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Stock Analyst Update

The Price Is Right for These New 5-Star Stocks

Three 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.

Quest Diagnostics, Inc.
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.72 | Three-Year Expected Annual Return*: 22.4%

What It Does: Quest Diagnostics (DGX) is a leading provider of laboratory testing services, and it generated more than $6 billion in revenue in 2006. The firm's clinical testing segment accounts for roughly 92% of sales. The remainder is attributable to clinical-trial testing services and its risk-assessment business.

What Gives It an Edge: According to Morningstar analyst Alex Morozov, Quest is the largest player in the independent diagnostic services field and a leader across all major product lines. The company has built an enormous infrastructure, with more than 2,000 patient service centers nationwide, and continues to expand its reach by acquiring smaller regional labs. In addition, Quest is putting significant effort into expanding its product offering, retraining its personnel, and investing in new information technology. Morozov believes these efforts, along with the company's large testing centers network, scientific know-how, and commitment to quality, should provide Quest with a competitive advantage over smaller rivals for years to come.

What the Risks Are: With nearly 18% of revenue derived from Medicare and Medicaid, Quest is sensitive to regulatory changes. Potential reimbursement rate adjustments, as well as a proposed competitive bidding process for clinical services, could hurt revenue. The company also faces the possibility that hospitals may elect to keep more testing in-house in lieu of outsourcing. Finally, growing popularity of point-of-care testing could reduce the need for the firm's services, particularly for routine tests.

What the Market Is Missing: Morozov notes that Quest's stock has not recovered since the company lost its largest customer more than a year ago. The firm revealed more bad news over the last three months, taking $240 million in write-offs related to the ongoing investigation of its now-discontinued test kit unit. While the noise surrounding Quest has been by and large negative, Morozov thinks the firm should bounce back nicely in the upcoming year. Morozov points out that the firm has successfully renewed the majority of its remaining contracts, integrated the acquisition of a large anatomic pathology business, rolled out a myriad of state-of-the-art diagnostic tests, and continues to expand its geographic presence nationwide. Quest also generates robust operating cash flows, close to $1 billion per year, which Morozov contends should make its cash-flow yield of almost 10% attractive to a long-term investor.

IMS Health, Inc.
Moat: Wide | Risk: Average | Price/Fair Value Ratio*: 0.73 | Three-Year Expected Annual Return*: 21.9%

What It Does: Based in Fairfield, Conn., IMS Health (RX) provides salesforce effectiveness, product portfolio optimization, brand management, and consulting services to the pharmaceutical industry. The firm offers these services by leveraging its database of prescription and over-the-counter drug sales. IMS uses almost 30,000 data suppliers to keep track of 90% of U.S. drug sales and 75% of sales in more than 100 countries.

What Gives It an Edge: Morningstar analyst Rafael Garcia credits IMS Health with a wide economic moat. IMS possesses a global database of drug prescription and sales information that pharmaceutical companies rely on to measure their sales. The company's hard-to-replicate database covers more than 1 million products from more than 3,000 drug manufacturers. Garcia believes any potential competitor trying to build a similar repository on a global scale would require significant resources and time. Also, Garcia points out that IMS assists drug companies in analyzing market trends and developing tailor-made applications, which further strengthens the firm's competitive position.

What the Risks Are: IMS faces two key risks. First, the company derives the majority of its revenues from drug companies, leaving the company exposed to fluctuations in demand from this industry. Second, a growing wave of privacy concerns over commercial use of prescribing information has spurred legislative changes. For example, a New Hampshire law aimed to restrict the collection and use of such information for profit purposes was recently struck down. However, other states have proposed similar laws.

What the Market Is Missing: In Garcia's view, IMS' weak stock price is due to a market overreaction to the current woes afflicting the drug industry. Some pharmaceutical companies are currently redesigning their sales and marketing operations, which have delayed the closing of a few transactions with IMS. Nonetheless, in light of the recent slowdown in demand for some of its solutions, Garcia likes that IMS is successfully adding profitable new services, such as business process outsourcing. Moreover, Garcia believes that the market is overly concerned by recent legislative initiatives aiming to restrict the collection and use of drug sales information for profit purposes. These proposals were contained to a couple of states, and most importantly, have been struck down, indicating that such laws are difficult to enact.

National Semiconductor
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.75 | Three-Year Expected Annual Return*: 22.1%

What It Does: National Semiconductor (NSM) was founded in 1959 and is based in Santa Clara, Calif. Even though it has produced virtually everything from logic chips to memory, it now focuses on the analog chip business and runs a close second in market share for highly sought-after power-management chips. Its focus on analog chips has helped it expand margins since 2003, but has also put it in direct competition with other firms also trying to reap the benefits of the analog market.

What Gives It an Edge: Over the past several years, National Semiconductor has transformed itself from a commodity chip producer to a strong competitor in the profitable high-performance analog segment. Morningstar analyst Erik Kobayashi-Solomon assigns the firm a narrow economic moat rating owing to its strong portfolio of proprietary designs, its manufacturing process expertise, and "sticky" customer relationships that lead to long, stable product cycles.

What the Risks Are: National's consumer base is diverse, but its exposure to the communications business, primarily through power-management chip sales, is large, representing 25%-30% of annual revenue. While the last few quarters have demonstrated National's ability to remain profitable even during demand downturns, Kobayashi-Solomon thinks a prolonged or severe shakeup in the communications market could have a negative effect on its growth and profitability.

What the Market Is Missing: Kobayashi-Solomon believes that short-term speculators, worried about a weak macroeconomic environment, have unfairly punished the shares of this strong company in their rush to distance themselves from semiconductor stocks in general. Given its economic moat, Kobayashi-Solomon thinks National will withstand near-term pressures better than most of its peers, and invites investors with a long-term focus to take another look at the firm.

One More New 5-Star Stock
Shaw Communications, Inc. (SJR)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Feb. 22, 2008.

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