Online Extra: Where To Go For Growth

A screen of 1,700 companies finds seven primed for a growth-stock comeback

It's been seven years since growth stocks had their day in the sun. That's why many market-watchers think the time is ripe for this group of stocks to come back strong. To find a few companies that might offer good opportunities, we asked Morningstar, the Chicago research firm, to find some attractively priced growth companies.

Toan Tran, Morningstar's equity strategist, screened a database of more than 1,700 companies to find those that are expected to have a minimum of 15% revenue growth and 15% operating income growth over the next five years. This, admittedly, is a high bar, which cut the list to 130. It also explains why the finalists are all small- to mid-cap stocks: Large companies don't usually have sustainable growth rates of that magnitude.

Next, we wanted companies with a strong competitive advantage that would allow for long-term profit sustainability. Toward that end, Tran required companies to have a "moat," or protection from rivals. (Morningstar classifies companies as having a wide moat, a narrow moat, or none at all.)

The moat filter narrowed the list to 68. The finalists were chosen based on their Morningstar (MORN ) ratings -- companies with a star rating of four or five made the cut. The ratings, simply put, are determined by stock price relative to fair value.

The resulting list has just seven companies. Four are in the health-care field, two are in the for-profit education sector, and one is a specialty retailer. Screening databases is a good way to start your research, but you need to look at qualitative factors, too. Five of these seven, it turns out, have sold off from 52-week highs because of some news that makes investors nervous. Still, that's where opportunity often lies, with the potential for a big payout if the worries disappear.

American Pharmaceutical Partners (APPX )

This company, based in Schaumburg, Ill., has two business lines -- injectable generic drugs and Abraxane, an important cancer drug. What rankles some is APP's pending acquisition of American BioScience, a company wholly owned by APP's chairman and controlling shareholder, Dr. Patrick Soon-Shiong. Many analysts believe APP overpaid for ABS, and they turned negative on the stock, but, says Morningstar analyst Brian Laegeler, "the underlying business hasn't been affected."

APP's profitability is expected to improve significantly after the merger because Abraxane's margins are higher than those for the generic drugs. Morningstar estimates that the $29.95 stock is selling about 25% below its fair value.

AMN Healthcare Services (AHS )

AMN, which recruits nurses and places them on temporary assignments at hospitals throughout the country, has had a bumpy growth path since it went public in 2000, because demand has been volatile. The San Diego company grew more than 50% through 2002, and then hit a rough patch in 2003-2004. But in an effort to cut costs, hospitals began filling their temporary staffing needs by offering more overtime hours and pay to their full-time nurses. AMN saw its growth rate turn negative 8% in 2003 and negative 12% in 2004. But growth turned positive once again in 2005, when hospitals saw their turnover shoot up due to overworked staffs and returned to using staffing agencies. "Hospitals realized it cost more to try and fill their nursing shortages on their own," says Joel Bloomer, a Morningstar analyst.

Going forward, AMN is positioned well. It recently acquired MHA, a leader in physician contract staffing, which will help smooth out the fluctuations in earnings by diversifying revenue to this less cyclical, more profitable, and faster-growing business. While AMN is a market leader in this fragmented industry, it has only 30% of the $2 billion traveling-nurse market and 15% of the $1.4 billion traveling and permanent doctor-placement business, which bodes well for future growth. AMN also has the highest operating margins: 6.09%, vs. 3.21% for the industry. Morningstar estimates the $18.62 stock is selling at about 25% below its fair value.

CarMax (KMX )

It's unique -- a used-car superstore chain with no-haggle sale and trade-in prices. While new store openings are expected to provide the bulk of the company's growth over the next few years, same-store sales "should also remain positive as the company's newer stores mature and CarMax gains market share," says Scot Ciccarelli, an analyst with RBC Capital Markets (RY ). The ding on CarMax is that used-car pricing is cyclical. Last year, Detroit chose price cuts over production cuts, which pushed down the price of used cars, too.

This year pricing is stronger because the auto makers are instead trimming production. That bodes well for CarMax. "This is the premier used-car seller, and it's cheap at current valuations of 22 times 2007 earnings," says Vince Gallagher, a co-manager of Needham Growth Fund (NEEGX ), which has 1% of its $232 million assets in CarMax. Among the other big shareholders are William Blair Funds and Lone Pine Capital, which, says Gallagher, "is a good endorsement for this stock."

Educate (EEEE )

This Baltimore company is most well-known for its tutoring brands: Sylvan Learning Centers and Hooked on Phonics. While sales of the company were up 21% last year, Educate is having growing pains since its 2004 initial public offering. The problem, in part, analysts say, is that same-store growth of its some 900 centers has been driven not by an increase in the number of families who visit the centers but by increasing the amount spent by the average family. That amount, $4,500, has "increased dramatically, but is not sustainable and seems to have reached its capacity," says Trace Urdan, analyst for Robert W. Baird.

Still, Educate has a plan to reverse the trend. First, the company is cutting costs by shrinking middle management in its centers and is initiating a better customer contact system to follow through with inquiries. It also is acquiring existing franchises and turning them into higher revenue-generating company-owned centers. Finally, Educate recently acquired Hooked on Phonics, which it plans to market at a lower price than Sylvan at retailers like Wal-Mart Stores (WMT ). It hopes to grow a service business around that brand as well.

Morningstar estimates the $9 stock is selling nearly 40% below its fair value.

Kinetic Concepts (KCI )

KCI is the leading provider of vacuum-assisted care products that help close wounds quickly. The cloud here is whether its margins are sustainable if the company loses an upcoming patent-infringement suit against BlueSky Medical, a company that offers a similar but cheaper product. Some analysts are also concerned that insurers might slash reimbursement rates, cutting Kinetic's revenues. In spite of the negatives, KCI is doing extremely well. Revenue grew 18% in the fourth quarter, and free cash flow for the year jumped 52%. It also has attractive operating margins of 23%, vs. a 6.5% average for the medical equipment industry, and wound care is still a largely underpenetrated market. Worldwide revenue growth in vacuum-assisted wound healing was up 25%. Morningstar figures that the stock trades at a 34% discount to its underlying value.

MGI Pharma (MOGN )

This early-stage biopharmaceutical company develops cancer drugs. Its most well-known profitable product is Alioxi, which mitigates the effects of chemotherapy-induced vomiting and nausea, and has racked up sales of $249 million in just two years. The Bloomington (Minn.)-based MGI also has several promising late-stage drugs under Food & Drug Administration review. The uncertainty here is that there are a few similar products in the marketplace and it is unclear how well some of these newer entrants will fare. Still, though MGI is a volatile stock, the company's full pipeline and solid sales of Alioxi are reason for optimism. Morningstar estimates this $16.23 stock is trading at 32% fair value.

Strayer Education (STRA )

A player in for-profit education, Strayer offers undergraduate and graduate degrees in the classroom and over the Internet. The company is expanding and opening eight new campuses this year. Unlike its much larger competitors, Corinthian Colleges (COCO ) and Apollo Group (APOL ), Strayer has not had regulatory problems with the U.S. Education Dept. Strayer also has the highest gross and operating margins: 65% and 34%, respectively, vs. 49% and 8% for the industry.

Margins have come down a bit because of increased selling and promotional costs. That's to be expected as the company expands. As one of the smaller players in the for-profit education business, analysts say it has more opportunity to grow. Strayer also tailors its course offerings to working adults over 35 who are looking to advance their careers, a market which is less cyclical than the vocational programs that competitors offer. Enrollment in vocational courses tends to decline when jobs are plentiful.

What's also important is that Wall Street has a high regard for the company's management. "CEO Robert S. Silberman has tremendous credibility with shareholders because he sets reasonable expectations and meets them," says Trace Urdan, an analyst with brokerage firm Robert W. Baird. Urdan thinks the company's revenue and earnings will grow 18% to 20% over the next three to five years.

If analysts are correct and the long winning streak for value stocks is finally due to end, shareholders of these small, competitive companies could soon be partying like it's 1999.

By Toddi Gutner

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