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Stock Analyst Update

Drill for High Returns with This 5-Star Pick

This $30 billion firm looks poised to gain 25%-plus.

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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.

National Oilwell Varco, Inc.
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.68 | Three-Year Expected Annual Return*: 26.4%

What It Does: National Oilwell Varco (NOV) is one of the largest equipment suppliers in the drilling industry. It provides a comprehensive line of equipment for rigs and consumable products used in oil and gas production. Grant Prideco adds drill pipe and drill bits to NOV's product portfolio. NOV also provides distribution services, which include maintenance, spare parts, and repair services for its equipment.

What Gives It an Edge: Morningstar analyst Stephen Ellis assigns National Oilwell Varco a narrow economic moat, owing to its vast market share in rig equipment that gives it scale efficiencies over smaller competitors. In particular, NOV is the sole supplier for many of its customers, as 90% of industry firms went out of business during the 1980s' equipment bust. Since that time, the company has acquired many of the survivors, strengthening its dominance over the industry. As a result, Ellis estimates the firm now controls about 60% of the rig equipment market and has its equipment on about 90% of all rigs. NOV recently completed the acquisition of Grant Prideco, which expanded its product portfolio to include drill pipe and drill bits. Accordingly, Ellis believes NOV is now more attractive to customers seeking a one-stop shop for rig equipment.

What the Risks Are: NOV is exposed to cost inflation on its raw materials and labor costs. It also has to meet tough delivery deadlines on certain fixed-price contracts. Many rigs in the 1980s missed their original delivery dates and were delivered significantly over budget. A repeat scenario could hurt the company's profitability and further damage its already-weak reputation for customer satisfaction.

What the Market Is Missing: Ellis thinks investor concerns about the sustainability of the demand for offshore rigs and associated rig equipment have tempered NOV's shares recently. While Ellis acknowledges that the current rig-building boom is extensive, he counters that it pales in comparison to the number of rigs that were added to the global fleets in the 1980s. According to Ellis, the current global equipment supply chain is only a fraction of what it was back then, which limits the possibility of rig oversupply and a severe slowdown in demand for NOV's equipment. Also, the average offshore rig is well over 20 years old and nearing the end of its useful life, meaning a replacement cycle could be around the corner. Ellis points out that relatively high oil and gas prices have boosted drilling activity and day rates and allowed cash-rich drillers to reinvest in their fleets for the first time in decades in order to boost rig productivity. Finally, deep-water rigs are being signed to contracts stretching up to two decades, implying that a continued state of rig undersupply is more likely than oversupply. As such, Ellis believes that NOV is well-positioned to benefit from years of strong offshore drilling activity and will soon put the market's fears to rest.

Cadbury PLC
Moat: Wide | FV Uncertainty: Low | Price/Fair Value Ratio*: 0.82 | Three-Year Expected Annual Return*: 16.4%

What It Does: Cadbury (CBY) operates as the leading competitor in the global confectionery market, with product lines spanning the chocolate, candy, and gum segments. The firm distributes its products in 86 countries, holding the number-five position in the chocolate market with 7.5% share, the number-two position in the gum industry with 27% share, and the number-one position in candy with 7% share of the market. Cadbury's brands include Halls, Trident, and Dentyne.

What Gives It an Edge: Morningstar analyst Erin Swanson credits Cadbury with a wide economic moat, given its leading positions in the markets for chocolate, gum, and candy. In addition to its well-known brand names, Cadbury benefits from its massive scale, which confers significant advantages to the firm in distribution and marketing, keeping its smaller competitors at bay. Over the past 20 years, the firm has used acquisitions to increase its scale further in confectionery and beverages, making more than 40 purchases.

What the Risks Are: The biggest risk to our valuation is that Cadbury fails to achieve significant margin improvement from its current restructuring initiatives, similar to its difficulties in the past. The firm's profitability may be hurt by rising commodity costs. Further, Cadbury's worldwide footprint subjects the firm to foreign exchange rate fluctuations. One third of the firm's revenue comes from emerging markets, where volatile political and economic climates could pressure sales.

What the Market Is Missing: Similar to other packaged foods firms, Swanson thinks Cadbury faces some near-term head winds in the form of rising commodity costs and challenging macroeconomic conditions in many of its markets, which have probably kept a lid on the firm's share price. However, Swanson believes Cadbury is worth a look today given its focus on cutting costs and continuing to expand its global presence over the longer term. While the firm's stand-alone confectionery profit margins today of 10% significantly trail the mid- to high-teens margins enjoyed by other confectionery stalwarts, Swanson thinks Cadbury will close the gap longer term. Aside from raising prices more aggressively, Swanson believes the firm will realize this margin expansion by meeting its objective to reduce stock-keeping units and scrap 15% of its manufacturing and distribution centers by 2011. In addition, the firm is concentrating on enhancing operations in Russia and China, which have been a drag on profits. Finally, following the spin-off of its last major beverage segment, Swanson argues that Cadbury will be able to make cuts to its now-bloated central cost structure. With the market instead expecting more of the same, Swanson contends that Cadbury is a bargain today, especially for investors willing to stick it out longer term.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Monday, Aug. 18, 2008.

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