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Stock Analyst Update

Narrow Moats, Big Returns for These 5-Star Stocks

Two stocks with 20%-plus expected returns.

Mentioned: , , ,

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.

Williams Partners L.P.
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio*: 0.75 | Three-Year Expected Annual Return*: 20.6%

What It Does: Williams Partners (WPZ) is a master limited partnership with interests in gas gathering pipeline and processing facilities that were acquired in stages from its parent, Williams Companies (WMB). The company was formed in 2005 by Williams Companies, which manages and owns more than 22% of the MLP. Williams Partners owns interests in U.S. Rockies, Mid-Continent, and Gulf Coast plants that gather and process natural gas from major onshore and offshore fields.

What Gives It an Edge: Morningstar analyst Catharina Milostan thinks Williams Partners has a leg up over many MLPs because of its close ties with its parent, Williams Companies, and well-situated gas gathering and processing operations in the heart of fast-growing U.S. fields. Milostan believes these traits give the firm two ways to grow. First, its parent has shown a willingness to carve out assets for Williams Partners with more than $2 billion sold to the MLP since 2005. Also, Williams Partners has organic growth opportunities in several "hot spots" where new fields need more gas gathering and processing services. Milostan thinks the firm's existing network of facilities gives it a head start for expansion projects in deepwater Gulf of Mexico, San Juan Basin, and the U.S. Rockies. Well-placed facilities with reputable operating histories often get first crack in connecting new wells, justifying a narrow moat for Williams Partners.

What the Risks Are: As with gas midstream peers, Williams Partners' primary risk is a prolonged drop in gas prices that would lead to lower gas production and lower demand for the company's gathering and processing services. Its operations in the Gulf Coast, including offshore pipelines, are exposed to potential storm or infrastructure disruptions. Changes in environmental regulations or tax law treatment for MLPs may also negatively affect the firm.

What the Market Is Missing: Master limited partnerships have been under pressure due to market fears that the current credit crunch may limit funding for growth. But, Milostan points out that Williams Partners' expansion projects are backed with customer contracts lined up in advance to make sure a steady cash stream flows from new projects. Milostan believes the firm has a full plate of growth projects already under way to drive cash distribution growth. In addition, Milostan contends that its steady cash generation from gas midstream operations in growing fields plus several home-grown expansion projects give Williams Partners an edge over competitors that need to acquire assets for growth.

MGM Mirage, Inc.
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio*: 0.70 | Three-Year Expected Annual Return*: 24.2%

What It Does: MGM Mirage (MGM) owns and operates casinos in Nevada, Mississippi, and Michigan. MGM acquired Mandalay Resort Group in 2005, adding casinos such as Mandalay Bay, Luxor, and Excalibur to its portfolio, which already included the likes of the Bellagio, MGM Grand, New York-New York, Mirage, and Treasure Island. The firm also owns a 50% interest in the Borgata in Atlantic City and a joint venture in Macau. MGM is also constructing the $7 billion Project City Center on the Strip.

What Gives It an Edge: Morningstar analyst Sumit Desai credits MGM Mirage with a narrow economic moat. The firm controls almost 50% of the hotel rooms, 39% of all slots, and 38% of the table games on the Las Vegas Strip. The company also owns almost 250 acres of underutilized or undeveloped land on the Strip. Desai believes MGM's leading market share of hotels and gaming positions on the Strip gives the firm pricing power and helps maintain disciplined growth among competitors. In addition, the company is expanding aggressively into other markets, namely Macau and Atlantic City. Desai thinks MGM's strong portfolio of brand names, such as Bellagio and Mandalay Bay, carry a strong cachet even in nongaming regions, giving the company an opportunity to enter into the resort business as well.

What the Risks Are: MGM Mirage's revenue is highly dependent on the Las Vegas market. Disruptions in air travel could send shock waves through the local economy. The company's high leverage makes it even more vulnerable to any downturn. Finally, an upcoming surge in gaming capacity on the Las Vegas Strip could lower the returns on MGM's Project City Center.

What the Market Is Missing: Desai believes the market is overly concerned with the impact a consumer-spending slowdown would have on MGM and other casino operators in general. MGM earns about 75% of its profit from Strip properties, all of which are heavily dependent on travel trends, which could slow during a recession. However, Desai considers the gaming industry to be relatively economically resilient. Although incremental gamblers may choose to postpone their trips to Vegas during the short term, a healthy convention business should help offset any leisure visitors. Also, Desai's valuation for the firm is more dependent on MGM's ability to grow via new developments, like CityCenter on the Strip and MGM Macau, and less on short-term fluctuations in revenue and profits. Desai assumes only modest growth for the company's existing properties, with strong growth coming from the company's new-property pipeline.

Other New 5-Star Stock
Resources Global Professionals (RECN)


* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Feb. 15, 2008.

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