These Wide-Moat Firms Hit 5 Stars for the First Time in 2008
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.
Moat: Wide | FV Uncertainty: Low | Price/Fair Value Ratio*: 0.84 | Three-Year Expected Annual Return*: 15.0%
What It Does: PepsiCo (PEP) is a global food and beverage producer. The company manufactures and distributes a wide variety of salty, sweet, and grain-based snacks, carbonated and noncarbonated beverages, and other foods. The firm conducts its business through three major divisions: PepsiCo Americas Foods, PepsiCo Americas Beverages, and PepsiCo International. Major brands include Fritos, Lay's, Ruffles, Doritos, Cheetos, Quaker, Pepsi, Mountain Dew, Sierra Mist, Gatorade, and Tropicana.
What Gives It an Edge: Morningstar analyst Greggory Warren credits PepsiCo with a wide economic moat owing to its portfolio full of strong brands, solid track record of product innovation and differentiation, and direct-store-delivery network, all of which make PepsiCo the gold standard in the consumer products industry. Despite the head winds created this year by rising commodity costs and economic weakness in its core market, Warren continues to believe that PepsiCo will weather the storm much better than many of its peers. Not just a beverage company, PepsiCo generates more than half of its sales and operating profits from its food operations--made up primarily of Frito-Lay and Quaker Oats. Better yet, according to Warren, the operating margins in those businesses have been higher than what PepsiCo has been able to generate with its beverage operations. Warren expects the company to continue to tap into the generous cash flows generated by its food and beverage businesses to expand its operations outside of North America.
What the Risks Are: As a global manufacturer and distributor of food and beverages, PepsiCo can be affected by commodity price volatility, especially for raw ingredients (such as corn, wheat, sugar, and oranges), as well as packaging materials. With more than 40% of sales generated outside the United States, the firm is exposed to foreign currency risk. PepsiCo is also expanding more aggressively into emerging and developing markets around the globe, which come with their own cultural, economic, and political risks.
What the Market Is Missing: With prices for raw ingredients and packaging materials continuing to skyrocket, and the domestic economy on life support, Warren believes investors have been extremely wary of any company (including PepsiCo) that produces goods that are dependent upon commodities such as wheat, corn, or dairy products, and that face significant private-label competition. While PepsiCo is now forecasting 9%-10% input cost inflation for 2008 (versus prior expectations of 6% for the year), Warren points out that the company believes that it has adequately hedged its commodity exposure for the remainder of the year. In Warren's view, the firm also faces much less private-label competition in its food operations than most other packaged food companies, while private label (or own-store) soft drink sales have done little to dent the positioning of PepsiCo's own branded products. Having already assumed a more conservative stance on the company coming into 2008, Warren feels that today's share price represents an excellent opportunity to invest in the long-term success that has been the story at PepsiCo over much of the past decade.
ONEOK Partners, L.P.
Moat: Wide | FV Uncertainty: Low | Price/Fair Value Ratio*: 0.83 | Three-Year Expected Annual Return*: 16.6%
What It Does: Oneok Partners (OKS) gathers, processes, and transports natural gas and natural-gas liquids. The partnership's interstate pipelines carry nearly one fifth of the gas exported from Canada to the U.S., while its large gathering and processing operations serve Texas, Oklahoma, Kansas, and the High Plains region. Oneok Partners plans to spend $1.5 billion through 2009 on growth projects, notably to increase its NGL transportation infrastructure.
What Gives It an Edge: Morningstar analyst Jason Stevens believes Oneok Partners benefits from a wide economic moat, owing to its network of pipeline assets. According to Stevens, without a demonstrated economic need, new pipelines are not approved. This, combined with large up-front building costs, creates sizable barriers to entry in the industry. In addition, Stevens is excited by Oneok Partners' big bet on natural-gas liquid (NGL) pipeline capacity. Together with Williams Companies, Inc. (WMB), the partnership is developing the Overland Pass pipeline, a 750-mile, $430 million NGL pipeline running from natural-gas processing centers in Wyoming to the Conway, Kan., NGL market center. The companies also intend to build a $120 million lateral pipeline from the Piceance Basin to the Overland Pass pipeline, connecting to two Williams processing plants. A third big bet is the proposed $260 million Arbuckle pipeline, which would connect Oneok Partners' NGL gathering pipelines in southern Oklahoma with the Mont Belvieu, Texas, NGL market center. Despite Oneok Partners' strategic shift away from long-haul natural-gas pipelines and toward a more balanced midstream asset portfolio, Stevens still thinks the company has strong competitive advantages, which its proposed NGL pipelines will only deepen.
What the Risks Are: While cash flows from midstream assets are among the least risky in our coverage universe, investors should note that master limited partnerships (MLPs) are not riskless. We think the largest risks to watch for are regulatory or tax-law changes, which could threaten the MLP business model, and access to financial markets, which is essential for MLPs seeking to fund growth projects or acquisitions. Of course, operating midstream assets exposes MLPs to potential losses from explosions, fires, or environmental damage, but most of these exposures are insured. Oneok Partners also has commodity price exposures in some business segments.
What the Market Is Missing: Stevens contends that Oneok Partners is making the right moves by concentrating on an overlooked piece of energy infrastructure--NGL pipelines. While Stevens blames market concerns over capital costs and project overruns for the recent weakness in Oneok Partners' unit price, he thinks the firm will deliver in the long run. According to Stevens, bottlenecks in NGL pipeline capacity is constraining natural-gas production in the prolific Barnett Shale, and new processing plants in the Rockies will not be able to run full tilt until new NGL pipelines are built. Oneok Partners is taking the lead to address these chokepoints with large new projects. In Stevens' opinion, given that the Overland Pass and Arbuckle pipelines are underwritten with long-term, fee-based contracts, these projects should provide significant cash-flow growth over the coming years, fueling steady distribution growth. The firm's cash-flow generation already allows units of Oneok Partners to yield 5.9% at Stevens' fair value estimate, and he expects the company to raise distributions at an 5.5% average annual rate during the next decade.
* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Monday, June 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.