Two Firms with Healthy Return Potential

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McGraw-Hill Companies
--Moat: Wide
--Risk: Below Avg
--Price/Fair Value Ratio*: 0.84
--Three-Year Expected Annual Return*: 15.6%

What It Does: McGraw-Hill (NYSE: - ) is an information services company. The financial-services division, which generates more than 70% of the company's operating profit, offers ratings and analytics to the worldwide securities market. The education division sells its products to all grade levels, from elementary schools to universities. The media division includes market-leading brands such as BusinessWeek magazine and J.D. Power and Associates.

What Gives It an Edge: Two dominant players, Standard & Poor's (a division of McGraw-Hill) and Moody's (NYSE: - ), each hold about 40% of the credit rating market. Morningstar analyst Michael Corty says the credit-rating business is a naturally concentrated market because both debt issuers and investors want to use as few rating agencies as possible. Most debt products require two independent ratings, and both debt issuers and investors want to use as few rating agencies as possible. Debt issuers want to limit their time spent with credit analysts, and investors favor fewer voices to many, because excessive competition could lead debt issuers to choose the agency that provides the highest rating or the lowest price.

What the Risks Are: Unfavorable changes in the volume of debt securities issued would hurt McGraw-Hill's financial results. The company faces litigation from time to time from parties claiming damages related to rating actions. As S&P's international business expands, these types of claims could increase, as foreign jurisdictions may not have legal protections or liability standards comparable with those in the United States.

What the Market Is Missing: Corty believes the stock price has fallen in reaction to the recent tightening of the credit markets and the worries about potential litigation risk. If the credit markets continue to tighten for an extended period, McGraw-Hill's revenue will decelerate from its robust levels of the past several years. Corty concedes that revenue from publishing ratings on structured finance products, such as credit derivatives, could face some headwinds over the near term to midterm, but he's confident in his long-term valuation assumptions for McGraw-Hill.

Mylan Laboratories
--Moat: Narrow
--Risk: Above Avg
--Price/Fair Value Ratio*: 0.63
--Three-Year Expected Annual Return*: 28.5%

What It Does: Mylan Laboratories (NYSE: - ) manufactures and sells generic drugs, including pills and transdermal patches. The pending Merck KGaA and completed Matrix acquisitions make Mylan the third-largest producer of generic drugs with the second-biggest portfolio of active pharmaceutical ingredients. The company has applied for Food and Drug Administration approval of nebivolol, a branded drug for hypertension.

What Gives It an Edge: Morningstar analyst Brian Laegeler believes Mylan carved a narrow economic moat through its development of hard-to-make formulations, such as transdermal patches, while maintaining superior quality control. The firm also maintains a broad portfolio of oral solids. A deep pipeline of generic drug applications, including profitable patent challenge opportunities, ensures a steady flow of new products.

What the Risks Are: Laegeler assigns Mylan an above-average risk rating, primarily due to a heavy degree of leverage in the corporate capital structure following the Merck KGaA acquisition. Laegeler thinks cash flow will be tight in 2008, with more than $5 billion of high-interest debt plus payments on other convertible instruments. However, Laegeler counters that Mylan will be a much more diversified company post-acquisition; the outcome of individual patent challenges, generic-drug applications, and branded-drug applications will have less of an impact than before.

What the Market Is Missing: Historically, Mylan lacked the operating scale of its larger competitors such as Teva (NasdaqGS: - ) or Sandoz (a division of Novartis (NYSE: - )), but that has now changed. Two recent acquisitions have transformed the company into the industry's number-three global powerhouse. Laegeler forecasts significant cost savings over the next five years as Mylan expands its active ingredient capabilities. Its European acquisition also puts the company on the new frontier of generic biologics. The stock is down due to a heavier debt load, the lack of a near-term catalyst, and perceived difficulty surrounding the latest acquisition's financing. However, Laegeler believes the debt is manageable and expects five years of impressive earnings growth following a tough 2008.

* Price/fair value ratios and expected returns calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Oct. 12, 2007.

Alex Morozov, CFA, has a position in the following securities mentioned above: MYL