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Stock Analyst Update

Market Rebound Leaves These Two 5-Star Stocks Behind

Two stocks with 20%-plus expected returns.

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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.

As the U.S. stock market plunged during the first weeks of January 2008, more and more high-quality stocks sank into 5-star territory each week, creating opportunities for astute investors willing to weather the storm. Last week, buyers were rewarded, as the market rebounded sharply, lifting the Dow Jones Industrial Average 4.4%. These market gyrations are not for the faint of heart, and at Morningstar we tend to overlook short-term stock-price movements, instead anchoring investment decisions to the fundamental values of the underlying businesses. This strategy allows us to separate market "noise" from the individual businesses' true worth, and take advantage of potential mispricings.

Just as plunging stock prices caused new 5-star stocks to sprout up each week, the market's rally has trimmed this week's list to only a few. However, we think these two stocks have been unjustly left behind and offer patient investors an opportunity to earn healthy returns.

EMC Corporation
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio*: 0.73 | Three-Year Expected Annual Return*: 22.0%

What It Does: EMC (EMC) is a leading provider of hardware, software, and services for enterprise network storage. Its legacy was built on leading-edge proprietary storage hardware. During the last couple of years, the company has increased its focus on its software and services segments, which now generate more than 50% of overall revenue. About 50% of sales are through partners including original-equipment manufacturers and resellers.

What Gives It an Edge: EMC is the market leader in networked storage hardware and software. Morningstar analyst Grady Burkett thinks the vendor's competitive advantage stems from its large installed customer base and focus on product integration and support. The amount of data stored on corporate systems is roughly doubling every two years, and the growing volume is leading to increasingly complex data centers. As a result, businesses look to EMC to provide better software management and integration services to meet their evolving storage needs. Furthermore, IT managers fear network disruptions above all else. Burkett believes EMC's customers find it safer and easier to buy more products and services from EMC than assume the risk of installing a competitor's solution.

What the Risks Are: EMC faces significant competition from established storage companies, such as IBM (IBM) and Hitachi (HIT), as well as a reorganized Hewlett-Packard (HPQ). Profit margins could be pressured as EMC is forced to offer lower-cost systems to compete in the small and medium business market. Additionally, EMC's large number of acquisitions brings a significant and continual degree of integration risk.

What the Market Is Missing: Burkett thinks the market fears a repeat performance of the technology meltdown from seven years ago, when EMC's sales fell nearly 40% over a two-year period. Because EMC has taken deliberate steps to reduce this risk, Burkett believes the company is in a much better position to weather an economic slowdown this time around. In 2000, the bulk of EMC's sales came from its storage systems hardware, with software and services accounting for less than one fourth of revenues. IT departments are typically quick to cut hardware spending during rough economic times, while renewing software licenses and service contracts to ensure business continuity. EMC now has its hands in all aspects of data management, and it generates more than half its revenues from its stickier software and service offerings. Burkett thinks the company has also done a nice job of diversifying its customer base, with more revenues coming from international markets and smaller enterprises than in 2000.

NightHawk Radiology Holdings
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio*: 0.71 | Three-Year Expected Annual Return*: 23.4%

What It Does: NightHawk Radiology Holdings (NHWK) provides radiology interpretation services to U.S. health-care providers during both daytime and nighttime hours. The company maintains operations in the U.S., Australia, and Switzerland, where its contracted radiologists provide reads during their regular business hours. NightHawk's direct clients include more than 700 radiology groups covering 24% of all U.S. hospitals.

What Gives It an Edge: Morningstar analyst Karen Yiu views NightHawk as a heavyweight in the nighttime teleradiology industry. While most of its rivals consist of a handful of radiologists operating solely within a region or state, NightHawk's 90 radiologists and client base amounting to over 25% coverage of all U.S. hospitals facilitate both a large volume of daily radiology interpretations and better use of each radiologist's time, an important factor considering the running shortage of U.S. radiologists. NightHawk intends to gain greater scale by acquiring smaller U.S.-based competitors, which Yiu believes will serve to increase its exposure to the budding daytime teleradiology market.

What the Risks Are: Yiu gives NightHawk an average risk rating, given the noncyclical nature of the radiology industry and the firm's established contracts with its clients and radiologists. The company has no exposure to Medicare and Medicaid reimbursement. However, if its final interpretation business takes off, NightHawk may be exposed to reimbursement risk as those organizations can reduce the profitability of covered services. NightHawk could risk overpaying for its acquisitions.

What the Market Is Missing: Yiu believes worries about increasing price competition within the industry and uncertainty about NightHawk's position in its new daytime teleradiology business have caused the market to discount the firm's profitable operations, its leading industry position, and its steadfast claim over the industry's scarcest resource: U.S. radiologists. Yiu contends that NightHawk's efficient processes, its relatively high customer retention rate, and industry growth opportunities make the stock a bargain.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Feb. 1, 2008.

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