Four Firms Selling at 80 Cents (or Less) on the Dollar
These stocks offer 15%-plus expected returns.
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.
Under Armour, Inc.
Moat: None | FV Uncertainty: High | Price/Fair Value Ratio*: 0.64 | Three-Year Expected Annual Return*: 29.1%
What It Does: Under Armour (UA) markets athletic apparel and footwear for men, women, and children. The firm specializes in developing technologically advanced "performance" apparel made of synthetic microfiber and designed to wick perspiration away from the skin and help regulate body temperature. Primarily a wholesaler to sporting goods stores, Under Armour also operates a handful of retail outlet stores domestically. About 6% of total revenue is generated outside the United States.
What Gives It an Edge: Although Under Armour has maintained a dominant position in the performance apparel category that it helped create a decade ago, Morningstar analyst Brady Lemos does not believe the firm benefits from an economic moat. Primarily, customer switching costs in athletic apparel and footwear are low, making it difficult for Under Armour to stay ahead of its competition indefinitely. That said, with market share approaching 75%, Lemos points out that the company can claim rare leadership over Nike (NKE) in a fast-growing and profitable industry. Even if competitors advance longer term, Lemos believes Under Armour has plenty of opportunities to expand in the meantime, such as increasing its presence in footwear and women's apparel.
What the Risks Are: Despite dominant market share in the performance apparel industry, Under Armour risks losing ground to a number of more powerful competitors such as Nike and Adidas. Competition should only intensify now that Under Armour has entered the athletic footwear market. Catering to fickle young consumers presents plenty of fashion risk.
What the Market Is Missing: While economic concerns have sent the firm's shares lower, as investors question whether Under Armour's sales will hold up amid lower overall consumer spending, Lemos believes the firm's durable brand and strong growth prospects are being overlooked by the market. According to Lemos, Under Armour has demonstrated substantial brand strength on its way to doubling sales over the last two years, which should keep near-term sales afloat. In addition, growth is well distributed among each of the company's divisions, suggesting that the brand's popularity will carry over into new categories including footwear and outdoor, golf, and women's apparel. Given the remarkable success of Under Armour's cleated footwear, Lemos anticipates that consumers will swarm to buy the company's recently introduced noncleated training shoe. Similarly, Lemos is encouraged by the growth prospects of its international markets, which are significantly underpenetrated and offer terrific opportunities for expansion.
Shaw Communications, Inc.
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.73 | Three-Year Expected Annual Return*: 23.0%
What It Does: Shaw Communications, Inc. (SJR), a diversified communications company, provides broadband cable television services, Internet, digital phone, Direct-to-home (DTH) satellite services, and satellite distribution services in Canada and the United States. The firm has more than 3 million subscribers based mostly in Western Canada.
What Gives It an Edge: Morningstar analyst Imari Love credits Shaw with a narrow economic moat, owing to its economies of scale in distribution and large subscriber base. With these competitive advantages, Shaw achieves the highest operating margin in the sector, and its returns on invested capital continually exceed its cost of capital. Also, Love sees some bullish trends inside Shaw's model that bode well for the firm longer term. Revenue per basic cable subscriber is not only growing but the growth is accelerating. After rising 6% year over year in 2005, it grew 11% in 2006 and 13% last year (not to mention 26% growth in the first quarter of this year). According to Love, Shaw's strong performance is due to its exceptional job at migrating customers from analog to digital services (where customers pay 50% more per month). In addition, Shaw's Internet penetration of its homes passed are best in class and management historically has focused its marketing efforts around the quality of its customer base instead of blindly building the quantity. This mindset makes Shaw a winner, in Love's view.
What the Risks Are: The major operational risks for Shaw center around its potential entry in the wireless sector. Having to fight against deep-pocketed competitors in a new industry could be problematic. From a shareholder perspective, there is always the risk that the Shaw family could put its own interest ahead of its shareholders'.
What the Market Is Missing: Love thinks the market's concern over Shaw's new venture into the wireless realm has put pressure on the firm's share price. While some fear that Shaw will be operating outside of its core competency and in the process, will incur some sizable up-front operating losses, Love points out that early returns for the ongoing wireless auction show that Shaw is acquiring licenses at very reasonable prices. This makes ultimate profitability in the project more likely. In addition, for those firmly against the expansion, Love believes that the company has not yet settled on rolling out a new network and entering the wireless fray, and that it's possible the firm will keep the licenses in its back pocket as a strategic asset. Either way, Love argues that the market is overestimating the near-term impact of the auction, allowing investors to buy a piece of Shaw at a bargain price.
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.72 | Three-Year Expected Annual Return*: 23.8%
What it Does: Oshkosh (OSK) is a designer, manufacturer, and marketer of a broad range of specialty vehicles. Its primary products include military trucks, fire trucks, concrete-mixer trucks, refuse trucks, telehandlers, and aerial work platforms. Customers include the U.S. Department of Defense and municipalities in the public sector, and equipment rental, waste management, and construction companies in the private sector.
What Gives It an Edge: Morningstar analyst Patricia Oey assigns Oshkosh a narrow economic moat because of its long-standing status as a U.S. government contractor for military trucks, which allows the firm to sustain returns on invested capital in excess of its cost of capital. In addition, Oshkosh has diversified beyond military trucks over the past 10 years and now builds different lines of specialty trucks, including fire trucks, access equipment, refuse trucks, and concrete mixing trucks. Although Oshkosh's newer segments are exposed to more economic cyclicality, Oey is optimistic about the global growth opportunities for its access equipment segment, which includes aerial work platforms and telehandlers. Oey expects spending for this type of equipment to be driven by construction spending, particularly in developing markets.
What the Risks Are: Oshkosh's defense segment represents about 25% of total revenue and has one main customer--the U.S. government. Healthy government spending because of the Iraq war has driven double-digit growth and margins in this segment. Any change in strategy in Iraq will have an effect on Oshkosh's financial performance. Oshkosh's commercial and access segments, which make up almost 60% of revenue, service customers in highly cyclical industries. Finally, we highlight the possibility of future acquisitions performing below expectations.
What the Market Is Missing: Oey believes the market is concerned that two of Oshkosh's four segments (access equipment and commercial, which includes concrete mixing trucks) are exposed to a slowing construction spending in the U.S., and that a wind-down of the U.S.'s presence in Iraq will weigh on the defense segment. Although Oey admits that Oshkosh may be facing cyclical head winds in the near term, she thinks that the firm holds the number-one market share in many of its product categories, and that it is highly regarded by its customers for its product quality and service. Even if business slows in the nearer term, these traits should ensure that the firm achieves attractive long-run returns. In the meantime, Oey thinks that Oshkosh is likely to win a new contract for the JLTV, the next generation high-mobility multipurpose wheeled vehicle, or Humvee, providing an immediate boost to the firm.
First Midwest Bancorp
Moat: Narrow | FV Uncertainty: Low | Price/Fair Value Ratio*: 0.80 | Three-Year Expected Annual Return*: 19.0%
What It Does: First Midwest (FMBI) is a commercial-focused bank that operates over 100 branches mainly in the Chicago suburbs. The company has over $8 billion in assets, over $5 billion in deposits, and offers a wide variety of products and services. Its portfolio is mostly commercial, with 40% of its loans commercial real estate, and almost 30% commercial and industrial (C&I).
What Gives It an Edge: According to Morningstar analyst Richard McCaffery, First Midwest earns a narrow economic moat through its deposit base, which provides a stable, low-cost source of funding for the firm. While this is true of most depository institutions, McCaffery ranks First Midwest's deposit base better than average, with a solid mix of non-interest-bearing and other core deposits. In addition, McCaffery thinks the company's long-term focus on business lending in the Chicago suburbs gives it an edge pursuing loans and extending relationships in an attractive market. Over time, McCaffery believes the bank can earn attractive returns (15%-plus) with moderate leverage.
What the Risks Are: The key risk in our view is credit quality given the weakening economy. First Midwest's focus on commercial lending and a solid credit culture in general should help the company weather the storm, but the firm has significant exposure to the local homebuilder industry, which has weakened. In addition, its portfolio is concentrated in commercial real estate in the Chicago area. If the economy should weaken significantly, we would expect credit quality to deteriorate and we would be forced to re-examine our fair value estimate. In addition, we wouldn't be surprised to see further write-downs in the company's CDO portfolio given continued turmoil in the credit markets. This could lead to weaker-than-expected results in the near term, although we think downside is limited at this point given the already discounted carrying value of its securities portfolio.
What the Market Is Missing: McCaffery points to the sharp sell-off of regional banks in general as the culprit for the recent weakness in First Midwest's share price. According to McCaffery, the market remains concerned about worsening credit quality as the real estate downturn continues. Roughly 40% of First Midwest's portfolio is commercial real estate. While most commercial real estate has held up well, the company has significant exposure ($400 million or roughly 8% of total loans) to the homebuilder industry, the hardest-hit sector so far. McCaffery admits that higher losses are likely from this portfolio, but he thinks it should be manageable based on the company's credit culture. In particular, McCaffery likes that the company has been disciplined, maintaining relationships mainly with lenders focused on the company's core markets. McCaffery forecasts 0.50% of loan losses for First Midwest in 2008, up from 0.16% a year ago. However, even with the assumption of higher losses, McCaffery argues that the firm's 2008 dividend payout should be reasonable at about 60% of net income. In addition, while the company's tangible capital ratio fell below management's 6%-6.5% target last year, McCaffery believes solid earnings should allow the company to rebuild capital organically. With the market already fearing the worst, McCaffery thinks investors should take another look at First Midwest.
Other New 5-Star Stocks
WPP Group PLC (WPPGY)
Dr Pepper Snapple Group, Inc. (DPS)
* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, June 13, 2008.
Jeff Viksjo does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.