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Stock Analyst Update

Viva Las Vegas with This 5-Star Pick

Plus, three other stocks that recently hit 5-stars.

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.

International Game Technology
Moat: Wide | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.74 | Three-Year Expected Annual Return*: 21.9%

What It Does: International Game Technology (IGT) designs and manufactures computerized gaming equipment (primarily slot machines), network systems, and licensing and services for the casino gaming industry. North American operations contributed 77% of consolidated revenue in fiscal 2007.

What Gives It an Edge: Morningstar analyst Bradley Meeks believes International Game Technology benefits from a wide economic moat, as evidenced by its 70% share of the slot machine industry. IGT derives its advantages from its product-development capabilities (spending nearly 4 times more than its next competitor), and significant barriers to entry in the industry, including time-consuming and costly local and federal gaming regulatory requirements, a wealth of patents, and significant economies of scale. Further making Meeks' case for a wide economic moat, IGT is extremely profitable with operating margins in the mid-30% range, and the firm converts an average of 18% of revenues into free cash flow.

What the Risks Are: Fickle casino operators' demand for replacement units and casino patrons' gaming preferences make predicting IGT's cash flows difficult on a year-to-year basis. A weak economy could also deter people from gambling, affecting profitability. Additionally, a delay of the server-based initiative and a protracted lull in the replacement cycle (see below) would aggravate IGT's long-term growth prospects. If IGT is unable to obtain the necessary gaming licenses or continue to comply with regulations in gaming jurisdictions in which it operates, growth and profitability could be hindered substantially.

What the Market Is Missing: Meeks thinks investors have shunned IGT stock lately as it is becoming clear that the next replacement cycle for gaming equipment probably won't happen until the second half of 2009, meaning lower profits for the firm in the meantime. However, although IGT's short-term results will stay bumpy, Meeks sees significant growth opportunities for the firm once the replacement cycle takes hold. For starters, IGT was chosen to install a server-based network in CityCenter,  MGM Mirage's (MGM) new $8 billion megacasino on the Las Vegas Strip. Once installed, Meeks believes this technology has the potential to revolutionize the gaming environment, causing other new casino properties to install similar systems. As this happens, an industrywide replacement cycle could kick off, as existing casinos also turn to IGT to stay competitive with newer properties, spurring a period of strong growth for the firm. Aside from the inevitable replacement cycle, Meeks also points out that IGT should capture more of the international marketplace as areas such as Macau (that are typically composed of table games), upgrade their technology and start playing more "high tech" slot games. While IGT should continue to suffer from a general slowdown in slot purchases until the next replacement cycle begins, Meeks points to the firm's leading market share, new product lineup, and international expansion opportunities as reasons to buy the stock today.

Governor and Company of the Bank of Ireland
Moat: Wide | FV Uncertainty: High | Price/Fair Value Ratio*: 0.63 | Three-Year Expected Annual Return*: 29.3%

What It Does: Along with its chief rival, Allied Irish Banks (AIB), Bank of Ireland (IRE) dominates banking in Ireland. Through its 250 branches there, it offers an array of financial services, including retail and corporate banking, mortgages, and insurance products. In the U.K., BOI offers mortgages and business banking and operates a consumer finance joint venture with the Post Office. BOI-UK specializes in niche businesses, such as nonprime mortgage and small-business lending.

What Gives It an Edge: According to Morningstar analyst Erin Davis, the driving force behind Bank of Ireland's wide economic moat is its large market share in Ireland; it and its largest competitor control about 70% of Ireland's banking market. As a result, Bank of Ireland consistently earns very attractive 20%-plus returns on equity. Also, despite its comfortable position, Davis likes that Bank of Ireland has not gotten lazy about controlling costs. Year after year, the bank grows revenues faster than costs, which further boosts shareholder returns. While Ireland's economy has slowed, Davis believes its low taxes and well-educated workforce bode well for its long-term economic prospects.

What the Risks Are: Nearly 70% of BOI's loan book is housing and property loans in Ireland and the U.K. Property prices in both countries have begun to fall, after many years of rapid appreciation. Moreover, nearly half of BOI's mortgage book is nonprime loans. An increase in bad debt could cause large losses for the bank. Loans have grown more rapidly than deposits, increasing the bank's reliance on wholesale funding. An ongoing credit crunch is likely to increase funding costs and depress net interest margins.

What the Market Is Missing: In Davis' view, Bank of Ireland's stock price has been driven down over the last year by concerns about Ireland's weakening property market--property prices are down 10% so far and may fall further. While Davis acknowledges that this deterioration will mean lower growth and higher charge-offs for the bank, she argues that the market is overestimating the scope and the long-term impact, as BOI should be protected from devastating losses by its conservative underwriting policies. For example, the average loan-to-value ratio for fiscal 2008 residential mortgage loans was 70%. With an average 30% equity stake, Davis believes homeowners will be loath to walk away from their mortgages. Also, the bank's loan-loss charges have historically been very low--0.07% in fiscal 2007 and 0.17% in fiscal 2008--and even with the fivefold increase incorporated into Davis' valuation model by 2010, Bank of Ireland's stock price looks like a bargain.

More New 5 Star Stocks
 Pacific Airport Group (PAC)
Darden Restaurants (DRI)

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, May 23, 2008.

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