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Stock Analyst Update

Two Old Economy Firms Ready to Rebound

These stocks offer 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.

Canadian National Railway Company
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.73 | Three-Year Expected Annual Return*: 22.1%

What It Does: Canadian National's (CNI) railway spans Canada from coast to coast and extends through Chicago to the Gulf of Mexico. During 2007, CN's 22,389 employees delivered 4.7 million carloads over the firm's 20,421 miles of track. CN derived CAD 7.9 billion in revenue by hauling forest products (19.7% of consolidated revenue), intermodal containers (17.5%), agriculture (16.6%), chemicals (15.5%), metals and mining (10.5%), automotive (6.4%), and coal (4.9%). Non-rail operations comprise the remaining 9%.

What Gives It an Edge: Morningstar analyst Keith Schoonmaker credits Canadian National Railway with a narrow economic moat, as the cost and challenge of replicating North American railroad assets essentially bar new entrants from the market. According to Schoonmaker, while CN benefits from the recent pricing power also enjoyed by its peers, CN's industry-leading profitability is the envy of all other North American railroads. In 2007, CN's 36% operating margin beat the Class I rail average by a whopping 13 percentage points. Schoonmaker believes the firm's standards of precision railroading start with CEO Hunter Harrison, the catalyst for the railroad's well above-average success, and permeate the firm more thoroughly than in other rails.

What the Risks Are: CN is exposed to the general economic health of North America, but given its freight mix, this rail is particularly susceptible to drops in housing starts and the declining paper market. Should fuel prices decline substantially, some volume of freight is likely to return to higher-service truck shipping. CEO Hunter Harrison has indicated his plan to retire at the end of 2009, but Schoonmaker thinks his philosophy has penetrated the organization sufficiently to enable a disciple to lead the firm in perpetuating its high performance.

What the Market Is Missing: During the past three to four years, all railroads have improved operating metrics dramatically, but CN has established itself as the top-performing railroad that others are still trying to imitate. Schoonmaker argues that the market mistakenly lumps all railroads together and fails to distinguish CN as the proven leader. Schoonmaker points out that this stock is not a turnaround play like some lower-margin, but improving, railroads. Instead, investors have a more certain idea of what margins to expect from CN. Also, Schoonmaker admits that CN's freight mix is exposed to forest product cargo, but counters that investors with a longer time horizon recognize cyclical commodity demand has peaks as well as valleys. In Schoonmaker's view, the market is well aware of the factors creating the present rail renaissance, but CN is a lower-risk alternative to rails with less-proven results.

International Paper Co.
Moat: None | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.73 | Three-Year Expected Annual Return*: 22.5%

What It Does: International Paper (IP) is a global paper and packaging company with operations in the United States, Europe, South America, and Asia. The company's primary business segments are uncoated paper and packaging. IP also runs a North American merchant distribution business. The company owns or manages about 300,000 timberland acres in the U.S. and 250,000 acres in Brazil, with harvesting rights on government-owned acres in Russia.

What Gives It an Edge: Despite a positive view of the firm's prospects, Morningstar analyst Daniel Rohr does not think that International Paper possesses a viable economic moat. The industry's cyclical nature means product demand and pricing can change dramatically, with overcapacity a common problem. Paper and packaging firms are also subject to volatile raw-material and energy prices. In addition, Rohr concludes that IP's ability to pass on rising input costs is circumscribed by its customers' strong bargaining position.

What the Risks Are: As a player in a cyclical industry, International Paper is at the mercy of fluctuating customer demand, which can strongly influence volume and pricing. Low-cost competition in South America and Asia also represents a risk to unit volume and pricing power. On the cost side, IP is subject to sometimes volatile and unpredictable prices for raw-material inputs and energy. Country-specific risks associated with joint ventures in Russia and China are also important factors to consider.

What the Market Is Missing: With the recent slide in International Paper's stock price, Rohr thinks the market is undervaluing the firm's emerging-market opportunities. According to Rohr, unlike many of its peers in the paper and packaging industry, whose fortunes are largely tied to the ebb and flow of North American paper consumption, IP is well-placed to profit from rising per capita paper consumption in emerging markets. The company used proceeds from a well-timed timberland sale to make major forays in Russia, China, and Brazil, which Rohr expects to deliver better returns on invested capital than its domestic operations. As a result, along with better growth opportunities, IP should remain more insulated than its peers to the struggling U.S. economy.

More New 5 Star Stocks
Atmos Energy Corporation (ATO)
Elizabeth Arden, Inc. (RDEN)

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

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