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Stock Analyst Update

Rain, Sleet, or High Oil Prices: Can This Firm Deliver?

We think this firm is poised to gain 20%-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.

FedEx Corporation
Moat: Narrow | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.74| Three-Year Expected Annual Return*: 21.9%

What It Does: FedEx (FDX), which pioneered overnight delivery in 1973 and remains the world's largest express delivery firm, derives two thirds of its revenue from its express division. The company's ground segment delivers small parcels at a lower cost than express to the entire United States, and the freight segment provides less-than-truckload freight services. FedEx Kinko's provides document production technology, Web-based printing, Internet access, and ground and express shipping services.

What Gives It an Edge: According to Morningstar analyst Keith Schoonmaker, FedEx's broad U.S. parcel shipping network, dense shipment volume, and international presence establish an economic moat matched only by its close competitor United Parcel Service (UPS). As evidence of FedEx's moat, Schoonmaker points to DHL's recent struggles in the U.S. express delivery market, which underscore the powerful barriers to entry in this industry: Despite its global shipping expertise, DHL's U.S. operations generated annual losses approaching $1 billion. Unlike FedEx, DHL lacks a complete network and established pipeline of parcel traffic, so it could not turn a profit without enduring tremendous up-front expenses. In the domestic market, Schoonmaker contends that FedEx and UPS are rational competitors, passing through fuel price increases in order to stay healthy and raising general rates to compensate for inflation, rather than competing away their profits. Also, FedEx has deepened its U.S. offerings by acquiring heavy freight trucking capability, and it has established a retail presence by acquiring Kinko's (now FedEx Office). Furthermore, FedEx derives 28% of revenue from international operations and continues to expand global operations, with particular focus on China.

What the Risks Are: FedEx faces several risks. As the firm expands into developing nations such as China and India, continuing success depends not only on busy, healthy domestic and global economies, but also on continued stable conditions in these regions. Domestically, drivers who are currently contractors may seek to become classified as employees; indeed, a small number of drivers in three facilities recently voted to approve collective bargaining. Widespread unionization may reduce FedEx's ability to flex shipping capacity to match demand.

What the Market Is Missing: Schoonmaker believes the market is punishing FedEx shares unjustly due to recent slower-than-historical earnings growth, owing mainly to higher fuel prices. In Schoonmaker's view, high fuel prices will not only constrain earnings until FedEx's fuel surcharges catch up to jet and diesel fuel price increases, but also burden the general economy such that customers downshift to slower, less-profitable FedEx shipping products. While Schoonmaker admits that this double hit to FedEx should result in margin contraction as the economy remains soft, he counters that the firm should also benefit when the economy recovers. Also, Schoonmaker thinks the market may be considering the recent write-down of intangible assets added in the 2004 acquisition of Kinko's. Although noncash write-downs do not affect Schoonmaker's valuation, they confirm his opinion that FedEx overpaid for low-margin retail assets in exchange for high-margin packages. Nonetheless, Schoonmaker argues that FedEx will still remain one of two powerful integrated shippers in the U.S.--a lucrative and defendable long-run position. With short-term issues hampering the stock, Schoonmaker believes investors have a rare opportunity to purchase FedEx at a substantial discount to its fair value.

Autodesk, Inc.
Moat: Wide | FV Uncertainty: Medium | Price/Fair Value Ratio*: 0.74 | Three-Year Expected Annual Return*: 21.4%

What It Does: Autodesk (ADSK) is the leading vendor of computer-aided design software. Its customers are in 160 countries and range from 98% of the Fortune 1000 to single-person architectural firms. Manufacturing, infrastructure, building, media and entertainment, and wireless data services firms use Autodesk software to create, analyze, and manage their digital designs more efficiently, enabling them to complete projects faster. The firm was founded in 1982 and is based in San Rafael, Calif.

What Gives It an Edge: As the leading provider of computer-aided design (CAD) software, Morningstar analyst Rafael Garcia assigns Autodesk a wide economic moat. The company has the largest user base of CAD products, making its software products the de facto standard in digital design. According to Garcia, it takes years to master a CAD application, and operational disruption, downtime, and training costs discourage companies from changing CAD providers, giving Autodesk a virtual lock on the marketplace.

What the Risks Are: Autodesk faces stiff competition from strong CAD providers like Dassault Systems and Parametric, which could limit Autodesk's growth or decrease profitability. Dassault has been trying to expand its products to small and midsize companies, Autodesk's main customer base. Parametric offers low-priced CAD solutions that could eventually place a pricing cap on Autodesk's products.

What the Market Is Missing: In Garcia's view, Autodesk's shares have been hampered recently by the market's concerns about the weak housing industry in the U.S. and its effects on the demand for the firm's software products for the infrastructure and building segments. Garcia points out that the company's building products are mainly used for commercial building projects and not for housing development, however, shielding the firm somewhat from the current U.S. economic woes. In fact, in Autodesk's most recent quarter, its architecture, engineering, and construction (AEC) division, which has been a source of concern for the market, expanded at a healthy 21% rate compared with the previous year. Also, Garcia points out that 67% of Autodesk's revenues come from markets abroad, which have stayed remarkably strong even as the U.S. has faltered.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Aug. 22, 2008.

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