Morningstar's 10 Small Companies to Invest in Now

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Small Companies to Invest in Now

Paul Larson

Morningstar’s 10 Small Companies to Invest in Now by Paul Larson, Equities Strategist, Editor of Morningstar StockInvestor

Copyright © 2010 by Morningstar, Inc. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/ go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. For more information about Wiley products, visit our web site at www.wiley.com. ISBN-13 978-0-470-58099-8 10 9 8 7 6 5 4 3 2 1

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Morningstar’s 10 Small Companies to Invest In Now by Paul Larson Stock prices, fair values, and recommendations as of Sept. 10, 2009.

The strong stock market rally experienced since early March has evaporated many of the bargains once present, but some still remain. It is not too late to be buying, especially if one is selective in what they purchase. In this report, I highlight 10 “hidden gems” you have probably not heard of before that we at Morningstar think look like attractive investment opportunities today. At Morningstar, we view stocks for what they really are—ownership stakes in businesses. As such, we value any given stock like we would value a business, by estimating how much cash that business is expected to generate in the future and valuing it in today’s terms. This discounted cash flow method is at the foundation of every single fair value estimate in this report. In coming up with this list of companies, I looked only at companies that had stocks trading at a significant discount to our estimate of its intrinsic value. In each of these cases, the trading discount to our fair value estimate is sufficient enough to give a margin of safety large enough to consider buying the stock. After getting a list of what we think are the cheapest stocks, I then focused my efforts on the smaller names that may not be well known by the average investor. Each of the companies in this report has a market capitalization of under $4 billion. The market is very often less efficient with smaller companies that have few investors looking at them, coughing up more situations where a stock may be mispriced. Plus, smaller companies can often be easier to understand and analyze. Also consider that as of Aug. 31,

2009, the Russell 2000 index (focused on smaller companies) has easily outperformed the S&P 500 index (focused on larger companies) in not just the year-to-date period, but also for longer fiveand 10 -year periods. Simply, the action is with small companies. Since my focus in my newsletter, Morningstar StockInvestor, is on the highest quality companies, I first selected the companies with wide economic moats— Compass Minerals CMP, Enterprise GP Holdings EPE, IMS Health RX, International Speedway ISCA, and Weight Watchers WTW. These are companies with sustainable competitive advantages that should allow them to generate high returns on invested capital for an extended period of time. Less than 10% of our coverage universe at Morningstar has an economic moat rating of wide, so these firms really are the best of the best. I then located some of the more interesting firms with narrow economic moats—Mohawk MHK, UTi Worldwide UTIW, Wesco Financial WSC, Wilmington Trust WL. While these companies have businesses that are not quite as attractive as the group above, each still has some sort of economic moat worthy of owning for the long-term. In StockInvestor I usually do not touch companies with no economic moats, yet the last company I selected for this report—SunPower SPWRA—is a firm with a number of short-term catalysts in front of it. More importantly, the stock simply does not appear to reflect the cash flow this company should generate. But still, this is the most speculative company in this report. It is often said that the stock market in the short term is a voting machine, but it is a weighing machine in the long term. I have no idea how the near-term popularity “votes” on these stocks will come in, but we at Morningstar do believe the market is under-

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appreciating the “weight” of these particular small companies. We think it is worthwhile to read what we have to say, do some of your own research, and then consider buying these stocks. Compass Minerals CMP Stock Price (09/10/09): $58.67 Morningstar Fair Value Estimate: $85.00 Profile Compass Minerals produces salt in North America and the United Kingdom. The company also produces sulfate of potash and magnesium chloride in North America. Compass Minerals’ products are used for highway deicing, consumer deicing, water conditioning, consumer and industrial food preparation, agriculture, and industrial applications. Nearly half the highway deicing salt used in Compass’ markets (primarily the Great Lakes region) is supplied by this company. Thesis Compass Minerals has strong competitive advantages as a result of its world-class rock salt and sulfate of potash, or SOP, resources.

Compass’ major offering is highway deicing salt, so its profitability is determined by cold, snowy, or icy winter weather. The firm also produces salt for consumer and industrial uses, such as water condi-

Company Name

Economic Moat

tioning, livestock feed, food processing, and table salt. Finally, Compass produces SOP, a specialty fertilizer that improves the yield and quality of highvalue crops. Compass is expanding its highway deicing salt and SOP production capacity, which should result in profitable sales growth. In addition, SOP prices increased dramatically during the first part of 2008, thanks to strong global demand for fertilizers and tight supply. As the world’s population grows, the amount of arable land per person decreases. Further, increasing personal income levels in developing countries are driving people to change their diets. Finally, high crude oil prices and political considerations have motivated countries to encourage biofuel production. All of these factors contribute to growing demand for fertilizers. Compass has a wide economic moat because of its low-cost advantage. Salt is a commodity product—there’s little differentiation, and industry players compete on price. But Compass’ worldclass rock salt mines in Goderich, Ontario; Cote Blanche, La.; and the United Kingdom plus access to water transportation systems give the company the ability to produce and deliver highway deicing salt cost-effectively. Further, Compass’ energy-efficient Great Salt Lake solar evaporation facility gives the firm an edge in the production of SOP. As a result, Compass’ SOP margins have been quite handsome.

Current Price ($)

Morningstar Fair Value Estimate ($)

Fair Value Uncertantiy

Forward P/E

Dividend Yield (%)

Compass Minerals International, Inc. CMP Wide

58.67

85.00

Medium

10.7

2.5

X

Enterprise GP Holdings L.P. EPE

27.87

53.00

Medium

16.5

7.1

X

Wide

Stewardship Grade

IMS Health, Inc. RX

Wide

14.40

26.00

Medium

9.3

0.8

C

International Speedway Corporation ISCA

Wide

27.32

51.00

Medium

14.0

0.5

C

Mohawk Industries, Inc. MHK

Narrow

49.54

79.00

Medium

22.6

0.0

X

SunPower Corporation SPWRA

None

28.00

75.00

Very High

20.4

0.0

C

UTi Worldwide, Inc. UTIW

Narrow

Weight Watchers International, Inc. WTW Wide

14.40

24.00

Medium

15.3

0.0

X

26.39

41.00

Medium

9.5

2.7

C

Medium

N/A

0.5

Z

High

20.5

0.3

C

Wesco Financial WSC

Narrow

302.50

455.00

Wilmington Trust Company WL

Narrow

13.11

25.00

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We think Compass’ economic moat is quite strong, but there is always the possibility of attacks from either competitors’ irrational pricing or future viable substitutes for highway deicing salt. For example, Compass’ highway deicing salt competitors could decide to cut prices during one season in order to gain market share and put a financial squeeze on Compass, which has a decent amount of financial leverage. However, as the highway deicing salt industry is oligopolistic, we think this scenario is unlikely. And while a viable substitute for highway deicing salt could be developed, we believe this is only a remote possibility. Although Compass’ results will fluctuate from year to year on the basis of winter weather, we believe that over the long run, demand for highway deicing salt will reflect normal winter weather patterns, on average. If winter weather turns out to be milder in the future than it has been in the past, Compass’ results could fall short of our expectations. Further, we expect Compass’ specialty fertilizer profits to remain above pre-2008 levels. Weak demand for fertilizer, caused by factors such as weak crop prices or excess fertilizer supply, could cause Compass’ earnings power to fall back to historical levels. We’ve tried to capture this uncertainty by using scenario analysis to value Compass’ shares. Moat Trend | Positive Compass Minerals has strong competitive advantages as a result of its world-class, low-cost rock salt and sulfate of potash specialty fertilizer resources. We believe Compass’ moat is widening because of its ability to continue investing in high-return (positive net present value) projects. For example, the firm’s Goderich rock salt mine has a remaining life of 144 years, based on current rates of production, and Compass is investing to expand annual production from 7.25 million tons to 9.0 million tons over the next several years. This will leverage the inherent cost advantages endowed by Mother Nature on this

unique asset, furthering the company’s scale advantages. As Compass expands its rock salt production capacity at Goderich, it will likely be gaining market share. Compass’ rock salt operations do have at least some operating leverage (the numbers point to this), so we argue that as production from Goderich increases, that mine’s cost position could improve relative to a mine with stagnant production. In addition, the firm’s Great Salt Lake (GSL) sulfate of potash evaporation business—operating with another world-class asset—is accessing minerals that have an estimated life in excess of 100 years based on current rates of production, and Compass is investing to expand production by over 20% during the next few years. The cost advantage at the Great Salt Lake solar evaporation facilities stems from lower energy costs and lower raw material needs. As Compass expands the GSL facility, it increases its advantage relative to energy-intensive operations, and decreases its reliance on purchased raw materials. In this way, the cost position of GSL should improve in relative terms. Valuation Our fair value estimate is $85. Our forecast incorporates increased highway deicing salt sales volume in the long run, based on expanded capacity at the Goderich mine. We expect stronger profitability in the salt business (thanks to moderately higher total operating costs spread out over an even greater increase in tons sold) and in the specialty fertilizer segment (thanks to strong prices) to improve Compass’ overall operating margins. Our fair value is sensitive to our assumptions regarding the long-term profitability of Compass’ SOP business. If we assume that SOP profit margins fall back to historical levels, our fair value would be roughly $65 per share. However, we think it’s possible that either the current fertilizer tail winds will prevail for quite some time, or the dynamics of Compass’ SOP business have fundamentally changed and outsize profits are here to stay. Under these

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more-optimistic scenarios, we think Compass could be worth as much as roughly $131 per share. Our $85 fair value estimate incorporates these different scenarios and our assumptions about the likelihood of each. Analyst: Elizabeth Collins Enterprise GP Holdings LP EPE Stock Price (09/10/09): $27.87 Morningstar Fair Value Estimate: $53.00 Profile Enterprise GP Holdings owns the general partner stake in Enterprise Products Partners, Duncan Energy Partners, and TEPPCO Partners. The company also owns a minority interest in Energy Transfer Equity, the general partner of Energy Transfer Partners. Combined, these companies control pipelines and infrastructure that stretch from coast to coast. As a partnership, Enterprise GP pays no corporate income tax; its tax burden flows through to individual stockholders. Thesis With two big acquisitions, Enterprise GP Holdings transformed itself from a simple general partner to something more akin to a pipeline investment company. The new investments will lead to enhanced cash-generating potential as the underlying companies build new pipes and expand their networks.

In 2007, Enterprise GP bought stakes in the general partners of two separate midstream master limited partnerships. First, it acquired the entire general partner interest in TEPPCO Partners TPP from the two companies’ mutual parent company, EPCO. In the second deal, Enterprise GP bought a 17.6% stake in Energy Transfer Equity ETE, the general partner of Energy Transfer Partners ETP. With these transactions, Enterprise GP gains control of TEPPCO but will not participate in the management of ETE.

Our favorite part of these transactions is the upside that both new investments offer. MLPs reward their general partners for increasing cash distributions to unitholders over time by paying an increasing share of total cash to the general partner as distributions increase. Known as incentive distributions, these payments reward general partners for prudent management of the company’s assets. By the same token, the general partner would be hit particularly hard if it were forced to cut its cash distributions. We think the chances of a distribution cut at any of Enterprise GP ’s investments are relatively small, however, given the stability of the underlying assets. What’s more, Enterprise GP benefits from something of a portfolio effect, where a distribution cut at one of its investments will have less overall impact to cash available for distribution than other MLP general partners would experience. Even with the new investments, Enterprise will continue to earn more than half of its cash flow from its investment in Enterprise Products Partners LP EPD, the largest midstream MLP. With a presence in the Rockies, the Barnett Shale region in Texas, and all along the Gulf Coast, Enterprise Products has found ample opportunity to initiate internal growth projects to transport and process the increasing amounts of natural gas and natural-gas liquids being produced in these areas. Three recent projects stand out. First, the Independence platform and pipeline off the coast of Louisiana, which hit full capacity in late 2007, now gathers and transports a billion cubic feet per day (bcf/d) of natural gas from its deepwater position. Second, the company is building a new pipeline through the Barnett Shale that will carry 1.1 bcf/d of natural gas to Sherman, Texas. There it will connect with a new pipeline being built by Boardwalk Pipeline Partners BWP that will provide access to a variety of delivery points in the southeast and northeast U.S. And third, in February Enterprise’s Pioneer processing plant came on line, processing up to 0.75 bcf/d of Rockies gas gathered

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by the company’s Jonah gathering system. The natural-gas liquids extracted by the plant then travel through the company’s NGL pipeline system. Investments in TEPPCO and ETE further diversify Enterprise GP ’s asset base. TEPPCO boasts an extensive network of liquids pipelines, while ETE holds the strongest position of any midstream company in the Barnett Shale and owns Transwestern gas pipeline. Greater asset diversity will further insulate Enterprise GP from disruptions in any one area, which leads us to increase our economic moat rating to wide. Moat Trend | Stable We think Enterprise GP Holdings has a stable and wide economic moat, thanks to its ownership interests in Enterprise Products Partners, TEPPCO and Energy Transfer Equity. All three companies have extensive pipeline operations across multiple midstream product categories, and we therefore think of Enterprise GP Holdings as a sort of portfolio company for midstream energy. Because its ownership stakes include interests in general partners of master limited partnerships, Enterprise GP benefits from incentive distributions, which we believe will allow Enterprise GP to grow its distribution more rapidly than its underlying entities. With no operations other than its ownership interests, Enterprise GP has minimal direct expenses and passes substantially all distributions it receives on to its unitholders. We note, however, that chairman Dan Duncan and his affiliates control 78% of Enterprise GP, so public investors are pretty much along for the ride. Valuation Our fair value estimate for Enterprise GP Holdings is $50. Despite rough capital markets, we see plenty of promise in the underlying operating companies in which Enterprise GP has invested, and owning general partner interests in each will lead to much more rapid cash flow growth than an ordinary pipeline would experience. By our calculations, cash received from

subsidiaries will grow almost 14% annually over the next five years, which will allow cash distributions per unit to increase at an 11% annual clip. The growth rate for distributions per unit comes in lower than overall cash received because of parent company expenses. Rather than use a standard discounted cashflow model, we derive our fair value estimate by discounting our forecast of Enterprise GP ’s per unit distributions using a classic dividend discount model. We rely on our company models for Enterprise Products Partners, TEPPCO Partners, and Energy Transfer Equity to calculate the cash Enterprise GP receives from its investments in these firms. We assume a discount rate of 9.25% and a terminal growth rate of 6%. We think a 6% terminal growth rate is appropriate for Enterprise GP, given that the leverage inherent in incentive distribution rights will drive faster cash flow growth than distribution growth at the underlying companies. Like any dividend discount model, our valuation is very sensitive to this assumption, and a plus or minus 25 -basis-point change would result in a minus or plus $3 swing in fair value. Analyst: Jason Stevens IMS Health RX Stock Price (09/10/09): $14.40 Morningstar Fair Value Estimate: $26.00 Profile Based in Fairfield, Conn., IMS Health provides salesforce effectiveness, product portfolio optimization, brand management, and consulting services to the pharmaceutical industry. The firm offers these services by leveraging its database of prescription and over-the-counter drug sales. IMS uses more than 130,000 data suppliers to keep track of drug sales activity in more than 100 countries.

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Thesis IMS Health’s long-term prospects remain bright. Despite the ongoing salesforce restructuring of drug companies and regulatory risks, which are hurting IMS in the near term, we believe the company’s core value remains intact, in part because of drug companies’ reliance on IMS’ global information repository of prescription and over-the-counter drug sales to measure and maximize the performance of investments in new drugs. IMS maintains a unique database of drug prescription and sales activity collected from more than 130,000 information suppliers around the world. The majority of pharmaceutical and health-care companies use IMS’ information to measure the performance of their salesforce, refine sales strategies, discover potential new markets, and decide the configuration of their product pipeline. We believe IMS has a wide economic moat, because it would be very difficult for a competitor to replicate its wealth of data on a global scale.

Despite the breadth of IMS’ solutions, its fortunes are tied to the pharma industry and the regulatory environment. The recent trend in pharmaceutical salesforce reductions has hurt IMS’ salesforce effectiveness services, which big drug companies rely on to plan and measure the performance of their sales representatives. These services account for about 45% of total revenues, and the current restructuring and reduction in sales representative levels has hindered IMS’ near-term growth. In addition, potential regulatory changes have clouded IMS’ long-term opportunity. The company faces increasing legal hurdles as some privacy advocates, states, and doctors oppose the commercialization of prescribing information. However, IMS has taken the right steps to preserve its wide moat. Looking for alternative opportunities, IMS has expanded its array of services. First, in 2003, the company leveraged its database resources to

provide consulting services and additional applications. Since then, consulting services revenue has increased from $121 million to $543 million in 2008. Second, IMS is focusing on the opportunities presented by specialty therapy areas, such as oncology and diabetes, which are expected to grow faster than the overall pharmaceutical industry. In this area, the company has been collecting information and creating expertise in the diagnosis and treatment of such diseases, so pharmaceutical customers can have a better understanding of the potential market opportunities. Moat Trend | Stable The growing complexity of a global marketplace and pressure to extract value from a dwindling portfolio of drugs ensures the dependency of pharmaceutical companies on IMS’ information and services solutions. We believe two factors contribute to the stability of IMS’ wide moat. First, none of its rivals is anywhere close to matching IMS’ global presence, which enables the firm to keep track of more than 70% of all drug sales around the world. In fact, the next two largest competitors command just a fraction of IMS’ market share, so even consolidation among competitors does not pose an immediate threat. Second, the firm has done a good job at leveraging the value of its information and analytics offerings. A few years ago, IMS started offering consulting and services solutions on top of its information products. Consulting and services offerings not only create additional demand for information products, but also enable IMS to deepen its knowledge of and relationship with clients. Building on this success, the firm has started to offer business process outsourcing, which we believe, should reinforce clients’ reliance on IMS’ solutions.

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Valuation Our fair value estimate for IMS is $26 per share. In our model, we reflect a sharp revenue drop during 2009 as the company continues to experience weak demand for its solutions. Moreover, the pharma industry not only has downsized its salesforce, but it’s also fine-tuning its marketing strategies, which in turn has slowed the demand for IMS’ solutions and services. In addition, a likely wave of mergers and acquisitions within IMS’ client base will have negative near-term effects. As a result, we project average revenue growth of about 3% through 2013, including a 10% decline during 2009. While revenue growth from consulting services has recently slowed down, we believe that pharmaceutical companies’ need to balance and optimize their product pipelines will increase demand for this services. In addition, we believe that IMS’ efforts to serve small, but rapidly growing generics and biotech clients will pay off over the long term.

We expect gross margins to remain in the mid-50s over the next few years as higher data costs offset gains from scale. We model selling, general, and administrative expenses to reach around 30% of sales. We expect that the 2008 operating margin of about 21% will decline during 2009 but should gradually increase to around 23% by 2013. Our valuation model incorporates the effect of pensions and off-balancesheet obligations. We use an estimated cost of capital of 10% to discount future cash flows. Analyst: Rafael Garcia International Speedway ISCA Stock Price (09/10/09): $27.32 Morningstar Fair Value Estimate: $51.00 Profile International Speedway is the leading promoter of motorsports entertainment in the United States. The company owns or operates 13 race tracks including the well-known Daytona International Speedway

and Talladega Superspeedway. International Speedway hosts more than 100 racing events per year, which generate revenue from admissions, broadcasting rights to the races, food, beverage, merchandise sales, and advertising sponsorships. Thesis International Speedway benefits from barriers to entry that prevent other track operators from competing in its markets, as well as substantial intangible assets that keep fans loyal to its tracks. These competitive advantages give the firm a wide economic moat. NASCAR, like most sports, has strong traditions. Fans and drivers are accustomed to having certain races at certain tracks on certain dates, and any change would probably result in significant backlash. This provides a reliable revenue stream for International Speedway, as it can count on NASCAR to distribute races in a predictable way each year. Because fans’ loyalty to tracks is so strong, it would be extremely difficult for any competitor to enter a region with an existing track and usurp its races—just as it would be difficult for Wrigley Field to lose the Cubs to a newly built ballpark in Chicago.

International Speedway has forged the path of motorsports evolution since its inception. The company built and owns the longest superspeedway in America, Talladega Superspeedway. It also operates the most recognizable track in NASCAR racing, Daytona International Speedway. These two tracks together seat more than 300,000 fans, not including the infield, and rarely fail to sell out. Fan loyalty to drivers, cars, and tracks creates huge opportunities for companies seeking to spend marketing dollars via sponsorship. International Speedway is a direct and indirect beneficiary of these sponsorship dollars. While premier NASCAR events are a big part of International Speedway’s moat, they will provide little of the company’s future growth. The most prestigious

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races are almost always sold out, and the racing schedule is packed. However, the less prestigious race series have room for popularity growth, and the company has begun using its tracks for nonmotorsports events such as concerts. The challenge for International Speedway will be to get people to attend these various events and to utilize its tracks—which currently sit dormant for much of the year—as much as possible. There is a medium amount of uncertainty surrounding International Speedway’s future results because of heavy reliance on discretionary consumer spending, uncertain track expansion, and industry maturity. However, we think the company will continue to earn returns on invested capital in excess of its weighted average cost of capital into the foreseeable future. Moat Trend | Stable International Speedway benefits from the extensive cost required to build a competing racetrack coupled with its track record of successfully hosting popular races that are relatively limited in number. The company’s long-standing relationship with NASCAR also helps as NASCAR is reluctant to make any changes to the racing schedule that would not present a clear and obvious benefit. This relationship is further galvanized because a single family, the France family, owns a controlling stake in both NASCAR and International Speedway. As a result, we see no serious competitive threats to International Speedway’s position as the largest racing host in the nation, and expect it to retain its wide moat. Valuation Our fair value estimate is $51 per share. We believe the company will be able to increase revenue at an annual rate of 5.2% during the next 10 years despite a short-term drop in revenue of 11% in 2009. Because International Speedway has fixed costs associated with maintaining race tracks no matter how many people attend its races, we expect the drop in revenue

to lead to operating margin compression. However, operating margins should recover to around 30% as general economic conditions improve and consumers feel more confident about spending their income. Despite the short-term head winds that International Speedway faces, we believe the company will earn an economic profit during the next 10 years as the company improves returns on invested capital by increasing the utilization of its tracks via an increasing number of events per year. Analyst: Warren Miller Mohawk Industries MHK Stock Price (09/10/09): $49.54 Morningstar Fair Value Estimate: $79.00 Profile Mohawk Industries manufactures flooring products including carpets, tiles, resilient, hardwood, and laminate. It markets its products under various brands that include Aladdin, Mohawk Home, Bigelow, Karastan, and Custom Weave. Mohawk distributes these goods through a variety of retail and wholesale channels for use in the construction and renovation of homes, offices, hospitals, schools, and government buildings. Thesis Mohawk Industries has steadily become a commanding force in the $22 billion floor-covering market. The breadth and depth of the company’s distribution system remain unrivaled by its peers and will allow Mohawk to continue to bolster its share of the market, in our opinion.

As a result of continued consolidation over the years, the U.S. flooring industry has become a virtual duopoly, with more than 45% of the market controlled by Mohawk Industries and Berkshire Hathaway’s BRK.B Shaw Industries. No other competitor has more than a single-digit percentage share of the market. Mohawk Industries is the leading producer of floor-

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covering products for residential and commercial applications in the United States. Consistent with its strategy to be a diversified total flooring company, Mohawk is entrenched in every floor-covering category and at every price range. During the past decade, Mohawk has steadily increased its share of the flooring market through a series of well-executed and strategic acquisitions, including Dal-Tile in 2002 and Unilin Holdings in late 2005. Both of these sizable acquisitions have proved to be highly strategic in helping the firm expand its market position, as well as fueling continued earnings expansion in the modestly growing flooring industry. Unilin is the global leader in laminate flooring, one of the latest and fastest-growing segments of the flooring market. Mohawk is using its relationship with more than 30,000 vendors and its superior distribution capabilities to accelerate the penetration rate of Unilin’s products in the U.S., where laminate flooring is quickly gaining in popularity and growing at a double-digit rate. We would not be surprised to see Mohawk expand its market presence through smaller, bolt-on acquisitions to existing product lines. The severe and prolonged downturn in the housing and renovation markets has delivered a blow to Mohawk. It’s unclear when construction and remodeling activity will reach an inflection point, but when these markets eventually recover, Mohawk will be well positioned to capitalize on the upturn. In the interim, its strong product portfolio should generate enough revenue and cash flow to keep Mohawk’s head above water. Moat Trend | Stable Mohawk is the world’s leading producer of flooring products. Though it was once concentrated predominantly in the soft flooring space (i.e. carpets and rugs), Mohawk has expanded its presence into the faster growing ceramic tile, laminate, and hardwood flooring product categories in recent years. This product offering expansion has put Mohawk slightly ahead of

Shaw Industries in terms of total flooring market share (24% vs. 21%.) The rest of the flooring industry is highly fragmented. Eight of the other top-10 flooring companies average less than 3% market share, and the remaining third of industry revenues are split among firms with a negligible share of the market. This industry-mix imbalance gives Mohawk a competitive advantage as the company can leverage its production scale and expansive distribution network to continue to take share from its smaller competitors—particularly during challenging market conditions. The fragmented nature of the industry also gives a well established firm like Mohawk the opportunity to expand market share by rolling up its smaller competitors through acquisitions. While the company appears to be expanding its competitive edge, this is negated somewhat by the fact that returns on invested capital have been trending down over the last couple of years. The erosion in ROICs suggests that the firm likely overpaid for past acquisitions. In order to grow its moat, the company will have to show that it can not only become more competitive, but that it can also generate returns which prove it’s doing so in a value accretive way. Valuation Our fair value estimate is $79 per share. We expect unit volume to remain under pressure over the next few quarters as increased order activity now appears to be a 2010 event. We model for a 12.5% revenue decline in 2009, marking the third straight year of revenue erosion. Lower volume will further depress margins and earnings, though the company should start to realize the benefit of declining input costs during the year. We believe the operating margin could dip to around 5% in 2009, which is roughly half the average operating margin the company has achieved the past five years. We expect sales and margins to snap back in 2010, assuming construction and renovation activity return to more normalized levels. Analyst: John Kearney, CFA

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SunPower Corporation SPWRA Stock Price (09/10/09): $28.00 Morningstar Fair Value Estimate: $75.00 Profile SunPower Corporation is a vertically integrated solar products and services company. The company offers a variety of solar cells and panels based on traditional silicon technology, which currently have the highest cell conversion efficiencies in the industry. SunPower acquired PowerLight in January 2007, through which it designs, manufactures, and installs solar electric systems. The company went public in 2005. Thesis The future of the immature and rapidly growing solar industry remains fraught with uncertainty. Still, we believe SunPower has the technology and business model that will allow it to become one of the industry’s strongest companies.

We believe SunPower’s industry-leading technology currently gives it a leg up on its solar competitors. SunPower is the leader in cell conversion efficiency, which means its solar cells can generate more electricity at a given size than its competitors. This attribute also makes SunPower an ideal choice for home and business installations, where space constraints and aesthetics are important considerations. Additionally, the company has developed its own tracking systems that allow its solar panels to follow the Sun throughout the day. This allows for up to 30% more energy generation than traditional solar systems, while only being 5% more expensive to install. We believe SunPower will successfully lower its costs to the point where it will become an industry leader. In our opinion, the long-term winners in solar will be companies that produce electricity at the lowest cost. The final price customers pay for solar electricity is mainly determined by the costs of cells, the system (i.e., the additional equipment required to make a

solar cell operational), and installation. SunPower has low system and installation costs, as its cells require less equipment and labor to be installed. We believe the company’s acquisition of PowerLight, which installs solar systems, will enable the company to realize further cost savings as it now directly controls this portion of the value chain. With regards to its solar cell costs, the company continues to roll out higher-efficiency cells. This is significant, as each 1% increase in efficiency reduces SunPower’s costs by approximately 5%. The company also has dramatically reduced silicon usage in production, requiring less of this vital raw material. Finally, economies of scale from capacity expansion should help drive cell costs down. We feel SunPower’s advantages will be short-term in nature, as competitors will close the technology gap and copy the company’s business model. Still, we think SunPower can leverage these to create a size advantage over its peers that will allow it to remain an industry leader for years to come. Despite the attractive business model that SunPower has developed, there are some serious risks to its future success. To begin with, SunPower has yet to prove it can consistently generate profits. Also, like all solar companies, SunPower’s economic viability is the result of government subsidies that are by no means indefinite. While the company has done a good job of positioning itself in a nascent industry, it has a long way to go before it will be able to stand on its own and compete with traditional electricity sources. Within the solar industry, startups and existing companies are rapidly expanding the manufacturing capacity of the solar industry. We expect cell supply to outstrip demand in the near future, and significant downward pressure on selling prices will follow. Finally, renewable energy companies are attracting significant amounts of capital. Alternative technologies could emerge that are superior to SunPower’s solar cells.

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Moat Trend | Stable Competitive (i.e. cost) advantages are likely to prove short-term in solar, which in our opinion is a nomoat industry. SunPower’s solar technology remains unique, as the company can generate more electricity over a given surface area than any other solar panel. However, its production costs are currently higher than the other tier one silicon-based players (Suntech, Yingli, and Trina Solar), reducing the value of this advantage. We expect the company will have success in the coming years, as future cost reductions will allow it to keep its status as one of the industry’s costs leaders. Still, we feel over the longterm competitive forces and disruptive technologies will eventually erase any cost advantages developed over the near-term. We do not see SunPower digging anything but the most fleeting of economic moats, and this situation appears stable on a net basis. Valuation Our fair value estimate is $75 per share. We believe SunPower will be able to reduce manufacturing, systems, and installation costs in the face of declining selling prices, and we have modeled gross margins to be between 23% and 25% during the next five years. Further, increased output will lower operating costs as a percentage of revenues, and we expect operating margins to remain above 10%. We caution investors that numerous factors create a very high degree of uncertainty to our fair value estimate. First, the oversupply that currently exists in the solar industry could lead to irrational pricing that would significantly hurt both revenues and margins. Finally, SunPower is very immature, and it is far from certain that the company will be able to generate solar electricity below the costs of its competitors in the long run. Analyst: Stephen Simko

UTi Worldwide UTIW Stock Price (09/10/09): $14.40 Morningstar Fair Value Estimate: $24.00 Profile UTi Worldwide is one of the world’s largest third-party logistics firms, offering a complete suite of supplychain management services, including air and ocean freight forwarding, customs brokerage, order management, contract logistics, and road distribution. UTi operates 390 freight forwarding offices, 200 logistics centers, and 60 contract logistics centers within client facilities. Net revenue is derived from Africa (16%), Europe (24%), the Americas (33%), and Asia (27%.) Thesis UTi Worldwide has knit together a freight forwarding and logistics web capable of serving as its clients’ single-source international shipping solution. The difficulty of establishing such a network establishes a narrow economic moat guarding the firm’s profits from potential competitors. We believe the logistics market is attractive and consider UTi to be wellpositioned to continue to generate returns in excess of its cost of capital.

Transporting goods from a manufacturer to an overseas customer can be a complex ordeal. Consider a small order for a component manufactured in central Mexico, bound for eastern Europe. A pallet must be trucked to a consolidation facility to be packed into an ocean container, driven to a sea port by truck or rail, then loaded on a ship. Upon arrival on the destination continent, an appropriate truck is contracted for delivery to a deconsolidation center, warehouse, or client. Reliable pickups and deliveries must be arranged in advance to avoid delays, import/export documentation must be compiled in appropriate languages, and tariffs have to be paid in proper currencies.

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Many firms prefer to focus on a core competency rather than develop the expertise required to accomplish deliveries to myriad nations. A third-party logistics (3PL) firm removes this hassle by establishing relationships with air and ocean lines, trucking firms, and warehouses. They provide the know-how for negotiating legal import and export in nations spread throughout the world. The 3PL industry is expanding with increases in international trade and outsourcing of manufacturing operations. Freight forwarders like UTi go beyond executing timely delivery to offer online shipment tracking and the ability to divert a load from its anticipated destination. UTi’s average 10% net operating margin pales by comparison with Expeditors’ EXPD mid-20% level. We believe this is because of lower efficiency stemming from UTi’s historical growth via acquisitions versus Expeditor’s more efficient practice of building a single network from the ground up. The profitability gap is also because of UTi’s offering of lower-margin contract logistics services in addition to pure freight forwarding. We expect UTi to improve profitability as it regroups during its present (and prudent) moratorium on acquisitions, particularly as the firm integrates onto a single technology platform during the next couple of years. Management made some tough loss-reducing decisions during February 2008 when it terminated its South African pharmaceutical delivery business, ended some unprofitable logistics contracts, and reduced head count in many locations. We expect these choices to pay dividends during the next few years. Moat Trend | Stable UTi has knit together a freight forwarding and logistics web capable of serving as its clients’ single-source international shipping solution. The difficulty of establishing a network of capable, connected offices arround the world establishes a narrow economic moat guarding the firm’s profits from potential competitors. While the firm’s low double-digit oper-

ating margins are not as high as Expeditors’ (EXPD) 25+% level, UTi has generated impressive returns on invested capital, averaging 20% during the past five years. We believe ROICs will improve in the future since we expect UTi to improve margins during the next few years when the firm is moving to a single IT platform to consolidate numerous acquired operations. Management also discontinued some unprofitable operations in early 2008. Market share is difficult to ascertain, given the fragmented nature of this industry. Larger forwarders include DHL, Shenker, Panalpina, Kuhn+Nagle, Expeditors, and Kintetsu. We estimate UTi’s share to be 1% of global air and ocean forwarding. Valuation Our fair value estimate for UTi is $24 per share. We project gross revenue during fiscal 2010 to contract about 14%, followed by an 11% recovery. Long run we project about a percent of growth per year because of acquisitions, but we model no acquisitions during 2010–11. We project UTi to deliver margins at 9% of net revenue during fiscal 2010, then improve slightly over the long run because we believe the firm will realize significant savings from its current marginimprovement projects, particularly the implementation of a single IT system and the rationalization of loss-making contracts. Although the firm has incurred nonrecurring reorganization expenses and taken some noncash impairment charges during the last couple of years, we don’t believe this will persist beyond fiscal 2010. Analyst: Keith Schoonmaker

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Weight Watchers International WTW Stock Price (09/10/09): $26.39 Morningstar Fair Value Estimate: $41.00 Profile Weight Watchers is a leading weight-management company with operations in more than 25 countries. Consumers bought $4 billion of Weight Watchersbranded products in 2008, and every week approximately 1.4 million people attend Weight Watchers meetings worldwide. The company encourages healthy weight loss through exercise, nutrition, and portion control. Weight Watchers also offers Internet- and magazine-based weight-management products. Thesis Weight Watchers has a reputable and differentiated product in an industry that is rife with false claims. The company benefits from a wide moat because it would be extremely difficult for a competitor to replicate the company’s brand recognition and meeting infrastructure to compete with Weight Watchers in a significant way.

According to the Center for Disease Control and Prevention, an estimated 66% of the adult population of the United States is overweight, and 34% is considered obese. Worldwide, nearly 1.6 billion people are considered overweight or obese. Increasingly inactive lifestyles and the prevalence of unhealthy food are often blamed for the growth of the number of overweight people, and we see no evidence that this trend will slow in the foreseeable future. Weight Watchers is the largest provider of weight-management solutions, and it captures nearly 3% of the highly fragmented $55 billion global market. Weight Watchers adds value for its customers by making the weight-loss process easier with groupbased support and easy-to-understand dietary guidelines. No other company can match the Weight Watchers’ support infrastructure of 15,000 leaders

who run more than 50,000 weekly meetings in which members discuss weight-loss challenges, set goals, and monitor progress. In addition, the Weight Watchers brand is so trusted that large food companies and restaurants have begun licensing the brand for use in the advertising of their own products. Weight Watchers can continue to capitalize on its strong brand reputation in several ways. The company’s licensing revenue has only scratched the surface with eight licensees in the United States and 11 more abroad. In addition, the company should have an easier time expanding internationally. International meeting attendance reached 23.6 million in 2008 compared with 36.5 million domestically. An increasing number of attendees fuels a network effect that increases the value of the member-driven support that Weight Watchers offers to its subscribers by improving the quality of meeting leaders and expanding the geographic convenience of meetings. The deteriorating consumer spending environment contributes to the medium uncertainty surrounding Weight Watchers’ future. However, we believe that short-term demand challenges will eventually subside, and Weight Watchers’ capital-light business model should allow it to earn an economic profit in all but the most dire of downturns. Weight Watchers recently increased its debt load to buy back approximately 20 million shares of its own stock. Moat Trend | Stable Weight Watchers provides a differentiated and valueadding product in the highly fragmented weightmanagement market. The company’s focus on sustainable weight loss has built its brand reputation to the point where food manufacturers are licensing the brand for use on their products. In addition, it would be extremely difficult for a competitor to replicate the company’s 50,000 member-driven group meetings per week where fee-paying customers gather to talk about the challenges of weight loss. The meetings are

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run by Weight Watchers’ 15,000 group leaders, who are trained by Weight Watchers and run their meetings as franchises. Since the Weight Watchers approach is based on member participation, its meetings hold greater value as participation increases. This allows Weight Watchers to keep competitors at bay because a start-up meetings-based organization would have a very difficult time luring members away from Weight Watchers’ established meetings. We do not see any competitive threat that would erode Weight Watchers’ economic moat in the foreseeable future. Valuation Our fair value estimate for Weight Watchers is $41. We believe Weight Watchers will be able to increase revenue at an annualized rate of 1.6% during the next five years. This is lower than the 13% annualized growth the company has realized since 2002 because we believe the global economic downturn will put pressure on demand for weight-management products in the short term. However, we think the growth that Weight Watchers does achieve will be driven by expanding its customer base to include men, increasing Internet penetration, and international expansion efforts. Weight Watchers should also gain operating leverage as it grows because of the rapid expansion of its fixed-cost lines of business such as Internet subscriptions. As a result, we think Weight Watchers’ operating margins will recover after bottoming around 25% during the economic downturn to about 30% within five years. Analyst: Warren Miller Wesco Financial WSC Stock Price (09/10/09): $302.50 Morningstar Fair Value Estimate: $455.00 Profile Wesco is a holding company that owns insurance, furniture rental, and steel service businesses. Wes-FIC offers super-catastrophe reinsurance. Kansas Bankers Surety provides bank insurance. Precision

Steel services niche steel markets. CORT leases furniture and also offers relocation services. Thesis Wesco Financial is a holding company whose subsidiaries rent furniture, bend metal, and underwrite insurance. Wesco is 80%-owned by Berkshire Hathaway BRK.B, and Wesco’s CEO and chairman Charles Munger has long been a close partner of Warren Buffett. We think Wesco has garnered a narrow moat through the financial strength in its insurance operations, which derives from a high level of capital, underwriting ability, and investment success. This is a timely combination, as Wesco has cemented its future prospects amid difficult times in the insurance industry.

Wesco’s insurance operations have expressly pursued underwriting profit as an independent goal; the firm doesn’t use insurance simply as a float vehicle for pursuing investment returns. Since 2000, the firm’s combined ratio has averaged well below 90%, an exceptional result in a period that included three significant industry loss years. But Wesco’s insurance operations have entered a transformational period. Wes-FIC has spread its wings, and it will be gathering significantly higher premium under a new reinsurance arrangement. Wesco has entered into an agreement with Berkshire’s National Indemnity reinsurance arm and Swiss Re, one of the largest insurance firms in the world, whereby Wesco will assume a 2% share of Swiss Re’s property-casualty exposure during a fiveyear period beginning in 2008. This arrangement and other opportunities should lead to significantly higher earned premium volume. Wesco carries very high capital relative to underwriting revenue and loss reserves compared with industry averages. Its capital should be more than adequate to support the higher underwriting volume and in relatively profitable positions in reinsurance arrangements.

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Wesco has accumulated funds for investment by reinsuring large catastrophes via agreements with parent Berkshire Hathaway. Wesco’s capital strength and relationship with Berkshire have enabled it to participate in super-catastrophe coverage on very attractive terms. Wesco’s subsidiaries also include insurer Kansas Bankers Surety, which offers a tailored line of specialty bankers’ insurance products and has established enduring relationships with many Midwestern banks. Wesco has announced its intent to exit this business in light of industry conditions, and while losses under this coverage could be material in 2009, we believe Wesco has managed to effectively cap exposure relative to its capital. Kansas Bankers provides a range of specialized banking insurance services, and should continue to do well in those areas in the years ahead. Wesco’s Precision Steel subsidiary provides value-added steel inventory and distribution services. The CORT subsidiary is a leader in the furniture rental business focused on the “rent-to-rent” market segment. We think this mixed set of subsidiaries add value in a number of ways, including the windows into general economic conditions that they provide for investment and capital allocation decisions. Moat Trend | Stable Financial strength has laid a basis for Wesco’s moat for some time, and its ample and underutilized underwriting capacity has come in handy as the unsettled financial and insurance market conditions developed in the past two years. Wesco and its parent, Berkshire Hathaway, have been attracting very good pricing for attractive positions on reinsurance contracts these days. Wesco’s earned premium revenue rose four-fold in 2008, with similar growth into the first quarter of 2009. Wesco remains exposed to difficult-to-anticipate casualty losses, but its capital attractiveness likely allowed it to write higher retrocession cover through National Indemnity for Swiss Re profitably.

Valuation We’ve reduced our fair value estimate for Wesco to $455 from $490 per share. We’ve cut our near-term growth and profitability assumptions in the firm’s operating subsidiaries in light of weaker-than-anticipated first-half 2009 results. We’ve also cut our overall earned premium growth assumptions somewhat but still anticipate an annual average rate of 17% through 2015, a significantly higher pace than that of other reinsurance enterprises, in light of Wesco’s outsized recent gains and its ample capacity relative to premium volume or loss reserves. We continue to project somewhat lower underwriting profitability than historical averages along with the higher growth, but Wesco should continue to attract relatively profitable reinsurance business. Like the other reinsurance firms we follow, we explicitly include a heavy industry loss year in 2011, followed by a hardening market and higher revenue gains in 2012, to gauge the possible impact on the capital position. It’s difficult to gauge the effects of a hard year with a any great deal of precision, but Wesco’s ample capital position clearly shows in this exercise. We assume a 10% cost of equity, significantly lower than that of most reinsurers, in light of Wesco’s capital strength. Our fair value uncertainty rating is medium. Analyst: Bill Bergman Wilmington Trust WL Stock Price (09/10/09): $13.11 Morningstar Fair Value Estimate: $25.00 Profile Wilmington Trust operates a distinctive multifocused business model. One half of revenue comes from its regional banking enterprise, which is the leading deposit taker and lender in Delaware and is also a major lender in Philadelphia, Baltimore, and surrounding areas. The other half of revenue comes from the fee-based trust, tax, and asset-management and administrative services offered to corporate and high-net-worth clients.

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Thesis Wilmington Trust’s regional banking business in Delaware and its fee-based services produce decent returns for shareholders. While future loan losses will probably be higher than in the past, we like the longterm prospects of this bank.

The focus on the state of Delaware enables Wilmington to benefit from the unique advantages it offers and shields it from potential competitors. Delaware enjoys a diversified economy powered by a pro-business political culture. As a result, the state is a prime tax, legal, and regulatory haven within the United States and draws a boatload of businesses that chose to incorporate and operate in Delaware. Wilmington, which holds a 45% share of the state’s deposits and is the largest lender and deposit taker, offers unsurpassed knowledge of the advantages of operating in Delaware. Wilmington has also built a formidable fee-based business that is anchored in trust and administration services, wealth advisory, and wealth management. These lines of business diversify the bank’s revenue stream and reduce its dependence on its spreadbased banking operation, which is subject to credit cycles. What’s most impressive to us is the bank’s global reach and product diversification. Wilmington has clients in 86 countries, most of which are corporations that seek trust services in Delaware. The bank offers a wide range of products, which provides some revenue stability when global capital markets perform poorly. If demand for a particular service declines because of a downturn in the market, the bank can still make money from its other services. We like the fact that fee income is more than 50% of total revenue, and although we don’t think past growth rates will repeat themselves, we think the fee businesses will continue to differentiate Wilmington from its peers.

However, we think the bank’s search for growth in neighboring states is a source of concern. With a loan/deposit ratio above 100%, the bank will have to garner new core deposits so that new loans put on the books will generate attractive returns. If the bank funds new loans with wholesale deposits or other expensive funding sources, net interest margins and returns on equity will decline. Given the operating and credit costs involved in underwriting loans, expanding to neighboring states might be an unattractive proposition to existing shareholders. Nevertheless, the scale of Wilmington’s banking endeavors outside Delaware is still dwarfed by the bank’s other businesses. Investors should watch out for major changes on this front. Moat Trend | Stable Wilmington operates the largest branch network in Delaware and holds more than 40% of the deposits. Thus, the bank dominates the Delaware market and keeps its competitors at bay. New entrants or even existing players will find it extremely difficult to match Wilmington’s deposit-gathering capabilities within Delaware. In addition, Wilmington is perceived to be the ultimate local choice for clients who want to “bank local,” leaving out-of-state competitors at a disadvantage.

Wilmington’s corporate trust and wealth management services aren’t as scalable as its prime competitors, but clients still face high switching costs and tend not to replace service providers for fear of disruption to their operation.

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Valuation Our fair value estimate is $25 per share. We estimate that average net charge-offs as a percentage of total loans will rise to as high as 200 basis points (previously 156) before settling down to 77 in the long run. This is much higher than the bank has traditionally seen, but we base this on our expectation of weaker economic conditions in Wilmington’s lending markets. We also think Wilmington has to step up its provisioning as the level of the allowance for loan losses is somewhat light, in our view. We assume annual loan growth will slow before picking back up to a 5% annual growth rate by 2013. For the fee-based business lines, we forecast noninterest revenue growth averaging 6% per year through 2013. We model a long-term efficiency ratio of 60% (previously 56%.) œ Analyst: Michael Kon, CFA

About the Author… Paul Larson is an equities strategist for Morningstar and editor of the company’s flagship stocks newsletter, Morningstar StockInvestor. As part of his role as editor, he manages two stock portfolios—the Tortoise Portfolio, which is designed for conservative stock investors who embrace slow and steady growth, and the Hare Portfolio, which is designed for those who can handle more volatility.

In the fall of 2005, Morningstar launched its first workbook series on stock investing, which Larson edited. The Morningstar Investing Workbook Series: Stocks is a sequence of three workbooks that guide readers through every stage of stock investing, from understanding the basics to refining a retirement portfolio. The workbooks are offered independently, but designed for use sequentially.

Disclosure: The cook at StockInvestor is eating the cooking! Paul

Larson owns the following: CMP, EPE, ISCA

Larson joined Morningstar as a stock analyst covering the energy sector in 2002. In 2004, he was named associate director of stock analysis for the energy sector. Previously, he spent more than five years as a writer-analyst with The Motley Fool. Larson holds a master’s degree in business administration from the Keller Graduate School of Management as well as a bachelor’s degree in biomedical engineering from the University of Illinois at Chicago. He completed two years of medical school at the University of Illinois at Chicago.

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