex to gather natural gas at the wellhead, remove any impurities, separate the gas from natural-gas liquids, provide compression and transportation to market hubs or interstate pipelines, and market their natural gas to utilities and end-users. Because of the incentive distributions common to most MLPs, XTXI sees its share of XTEX's cash distributions increase as XTEX raises its distribution to common unitholders.

What the Risks Are: Crosstex is betting on the Barnett Shale to provide earnings growth for years to come, which, in Stevens' opinion, is perhaps the largest competitive risk facing the company. Crosstex faces stiff competition from other midstream companies for producers' gas. Any further declines in Gulf Coast gas production may further reduce the earnings power of the company's South Louisiana Processing assets. Additionally, evolving industry regulation, spills, and explosions are always risks.

What the Market Is Missing: Barnett Shale production is booming, with hundreds of new wells completed each month. Crosstex connects these wells to the nation's pipeline system, and booming production means more and more gas flowing through Crosstex's gathering systems and processing plants, which Stevens expects will translate directly into robust distribution growth. Given the credit crunch, some investors may fear that Crosstex's growth is constrained by reduced access to debt markets, but Stevens hasn't seen much evidence of financing difficulties in the MLP sector. Moreover, much of Crosstex's near-term growth will come from past projects and deals.

Scotts Miracle-Gro
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.75 | Three-Year Expected Annual Return*: 20.9%

What It Does:  Scotts Miracle-Gro (SMG) is a world leader in lawn and garden care. The firm manufactures and markets a variety of plant nutrients and pesticides under the Scotts, Miracle-Gro, Ortho, and Roundup brand names. Its products are carried by large retail chains throughout North America and Europe. Scotts Lawn Service is one of the largest lawn-care providers in North America. The firm also owns Smith & Hawken, a leading manufacturer of patio furniture and outdoor accessories.

What Gives It an Edge: Morningstar analyst Ben Johnson assigns Scotts a narrow moat. Scotts' North American business, which accounts for more than 70% of total sales, benefits from having a deep roster of successful brand names. The firm's core brands, Scotts and Miracle-Gro, have built a solid reputation based on decades of proven performance in delivering healthy plants and thick, green lawns. The company has a market share of 50% or greater in all but one of the categories in which it participates. By investing 7%-9% of sales into marketing these products, the firm has captured 85% of total media exposure in the category, making its merchandise the only option in the minds of many consumers.

What the Risks Are: Demand for the company's products is extremely sensitive to weather patterns. Unfavorable gardening conditions could undercut demand. Scotts' products are faced with highly volatile input costs linked to fluctuating natural-gas and grain prices, making profitability in these lines difficult to predict. Large retailers account for the majority of Scotts' revenue. The cooling of any of these relationships could significantly harm sales.

What the Market Is Missing: While Scotts is certainly not immune to the effects of a slowing U.S. economy, Johnson asserts its sales are far less economically sensitive than the market assumes. Most of Scotts' products retail for less than $10, making them far from a discretionary purchase--especially considering the uncompromising nature of Scotts' customers when it comes to keeping their lawns and gardens healthy. Furthermore, during periods of economic softness consumers tend to stay close to home and typically spend more time tending to their gardens. Over the longer term, Scotts stands to catch a strong tailwind from the rapidly growing baby boomer demographic--one of the fastest-growing segments of the U.S. population, and the one that participates most broadly in the lawn and garden category.

Other New 5-Star Stocks
 Infosys Technologies (INFY)
 Allscripts Healthcare Solutions (MDRX)
 Wipro (WIT)
 Schering-Plough (SGP)
 Dover (DOV)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Jan. 11, 2008.

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