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Stock Strategist

We See Value in This Beaten-Down Stock

This stock offers 20%-plus expected returns.

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Following is a sampling 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.

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Veolia Environnement
Moat: Narrow | Risk: Average | Price/Fair Value Ratio*: 0.68 | Three-Year Expected Annual Return*: 26.3%

What It Does: French-based Veolia Environnement (VE) is a leading global provider of environmental services. Its largest segment, water, helps provide potable water to more than 67 million people. Its other business services include environmental (waste), energy, and transportation. Veolia operates in uneconomically regulated markets across the globe, creating partnerships with municipalities.

What Gives It an Edge: According to Morningstar analyst Basili Alukos, Veolia's unique business model and its deep roots as a water provider give it an edge over its competitors. Veolia bypasses economic price-setting by operating in nonregulated markets. This gives it more flexibility to quickly pass price increases to its customers. In addition, Alukos points out that Veolia essentially has customers for life with renewal rates in excess of 90% on 10- to 15-year long-term contracts. When you combine this model with a reputation of providing quality water since the Napoleon III era, Alukos believes Veolia will remain a market leader well into the future.

What the Risks Are: In Alukos' view, contract renewal risk is Veolia's biggest threat, as customers typically reevaluate the costs and benefits of outsourcing environmental services when contracts expire. Furthermore, Veolia assumes operational risk, and any cost overruns could compress returns. Weather creates an uncontrollable risk for Veolia because of its direct effect on water and energy usage. Finally, poor selection of future acquisitions could compress returns and destroy shareholder value.

What the Market Is Missing: Alukos thinks the market has unjustly focused on Veolia's weather-related struggles recently rather than on its success in delivering above 8% annual organic revenue growth over the longer term. Also, while Alukos acknowledges that a potential downturn or recession in Europe could affect the majority of Veolia's operations, environmental services are life necessities and their demand is relatively stable regardless of economic output. Furthermore, Alukos believes the market is missing Veolia's ability to organically grow sales by persuading more governments to relinquish operational control of their environmental services. In Alukos' opinion, this gives Veolia the power to increase sales regardless of the overall economic environment.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Thursday, March 20, 2008.

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