Who's Who in PowerPicks 2005

S&P's analysts give the inside scoop on their collective favorites and why the stocks could perform strongly

By sector, here are the 40 members of Standard & Poor's PowerPicks 2005 portfolio -- the collective "best ideas" of S&P's equity research staff (see BW Online, 12/31/04, "S&P's New Picks of the Crop") -- and a brief investment rationale from S&P for each:

Consumer Discretionary

Best Buy (BBY ): We expect this well-positioned retailer of consumer electronics to benefit from strong demand for products such as LCD and plasma TVs, digital-imaging products, and portable audio devices. Additionally, we think Best Buy has been able to consistently demonstrate its operational excellence, and we have confidence in its goal to achieve 7% operating margins by fiscal 2007 (ending February). We think a premium valuation to the S&P 500 is warranted due to our expectation of above-average earnings growth.

Guitar Centers of America (GTRC ): As the leading player in its market niche, we believe Guitar Centers is a "category killer" in a fragmented U.S. market. We forecast total revenue growth of 14% in 2005, with EPS driven 17% higher by margin expansion from improved inventory management and leverage over fixed costs. Based primarily on our discounted free cash-flow model, we believe the shares are significantly undervalued.

Harrah's Entertainment (HET ): S&P expects this diversified gaming outfit to acquire Caesars Entertainment by mid-2005, which should provide opportunities to boost revenue and reduce cost. The transaction will likely boost Harrah's presence in a number of markets, including Las Vegas and Atlantic City. Looking ahead, S&P expects Harrah's to benefit from efforts to encourage customer loyalty, and we see opportunities to utilize the Caesars brand with additional gaming facilities. Trading at a discount to peers, we believe the stock is underpriced.

La Quinta (LQI ): Our bullish 2005 investment outlook for the lodging-property owners largely reflects solid leisure and improving business-travel assumptions boosting the recovery in the lodging industry. Also, the U.S. dollar's decline relative to other currencies should stimulate foreign tourism and provide an incentive for domestic travelers to remain in the U.S. With recent acquisitions, we believe La Quinta is well-positioned to generate revenue and earnings above its peers. We see rising net asset value as providing stability for the shares and expect that profitable quarterly results forecasted for mid-2005 will provide a longer-term catalyst.

News Corp. (NWS ): This vertically integrated media conglomerate, which recently changed its domicile from Australia to the U.S., seems to be well-positioned to benefit from a changing competitive landscape. The key drivers should include a global satellite-TV distribution platform (in DirecTV, BSkyB and Sky Italia), and ownership of some premier content assets (through Fox Entertainment). We believe that the group's portfolio offers a good mix of diversified assets, with a relatively balanced exposure to different but somewhat related businesses (advertising, subscription, content) and geographic regions (the U.S., Europe, Australia, and Asia).

Pacific Sunwear (PSUN ): PacSun's multiplicity of apparel, accessories, and footwear brands seems to us a key competitive advantage, allowing management to adjust brand assortments to best meet its core customers' changing tastes. Based on our fiscal 2006 (ending January) EPS estimate, the shares are priced at a steep discount to the S&P MidCap 400 and the teen-apparel retail peer group, a discount we regard as unwarranted. We think it will diminish over the coming 12 months.

Consumer Staples

Brown-Forman (BF.B ): We see the concern's premium brands, such as Jack Daniel's whiskey, benefiting from favorable demographic trends and rising demand in the premium spirits categories. We also expect international sales to strengthen in light of a weaker dollar and continued investment in leading growth brands. Trading at a 2005 p-e multiple well below both its alcoholic-beverage peers and the stock's historical average, we view the shares as attractive.

Chattem (CHTT ): Our strong buy recommendation is driven by Chattem's leading market position in niche personal-care categories and attractive valuation. Success in niche categories such as over-the-counter health-care products, dietary supplements, and skin-care products, affords Chattem the highest operating margin in our personal-care universe -- over 25%. We think the stock is underpriced on a forward p-e, p-e to growth rate (PEG), and discounted free cash-flow basis.

PepsiCo (PEP ): We believe strong demand for new products, expanding margins, a high degree of EPS visibility and consistency, rising free cash flows, a robust innovation pipeline, and a large share-repurchase program make this food and beverage giant's stock attractive. Based on the business' leading market positions in the growing worldwide packaged beverage and snack-food industries, we expect PepsiCo to deliver 11% to 12% annual EPS growth for the longer term, placing it among the top companies within our food and beverage coverage universe.

Walgreen (WAG ): As one of the largest chain drug-store operators in the U.S., we see the outfit as well-positioned to benefit from new drug introductions, a strong and efficient new store expansion program, and favorable demographic trends. We believe an innovative management team, which is increasing stand-alone store locations and shop hours, will continue a 30-year trend of earnings and sales growth. We think the stock is undervalued on a discounted cash-flow and forward price-to-earnings basis. Energy

ChevronTexaco (CVX ): As the second-largest U.S. oil concern and a top-five U.S. refiner, ChevronTexaco's earnings and returns are likely to improve as it restructures globally. While we view recent hydrocarbon production declines as reflected in the outfit's relatively low forward p-e, ChevronTexaco targets annual growth of 3% through 2009 as it shifts away from mature oil and gas fields into deepwater areas, non-conventional oil fields, and liquefied natural gas (LNG), which have higher margins and growth prospects. We calculate a wide spread between its return on capital employed and cost of capital over the past 12 months, indicating that the outfit is creating value for its shareholders.

Devon Energy (DVN ): On an earnings and cash-flow basis, Devon is among the most attractively valued stocks in our universe of exploration and production players. We like the company's emphasis on North American production and natural gas reserves and believe it will continue to control cash operating costs more successfully than peers due to savings resulting from its merger with Ocean Energy. Substantial excess cash is likely to be generated from operations, and divestiture proceeds will probably be used to accelerate balance-sheet improvements and repurchase common stock.

Nabors Industries (NBR ): This is the leading player in U.S. land drilling, with nearly 600 rigs and a strong presence in important international markets, such as the Middle East. Industry fundamentals remain extremely strong, and with very little spare capacity industrywide, Nabors is best able to take advantage of strong demand. The shares trade at a modest premium to peers, based on enterprise value to 2005 EBITDA, but are priced at a discount on a price to cash-flow basis.


Allstate (ALL ): Shares of this leading property-casualty insurer are expected to benefit from improved underwriting trends in its core personal line insurance business. We're also encouraged by its recently enhanced pricing and risk-selection capabilities. Allstate is also likely to gain from some macro improvement in personal auto-loss trends. We don't think the company will be impacted by the widening Attorney General investigations into certain industry marketing practices. We believe the shares deserve an expansion in their current discounted forward p-e multiple.

Citigroup (C ): Citigroup's geographic and product diversity, focus on expense management, improved credit quality, profitable capital allocation, and strong global brand will result in above peer-average double-digit earnings growth in 2005 and beyond, we believe. Trading at a forward p-e that's materially discounted to the historic average of both Citigroup and its large-cap bank peers, we think the shares are undervalued.

Commerce Bancorp (CBH ): We believe Commerce has a strong retail-banking model relative to its peers, which will allow low-cost core deposit growth to continue driving revenue and earnings growth at rates above its peers in 2005 and beyond. Annual deposit growth is likely to exceed 20% over the next five years as the bank expands its distribution into new markets such as Washington, D.C., and Boston. Trading at a steep discount to its peers on a forward PEG ratio, the stock appears undervalued.

Goldman Sachs (GS ): Goldman has a solid competitive advantage, in our view, because of the global footprint of its investment-banking franchise, the consistency of its sales and trading revenues, and the growth of its asset-management business. We expect strong growth in the outfit's financial-advisory, equity-underwriting, and merchant-banking businesses to more than offset a projected decline in the fixed-income division in fiscal 2005 (ending November). The shares were recently priced well below Goldman's historical multiple, and we view the valuation as attractive.

IndyMac Bancorp (NDE ): Dividend and EPS growth is likely in the mid-teens in 2005 for this hybrid mortgage banker/thrift, fueled by market-share gains in home lending, along with a larger loan portfolio and deposit base. With a Web-enabled, technological edge over its peers, we also expect 13% EPS growth in the coming five years, as IndyMac continues to take market share while controlling operating costs. We think these fundamentals are underappreciated and that the shares offer compelling value, with a single-digit p-e over our 2005 EPS estimate, along with a projected 4.1% dividend yield.

Simon Property Group (SPG ): We expect shares of this owner and operator of shopping centers to appreciate significantly in 2005, driven by continued healthy consumer spending that should prompt Simon's retailer clients to continue expanding. Robust demand for space should contribute to further growth in rental rates and healthy occupancy levels. We look for Simon to generate funds from operations of $4.35 per share in 2004 and $4.85 in 2005. Health-Care

Cooper Companies (COO ): We believe that this health-care-goods supplier will continue to gain market share in each of its core segments through product-line enhancements and extensions, geographic expansion, and strategic acquisitions. We expect favorable demographic trends and improved product technologies to drive double-digit revenue and earnings growth over the next several years.

Invitrogen (IVGN ): This outfit provides research institutions, as well as pharmaceutical and biotechnology concerns, with a broad line of goods for disease research and the discovery and commercial production of life-science products. Over the next few years, we expect that key growth areas will include protein discovery and design, nucleic acid purification, and animal origin free-cell culture products. Based on our discounted free cash-flow model, we believe the stock is significantly underpriced.

Kinetic Concepts (KCI ): To us, the stock represents a compelling investment in emerging wound-care technology, and the business will likely generate three-year sales and earnings growth in excess of our medical-device coverage. These gains will, in our view, largely be driven by rising physician usage of Kinetic Concepts' proprietary vacuum-assisted closure device for the treatment of complex wounds, along with rising gross profit margins. Based on our discounted free cash-flow and relative price-to-earnings and PEG analysis, we feel the shares are underpriced relative to similar small- and mid-cap medical-device stocks within our coverage universe.

Protein Design Labs (PDLI ): We believe that royalty payments to Protein Design should continue to grow at a rapid rate through 2006 as a result of the recent or upcoming launch of drugs from Genentech, Novartis, Biogen Idec, and Elan. Separately, we expect a potential partnership deal for daclizumab, a multiple sclerosis treatment, and increased visibility on Nuvion's development path in treating ulcerative colitis to potentially aid the company's shares in 2005. Based on our net present value analysis of Protein Design's royalties, pipeline, net cash, and manufacturing, we think the shares are significantly underpriced.

Waters (WAT ): It's poised for significant growth in the coming years, in our view, because of continued strong pharmaceutical and biotech R&D expenditure levels and the introduction of new, higher-margin products. These new products will likely solidify and increase its leadership position in the industry and will also enable the outfit to introduce new ancillary products and services in the coming years. We view the shares as undervalued on a discounted cash-flow and PEG basis.

WellPoint (WLP ): We see significant new growth opportunities for this managed-care concern, formed through the December, 2004, merger of Anthem and Wellpoint Health Networks. In our view, the concern has the ability to generate membership growth above its peer group in 2005, aided by its Blue Cross Blue Shield licenses and extensive product offerings. We look for EPS to grow in excess of 15% a year for the next three to five years and believe the stock is attractively priced relative to its HMO peers on a price-to-earnings and forward PEG basis.


American Standard (ASD ): This maker of commercial and residential air-conditioning systems, bathroom and kitchen fixtures, and commercial vehicle braking systems should benefit from an expected revival in its primary commercial air conditioning business and ongoing solid results in its other activities. We find the shares undervalued on both a relative p-e and discounted cash-flow basis.

Burlington Northern Santa Fe (BNI ): We expect Burlington Northern, which operates the second-largest rail system in the U.S., to achieve above-peer-average growth, thanks to a superior value proposition in its key intermodal and coal-transportation services. We forecast about 14% annualized earnings and cash-flow growth over the next six years and see its positive cash flow, strong balance sheet, and attractive valuation driving strong capital appreciation in 2005.

FedEx (FDX ): Revenues and earnings should continue to benefit in 2005 from strong export activity out of China and the entire Asian region, as well as a likely strengthening in U.S. express delivery services. We expect its return on equity and return on assets to keep improving, so we see FedEx's valuation expanding closer to that of main competitor UPS on the metrics of p-e, PEG, and price-to-sales.

Ingersoll-Rand (IR ): This global industrial conglomerate should benefit from accelerating growth in the non-residential construction market, ongoing new product introductions, strong demand for security, and significant margin expansion. The stock is priced below the historical average and peer group p-e multiples, and we also find it undervalued based on our discounted cash-flow analysis.

Kaydon (KDN ): We believe this manufacturer of high-margin industrial components is boosting per-share intrinsic value through new product offerings, ongoing efforts to improve powerful positions in niche markets, and the streamlining of operating cost structures. The stock is priced at a sharp discount to our calculation of intrinsic value. Information Technology

Automatic Data Processing (ADP ): The outfit will likely gain from opportunities in both its core payroll-processing market and its more emerging business-processing outsourcing market. The shares appear attractive based on relative and intrinsic analyses. ADP also has what we consider a strong balance sheet and an S&P Earnings & Dividend Ranking of A+, indicative of considerable growth and stability in dividends and earnings.

Dell (DELL ): This leading supplier of PCs has the opportunity to gain incremental market share in 2005, following IBM's sale of its PC unit to Lenovo Group, and take share from Hewlett-Packard in servers as the rival struggles with its strategic roadmap and execution in the enterprise unit. We believe Dell's ability to gain market share could yield upside earnings surprises, which should spur superior stock price appreciation.

EMC Corp. (EMC ): We see this leading provider of data-storage products and services gaining from the escalating level of data creation and more stringent record-keeping requirements. EMC's operating leverage is likely to keep improving and should be aided by synergies from recent acquisition activity, market-share gains, and what we regard as an attractive capital structure. Based on discounted cash-flow analysis and a relative price-to-sales metric, the shares seem undervalued.

Maxim Integrated Products (MXIM ): This outfit is expected to outperform peers during the current semiconductor up-cycle, based on our view of its strong proprietary product portfolio, wide margins, diverse end markets and customers, and balance-sheet strength. We believe the shares are attractively valued on the basis of our historical p-e and price-to-sales analyses and possess attractive appreciation potential.

Microsoft (MSFT ): The world's largest software provider is likely to keep growing revenues at a low double-digit rate, generate strong cash flows, and demonstrate a focus on returning value to shareholders. In 2004, it established and increased its regular dividend, paid a $32 billion special dividend, and established a $30 billion stock-repurchase program. Microsoft should benefit notably from a weak dollar, as international revenues comprise over 33% of total revenues. We view the shares as attractive, based on forward-valuation analyses, relative to its peers.

Qualcomm (QCOM ): Its intellectual property in designing code division multiple access (CDMA) for the mobile wireless industry gives it a unique pricing power, we believe. Its patents' strength has enabled it to receive high-margin license royalty fees from all users, handset and infrastructure suppliers, as well as service providers that use CDMA for software-enabling applications. In addition, Qualcomm is the leading fabless semiconductor company. We believe the valuation of the shares is attractive, based on discounted cash-flow, forward price-to-sales, and price-to-earnings valuation metrics.

ValueClick (VCLK ): We see this concern gaining from increasing spending on Internet advertising in the U.S. and around the world. ValueClick enables marketers to advertise and sell their offerings through a variety of online channels, including display advertising, keyword search, and e-mail. This diversification seems to offer unique and notable appeal. We see the stock as compellingly valued based on comparative and intrinsic valuation analyses. ValueClick's balance sheet is also very healthy, in our view.


Dow Chemical (DOW ): Further sharp earnings improvement in 2005 is projected for the largest domestic chemicals producer, on our forecast of a continued industry upswing driven by tighter supply balances for commodity plastics and chemicals. While Dow is focusing on reducing its debt load, we also expect it to increase its dividend rate over the next year.

Telecommunications Services

CenturyTel (CTL ): This rural carrier's prospects seem more favorable than those of the Baby Bells, based on our view of CenturyTel's limited competitive pressures from wireless and cable carriers and what we see as higher earnings quality -- based on our projection of S&P Core EPS. We note that CenturyTel maintains an S&P Earnings and Dividend Ranking of A, which indicates a high degree of earnings and dividend growth over the past 10 years.


TXU Corp. (TXU ): We expect TXU's EPS to more than double in 2005, driven by an aggressive stock-buyback plan, approved fuel-adjustment revenues, and sharply lower selling, general and administrative -- and operational and maintenance -- expenses. Other factors expected to contribute to the increase are reduced purchased-power costs and wider margins at the electric-delivery operations. Based on our earnings outlook for 2005 and 2006, the shares appear compelling with their steep discount to TXU's peers based on forward p-e.

Biggar is director of North American equity research, and Gold a senior portfolio group analyst, for Standard & Poor's Equity Research Services

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