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Stock Analyst Update

After Five Years, These Firms Finally Hit 5 Stars

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.

Laboratory Corporation of America Holdings
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.74 | Three-Year Expected Annual Return*: 21.3%

What It Does: Laboratory Corporation of America (LH) is the nation's second-largest independent clinical laboratory, with about 20% of the independent lab market. The company operates more than 1,600 patient-service centers, offering a broad range of clinical lab tests, ranging from routine blood and urine screens to complex oncology and genomic testing.

What Gives It an Edge: Morningstar analyst Jeffrey Stafford believes LabCorp's vast national infrastructure gives it scale advantages over small regional labs and is the base of the company's narrow economic moat. LabCorp and competitor Quest Diagnostics (DGX) operate in the independent diagnostic-services industry as a duopoly; jointly the two players control more than 50% of the market. According to Stafford, LabCorp's network also makes the firm an attractive partner for large managed-care organizations that value the cost efficiency provided by large-scale automated testing. LabCorp has been adding to its infrastructure advantage by acquiring regional labs, a trend Stafford expects will continue.

What the Risks Are: LabCorp faces intense competition from its larger rival, Quest. Increased pricing pressure from managed-care providers and the government remains a challenge for both companies, as payers try to rein in rising health-care costs. As point-of-care testing becomes more widely available, LabCorp could see volume decline in routine testing. Drugstores could also put a dent in the company's routine test volume by adding diagnostic facilities in their locations.

What the Market Is Missing: Stafford thinks investor concerns over the lower-than-average pricing terms of LabCorp's deal to be the exclusive provider of testing services to UnitedHealth Group (UNH) has kept a lid on LabCorp's share price the past few years. In short, by accepting subpar pricing to secure higher volumes from UnitedHealth, Stafford believes LabCorp spooked the market into thinking that a long-term precedent had been set, possibly leading to future bidding wars between diagnostic firms and lower industry profitability. While Stafford acknowledges that the company's relationships with managed-care providers have undergone a significant transformation over the past few years, he disagrees with those worried that the bargaining power in contract negotiations has forever shifted to large managed-care organizations. In Stafford's opinion, LapCorp's deal with UnitedHealth is a unique situation aimed at expanding the company's footprint in the valuable Northeast market. As such, Stafford expects pricing behavior at the firm to revert to the industry norm in the long run, stabilizing LabCorp's revenue growth and cash flows and making the firm a bargain at today's prices.

Pactiv Corporation
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.72 | Three-Year Expected Annual Return*: 23.6%

What It Does: Spun off from Tenneco in 1999, Pactiv (PTV) has two operating segments. The consumer-products segment features the Hefty line of household goods, which includes waste and food bags, disposable plates, and EZ Foil oven-ready containers. The food service/food packaging segment manufactures mostly plastic products used to package meat, confectioneries, restaurant takeout, and many other foods. The former sells through retail, while the latter sells mostly through a direct salesforce.

What Gives It an Edge: Morningstar analyst Parrish Glover credits Pactiv with a narrow economic moat, owing mainly to its Hefty brand, which has corralled 60% of the plastic tableware market and a 30% share in waste bags. Though competing brands like Glad and Ziploc pose ongoing threats, Glover finds that skirmishes are rational and brief. While generics also command a space on store shelves, Glover believes the value proposition for the premium brands, like Hefty, is overwhelming. For instance, the experience of an inferior trash bag breaking, staining carpet or clothing or simply creating a time-consuming mess, is one that lingers in customers' minds for years. With frequent promotions and coupon offerings, Glover contends that bargain shoppers will still be able to purchase Pactiv's premium Hefty garbage bags and save at checkout. While the company is facing lower margins due to rising plastic resin costs, Glover points out that firm is in no worse a position than Glad, Ziploc, or generic competitors, meaning its market position should remain intact.

What the Risks Are: Pactiv's growth strategy rests on product innovation. Yet Pactiv's competitors are also developing new products, so the firm could find itself outmaneuvered in the race for additional customers. Plastic resin costs are closely tied to oil prices, which has hurt margins in the past and could easily do so again.

What the Market Is Missing: Glover believes Pactiv's shares are trading near their 52-week low due to the market's concern over higher input costs for the firm's products. While Glover admits that higher raw material costs should lead to a rough year for Pactiv, he counters that Pactiv should retain pricing power in its premium markets, allowing it to pass on some of these costs to consumers. While its projected price increases would not keep up with current price hikes for plastic resins, Glover forecasts a decline in polyethylene prices later in the year, caused by increases in global production capacity. In the long run, Glover argues that the company remains on solid footing, with no competing technologies on the horizon to replace its consumer products and its Hefty brand name intact. Furthermore, even if resin costs do not moderate, Glover believes the company will be able to compensate for its higher expense structure in time, given its history of cutting costs and making operational improvements.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Thursday, July 3, 2008.

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