Steer Clear of Sectors Capsized by Capacity

Even if the economy as a whole is headed for better times in the second half, some industry sectors seem poised for their own double-dip growth recession.

I call this problem "the MCI syndrome." It affects stocks in the telecommunications, airlines, auto and supermarket sectors.

I think it's too early to step away from this rally because the economy is looking better and because the market's momentum is so strong right now. But I think it's time to sell stocks in those sectors with almost no prospects for future growth.

These sectors have such extreme imbalances between supply -- way, way too much -- and demand that even a strong economic recovery won't push bottom-line results into the black. Investors who believe in a second-half recovery story should be selling stocks in these sectors into current strength and buying stocks in sectors with better prospects.

Here are the sectors that I believe are most in danger.

A Rally Built on Hope

Friday's market action was a prime example of what I've called a rally built on hope. The market chose to look past awful unemployment numbers. True, the official unemployment rate climbed to 6%, but everyone knows the unemployment rate is a lagging indicator that gives a solid picture of where the economy is coming from. At least that was the talk on the trading floors.

And the market's willingness to bet on hopes of a stronger economy in the second half got just enough from a jump in factory orders of 2.2% in March. That jump, in data announced just hours after the unemployment numbers, was much higher than the 1.2% gain economists had expected. And it marked the biggest increase in orders since July 2002. Put it all together and the indexes roared out of the gate.

The Dow Jones Industrial Average broke through important overhead resistance at 8521. The Nasdaq Composite looks like it's gearing up for an assault on its next ceiling at 1521. Technicians say this rally could run until the indices hit important resistance levels: 8930 on the Dow and 1619 on the Nasdaq.

So far this has been a rally that lifts all boats -- and lifts some of the leakiest vessels the most. Friday's biggest winners were the airline stocks. Continental Airlines ( CAL) climbed 20%. American Airlines parent AMR ( AMR) soared 137%. Delta Air Lines ( DAL) jetted ahead 13.5%.

A buy call on airlines from Merrill Lynch on Friday helped power the stocks. The worst might be over for the sector, said Merrill. But the analyst report went on to say that the industry is still set to lose $8.2 billion in 2003 and another $2.5 billion in 2004.

The current Wall Street consensus has Continental losing 79 cents a share in 2004. Delta's 2004 loss is projected at $3.21 a share. AMR tops the list, with a projected loss of $6.56 a share.

In another case, I'd certainly wonder if numbers such as these weren't just another example of Wall Street analysts over projecting current bad news too far into the future. But with airlines, the group's deep structural problems support these numbers. There is simply too much supply, too many seats on too many flights and too little demand at current price levels for the airlines to turn quickly profitable with an economic uptick.

The striking thing to me about the way the airline's profit disaster has unfolded over the last two years is how little has changed about this supply/demand imbalance. Airlines like US Airways and United parent UAL have been forced into bankruptcy because their business models can't generate any profits.

Yet no major carrier has gone out of business. And very little capacity has been eliminated even at the bankrupt airlines. As airline shakeouts go, this one is very different than previous versions that led to the demise of PanAm, Braniff and Eastern.

The Battered Telecommunications Sector

You can see a similar dynamic at work in telecommunications. Global Crossing, Qwest ( Q) and MCI, once WorldCom, have bled rivers of red ink in the last two years, enough so that Global Crossing and MCI have sought bankruptcy protection while they reorganize. Qwest merely lost $2.39 a share in 2001 and $1.25 a share in 2002.

But nobody has folded. Capacity, which so far outstripped demand that telcos resorted to trading it among themselves in an effort to create revenue to prop up their stocks, is largely now exactly what it was when the sector collapsed.

It's what happens now that's important to investors. MCI delivered its planned bankruptcy reorganization to the courts April 14. The company's postbankruptcy capital structure would give the company about $3.5 billion to $4.5 billion in debt, net of cash. That's pretty spectacular for a company that had $30 billion in long-term debt when it went into bankruptcy. In March 2002, MCI was paying $450 million in interest on that debt each quarter, or about $1.8 billion a year.

Rough cost savings to the company of paring that $30 billion in debt down to $4 billion comes to $1.6 billion annually.

No wonder MCI's competitors tried to block the bankruptcy proceedings and force the liquidation of MCI. When it comes out of bankruptcy, the company will have an extra $1.6 billion in cash flow to play with. To do things like invest in new equipment, if it likes. To upgrade service, perhaps. Or cut prices to win market share.

That $1.6 billion would have been enough to give every MCI customer a 5% discount on their bills in 2002, a year when revenue came to $30 billion. And it amounts to an even bigger potential discount in 2003. Credit Suisse First Boston estimates that MCI revenue will come in near $24 billion. A 5% or better discount will certainly be a powerful weapon for the company to consider using as it contemplates projections that show 2004 revenue falling further to $22 billion.

Think the possibility of MCI cutting prices by 5% doesn't send shivers up competitors' spines? A look at Sprint ( FON) lets us see exactly how big a deal this could be. Sprint reported first-quarter revenue of $6.34 billion and net income from continuing operations of just $97 million. That's just 1.5% of revenue for the period. Sprint, by the way, carries $17 billion in long-term debt and paid $370 million in interest last quarter.

A relatively debt-free MCI, operating in pretty much the same environment as the one that existed before it entered bankruptcy, has the potential to unleash a game of beggar thy neighbor in the sector. The telecom market is glutted with supply. If MCI cuts prices to increase market share, competitors will have to cut their own rates just to maintain current revenue levels.

At some point, the price-cutting forces the next-weakest competitor to the wall. That competitor in turn enters bankruptcy, comes out stripped of most debt and now can cut prices some more. That's one vicious cycle.

It's not inevitable, of course. A huge surge in demand -- without a corresponding increase in supply -- would let the Sprints and MCIs of the world grow revenue without price competition. Another way to prevent the cycle: new technological development that transforms phone and data service from commodities into value-added and differentiated goods.

But trends in the telecom sector point in exactly the opposite direction. The increasing reach of cellular and other kinds of wireless access is creating more supply. And new services being introduced to enable suppliers to raise prices may actually increase the commoditization of existing pre-bells-and-whistles services.

In the Same Boat

The telecommunications sector isn't alone in facing the grim prospect of a profitless future in a period of modest economic growth. The analysis fits any sector with huge excess capacity, commodity products and substantial debt loads.

I've mentioned the airline business. The sector is awash in capacity -- and even much of the currently mothballed capacity is only in storage -- and air travel, as anyone who has flown recently knows, sells on price and pretty much only on price. The major airlines are loaded down with enough debt that it's easy to see a round of price-cutting driven by the newly cost-efficient postbankruptcy airlines tipping another competitor into bankruptcy.

The auto sector fits the bill too. Producers now are willing to pay customers to buy -- paying incentives and offering interest-free financing -- because there is no other way to keep the sector's excess plants running. And the high fixed-cost nature of this business means that anyone who loses market share bleeds red ink on the bottom line.

Supermarket stocks are worth analyzing from this perspective as well. Here the industry faces one dominant competitor -- Wal-Mart ( WMT) -- that can undercut prices and take market share almost at will. And this is in a narrow-margin and debt-intensive sector.

My analysis doesn't mean every company in these sectors is headed down the tubes in the near or even the moderately distant future. But it does suggest these sectors come with a high degree of risk.

Add the sector-specific risk to the general market risk that the economy won't behave to match investors' fondest dreams, and sectors like these offer more risk than I'd like to take on.

In my next column, I'm going to reverse this analysis and look for sectors that have a better-than-average chance of meeting investor hopes, even if the economy in general doesn't live up to current dreams.

Jim Jubak appears Wednesdays on CNBC's "Business Center" at 6 p.m. EDT. At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.

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