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The 5 worst blue chips to own in 2004
Stocks of companies that sell daily necessities should protect investors against wild swings, right? No more, thanks to intense competition at home and abroad. Here are five such stocks you may want to avoid.
By Michael Brush
Every day, they sell us lifes necessities, big and small -- from cars and medications, to the food that keeps us alive. So auto companies, drug companies and supermarket chains ought to be safe havens for investors wary of a market that has come so far in so little time. Right?
Wrong.
In fact, because of nasty problems in their industries, leaders in these sectors including General Motors (GM, news, msgs), Schering-Plough (SGP, news, msgs), Safeway (SWY, news, msgs), Kroger (KR, news, msgs) and Albertson's (ABS, news, msgs) are likely going to be among the worst stocks to own next year.
Heres why.
General Motors: Does reliance on finance make it vulnerable?
U.S. auto companies used to make money selling cars and trucks. But now they are largely finance companies, says Christopher Bonavico, a money manager at Transamerica Premier Focus (TPAGX). And that may be their downfall.
In the most recent quarter, for example, the finance division of General Motors generated a whopping 96% of the companys profits. That wouldnt be so bad, except next years economic growth seems likely to drive up interest rates. And rising interest rates can be very bad for finance companies.
Whats worse, in the last two quarters, GM's finance arm -- known as General Motors Acceptance Corp. (GMAC) -- got as much as half of its profits from mortgage refinancing. The problem here is that the mortgage refi sector is one of the first to suffer when interest rates rise, says Value Line analyst Anthony Pandolfi.
GM thinks any weakness in its finance arm could be offset by a rebound in North American car and truck sales next year as the economy recovers. Besides, business will continue to boom in Asia, and Europe may be turning around. We have a core automotive business that clearly has the capability of earnings power, says a GM spokesperson. Whats more, GM will introduce 17 new cars next year, and new trucks, as well. The company thinks the new models will help it close the quality gap with foreign competitors like Toyota (TM, news, msgs) and Honda (HMC, news, msgs). Meanwhile, GM still has more cost cutting ahead of it -- which will add to the bottom line, the spokesman says.
Skeptics point to several problems with this rosy scenario. A recent settlement with GMs unions brought little hope for a reduction in overcapacity in the sector. Carmakers got few victories in the way of concessions on plant closings -- and they will continue to run existing plants at near peak capacity to limit job cuts.
The upshot: Downward pressure on car prices will continue, and carmakers will have to offer cheap financing and other incentives to sell cars, says Bonavico. This practice will, among other things, coax current demand from future quarters. You cant expect America to keep swallowing more and more cars, Bonavico says.
Car companies like GM hope to offset pricing weakness with more cost cutting. But a failure to get meaningful concessions from unions on health care and pensions in contract talks this year will make it tough to wring out enough costs, says Prudential Equity Group analyst Michael Bruynesteyn. Prudential estimates the retirement costs built into each vehicle sold by GM next year will be $1,707. For Toyota, its just $178.
Indeed, the total pension claims on GM recently stood at an awesome $80.1 billion -- or more than three times the auto giants current market cap of $24.1 billion. This suggests theres nothing left for anyone who buys the stock now. There is no shareholder value in GM, says Bonavico. Pension retirees own all of the value in the company.
To be sure, GM looks tempting as a value play, with a forward price-to-earnings ratio of around 8.3, well below competitors. And investors buying now get paid a nice 4.68% annual dividend to wait for things to get better. But thats not enough for Morningstar analyst Brian Lund. Considering the variety of risks GM faces, not even its hefty dividend makes the stock attractive to us, he says. A lot of investors apparently agree. The stocks up a bit more than 8% this year but is down 54% since April 2000.
Schering-Plough
On the surface, the recent Medicare reform bill that set up a prescription drug benefit for seniors looks like a positive for the pharmaceutical industry. But dig a little deeper, and youll see a lot more harm than good coming out of Washington for the drug makers.
First, the Medicare reform will concentrate a lot of the nations pharmaceutical buying in the hands of the government. You can bet Washington will try to use its new-found purchasing power to push down drug prices at some point.
Before then, political candidates during the 2004 election campaigns will trash pharmaceutical companies for high drug prices, scaring investors away from drug stocks, predicts Timothy Ghriskey, a money manager with Ghriskey Capital in Greenwich, Conn.
Next, Congress is taking steps to close loopholes in a law originally meant to ease the way for more generic drugs. This will hurt, because the major drug companies have lots of blockbuster drugs coming off patent. They face margin-crushing competition from generic drugs, which consumers are all too eager to turn to now that insurance companies are jacking up co-payments.
Meanwhile, drug company research activities to create new blockbusters have fallen into remission. Their pipelines look weaker than they have in years. Finally, investors typically view large-cap pharmaceutical stocks as defensive investments. These stocks will be shunned as more signs of economic recovery emerge.
Given the daunting headwinds for the drug sector, we thought it would be a great place to go fishing for one of the worst stocks for 2004, and we found it -- in Schering-Plough. Of all the big pharma companies, few could serve as a poster child for the industrys problems any better than this troubled drug maker, whose stock is down nearly 29% so far this year. It's fallen 71% from its peak in December 2000.
Thanks to generic competition this year for its Claritin antihistamine and its drugs used to treat hepatitis C, Schering-Plough sales declined 16% in the most recent quarter, to the lowest level in five years. The underlying business continues to erode with no signs of improvement, says First Albany analyst Adam Greene. Indeed, Wall Street analysts are cutting estimates clear out to 2007.
At a recent annual analyst meeting, chief executive Fred Hassan stressed that 2004 will be the bridge year to better times in 2005 and beyond. He cited promising drugs in development, for ailments like HIV, Parkinsons, erectile dysfunction, lung cancer, fungal infections and heart disease. But analysts like Adam Greene dismiss these as too distant to matter, because so many are still in the early stages of development. We cannot emphasize enough how little visibility there is regarding sales and earnings, Greene says. We believe the turnaround will take several years.
Despite all these obstacles, there is some hope on Schering-Ploughs horizon. First, a new cholesterol-lowering drug called Zetia is selling well. And Zetia will soon be sold in a pill that combines it with Merck's (MRK, news, msgs) Zocor, another anti-cholesterol drug. Second, Schering-Plough CEO Hassan bought a sizable $4.68 million worth of his companys stock last week.
But as for Zetia, Value Line analyst George Rho points out that a generic Zocor may be on the market in mid-2006.
So what about Hassans stock purchase? Neil Sweig of Fulcrum Global Partners thinks Hassan, like other shareholders, will be caught in a value trap -- owning a cheap stock that only gets cheaper. Why? Renewed waves of selling by many investors who have been too wrong for too long, with huge losses.
The supermarket chains: Can they push back Wal-Mart?
At the start of a recovery, such as now, investors typically dont want to own defensive plays like supermarkets -- with their traditionally stable earnings.
But thanks to vicious price competition from the likes of Wal-Mart Stores (WMT, news, msgs) and Costco Wholesale (COST, news, msgs), you cant even call supermarkets like Safeway, Kroger or Albertson's defensive anymore.
Pummeled might be a better word.
In the past 18 months, analysts have slashed their 2003 earnings by anywhere from 20% to as much as 44% for Safeway, mainly because of tough competition from lower-cost upstarts on the retail food scene. In the past year, for example, Wal-Mart has increased supermarket-type sales by 20%. Meantime, major supermarkets have seen their sales grow by a scant 4% to 5%, in an industry thats growing only 3% a year at best, says Morgan Stanley analyst Mark Wiltamuth.
The stocks reflect the beating as well. Safeway is down 60% since October 2000; Albertsons and Kroger are down something under 20% each. For the year, Safeway is off nearly 20%, Albertsons about 10%. Kroger is up about 15%.
Because consumers crave the lower prices that non-union stores like Wal-Mart can bring, these big discount chains will continue to expand. That means more hard times ahead for the basic supermarkets like Safeway, Kroger and Albertsons. Wal-Mart, for example, plans to open 40 super centers in California by 2006, starting early next year.
There is a lot of capital coming into the food business, says Bonavico. Any time capital rushes into an industry, returns go down. Morgan Stanley thinks that over the next 10 years, Wal-Mart (including its Sams Club division) will expand to control 34% of the retail food market, up from 12% now. The share controlled by the top grocery chains, including Kroger, Safeway, Albertsons, will only nudge up slightly to 29%.
The supermarkets, of course, are fighting back. Safeway is centralizing its purchasing, which should help bring down costs. We are also focusing on differentiating our offerings on the basis of quality, especially in perishables like produce and meat, says Melissa Plaisance, a senior vice president at Safeway. This is not where Wal-Marts strength is.
Besides, says Plaisance, three years after Wal-Mart arrives on the scene in a given local market, growth normally returns for Safeway -- as smaller, independent grocery chains go out of business and many of their customers switch to Safeway instead of Wal-Mart. We offer a different shopping experience, Plaisance says. We have more convenient locations and better service, and specialty departments like bakeries and delis. She also believes Safeway sales will pick up as the economy recovers and fewer people feel compelled shop around for the absolute rock-bottom price at places like Wal-Mart.
Ultimately, though, the supermarket chains will need to bring down labor costs if they want to compete with non-union chains like Wal-Mart. Union grocery workers get paid 30% or so more in wages, and they get much better benefits than non-union grocers. Since the cost of wages and benefits represents about 16% of sales, labor costs have a big impact on profits.
Supermarket chains like Safeway have been trimming the costs in work contracts in fringe markets around the country. But the real showdown began in California in October, when the United Food and Commercial Workers started a strike against the three big supermarket chains over pay and benefits.
Unless the supermarket chains hold tight and bring labor costs down close to those of Wal-Mart, which seems unlikely, Wal-Mart will continue to expand and take share. Remember, it is a fixed-cost business, so losing a little market share is a problem, says Transamericas Bonavico. Thats one reason why even sell-side analysts are calling Safeway another classic value trap, and possibly one of the worst stocks to own in 2004. They look cheap, but they are actually more expensive than they look, agrees Bonavico. Really expensive, because earnings are going down.
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