Morningstar.com
Market Dip Spells Opportunity for Bargain-Hunters
Monday July 30, 5:30 pm ET
By Jeffrey Ptak, CPA, CFA

Following is a sampling 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.

BioMed Realty
Moat: Narrow Risk: Avg Price/Fair Value Ratio: 0.71 Trailing 1-Year Return: -24.1%

What It Does: BioMed Realty (NYSE:BMR) is a real estate investment trust that owns and develops laboratory and office space for the life science industry. The company's tenants include biotech and pharmaceutical firms, research institutions, and government agencies. The firm's nearly 100 buildings constitute almost 9 million square feet and are located in markets recognized for life science research. BioMed also has a development pipeline and land bank that comprise about 2.4 million square feet internationally.

What Gives It an Edge: In Morningstar analyst Heather Smith's estimation, BioMed has carved out a narrow moat by focusing on an under-penetrated niche in the commercial real estate market--laboratory space in the life sciences. The firm has built a collection of premiere facilities in life sciences cluster markets such as San Francisco, Boston, and San Diego, and also possesses a large network of contacts in order to make wise leasing decisions. Tenants are also extremely sticky given their substantial investments in customizing lab space, and sign multiyear leases that cover most property operating expenses. As a result, BioMed's return on real estate assets is solid at 10%.

What the Risks Are: Smith believes that BioMed courts average business risk, meaning that she'd invest in the shares at a moderate discount to her fair value estimate. Because BioMed is focused exclusively on the life sciences, it is vulnerable to any slump in the sector. A decline in research and development spending at pharmaceutical companies, or a drop in government funding for research, would adversely affect cash flows and the company's ability to fully cover the dividend.

What the Market Is Missing: Shares of real estate investment trusts have taken a tumble year-to-date, falling nearly 15% on worries about rising interest rates and pricey stock valuations. BioMed itself has seen its stock plunge 26% despite strong earnings reports and promising new development projects. Given its conservative capital structure and business strategy, Smith believes the company has little exposure to rising interest rates and, thus, thinks the shares are attractively valued at current levels. In Smith's view, the firm's growth prospects remain bright as more pharmaceutical companies sell their real estate and funding for life sciences research climbs.

Isilon Systems
--Moat: None --Risk: Above Avg --Price/Fair Value Ratio: 0.53 --Trailing 1-Year Return: NA

What It Does: Isilon Systems (NasdaqGM:ISLN - News) is a high-growth storage vendor specializing in storage systems for digital assets, such as audio, video, and digital images. The solution depends on a proprietary storage operating system called OneFS, which lowers customers' management costs for a cluster of storage boxes. The overall system can scale larger than traditional storage systems by connecting multiple storage boxes that can be accessed and managed as one unit.

What Gives It an Edge: Morningstar analyst Rick Summer points out that while traditional storage systems are great at storing large numbers of small blocks of data, they perform poorly holding large files that need to be accessed simultaneously by a large number of users. However, storing large files that are not easily separated (e.g., heavy graphical images or video) is much more difficult. Isilon's proprietary storage products help customers store and manage these large files with great flexibility. In fact, storage needs are expanded almost as easily as blowing air into a balloon. As a result, Isilon's existing customer base has been a steady source of new revenues for the company, representing approximately 50% of last quarter's revenues. If Isilon can continue to grow, these existing customers may become the source of a strong competitive advantage.

What the Risks Are: Summer believe that Isilon poses above-average business risk and, thus, would demand a wide margin of safety when investing in the shares. The company faces several risks, including competition from a host of startups such as Exanet and Polyserve, as well as large companies like EMC (NYSE:EMC), NetApp (NasdaqGS:NTAP), and Sun Microsystems (NasdaqGS:SUNW). As many companies may look to consolidate their number of storage vendors, Isilon may be shut out of future sales opportunities. Finally, the company faces execution risk as it moves into new geographies and new industries.

What the Market Is Missing: Summer thinks the market is overly focused on the uncertainty of short-term results. Because Isilon is a hyper-growth company growing in excess of 50% annually, Summer believes its long-term growth opportunity is the most important area for investors to focus on. Furthermore, due to the company's small size, Summer doesn't expect linear growth (which is why he demands a large margin of safety when investing in the shares). As Internet companies, cable companies, and medical companies continue to starve for storage capacity to hold their video and images, Summer thinks Isilon is in the sweet spot of storage.

Progressive
--Moat: Wide --Risk: Avg --Price/Fair Value Ratio: 0.75 --Trailing 1-Year Return: -13.5%

What It Does: Progressive (NYSE:PGR) underwrites private and commercial auto insurance and has almost 10 million policies in force (PIF). It is the third-largest auto insurer in the United States. The company markets Drive Insurance policies through more than 30,000 independent insurance agencies in the United States and Canada. Direct-marketed policies, sold under the Progressive brand online and via telephone, represent about 36% of total PIF, while agent-marketed policies represent the remaining 64%.

What Gives It an Edge: In Morningstar analyst Jim Ryan's view, Progressive's superb underwriting and pricing model is the best in the auto insurance industry. This allows Progressive to accurately assess the consequences of rating changes and the effect on the bottom line. In Ryan's view, this capability, along with strong claims service and advanced technology, confers a wide economic moat.

What the Risks Are: Ryan thinks that Progressive courts average business risk. Progressive's key risks are a lapse in underwriting discipline that causes underwriting losses and an increasingly hostile competitive environment that is driven by firms cutting prices to steal business. Consumer groups have been lobbying state governments to outlaw the use of credit reports in underwriting decisions. If they succeed, Progressive's "financial responsibility" algorithm would need to be replaced, which might temporarily reduce the firm's underwriting margins. We think this is a low-probability risk. Progressive's wide margins are a helpful cushion.

What the Market Is Missing: With falling rates and an increasingly competitive auto insurance market, Ryan believes investors should be gravitating to the more experienced and reliable companies such as Progressive. Ryan also thinks the market is not granting full credit to Progressive's recently announced $4 billion recapitalization plan that will pay a $2 per share dividend in September of this year. Ryan also points out that the firm is slated to repurchase about 100 million shares over the next two years.

Warner Music Group
--Moat: Narrow --Risk: Above Avg --Price/Fair Value Ratio: 0.61 --Trailing 1-Year Return: -45.9%

What It Does: With about $3.5 billion in revenue, Warner Music Group (NYSE:WMG) is one of the largest music companies in the world. More than 80% of Warner's revenue comes from recorded music, which has a roster of almost 40,000 artists. The rest of Warner's sales come from music publishing. Warner Music was formerly a subsidiary of Time Warner (NYSE:TWX), was purchased by a consortium of private equity investors in 2004, and is now a public company trading on the NYSE.

What Gives It an Edge: As one of the largest music companies in the world, Warner owns a huge catalog of hit songs that can be monetized for many years in a variety of ways including CD sales, digital sales, and licensing to film studios and advertisers. Also, by owning some of the best labels in the music industry, Warner is able to continually attract top musical talent. Taken together, Morningstar analyst Larry Witt believes that these traits make for a narrow economic moat.

What the Risks Are: Witt thinks that Warner courts above-average business risk. Digital piracy has been a major disruption to the music industry. If Warner can't convince consumers to pay for digital music, our forecasts might be too optimistic. Another concern is Warner's debt load, a legacy of the company's buyout from Time Warner. Warner doesn't have much flexibility, and most of its cash must go to servicing debt. With more than half its revenue coming from outside the United States, Warner also faces currency risk.

What the Market Is Missing: Like its peers, Warner Music continues to suffer from the decline in physical sales as consumers increasingly rely on digital downloads and file-swapping for their music. Witt believes that piracy and the ability to digitally purchase single tracks as opposed to entire albums will lead to continued revenue declines for Warner and the industry. However, Warner seems to be suffering less than its peers. During the first quarter of 2007, CD sales slipped 17% industrywide, but only 5% for Warner. In addition, Warner has done a better job, in Witt's opinion, of distributing its content through digital sales than its peers. Witt also thinks the market is overlooking the smaller, but fast-growing ancillary markets like mobile music and licensing to video games.

* Price/fair value ratios calculated using fair value estimates and closing prices as of Friday, July 27, 2007.

Jeffrey Ptak, CPA, CFA is a stock analyst with Morningstar.