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2001 BW 50

SPRING 2002

INVESTING FOR GROWTH

The Best of the Rest
A look at the standouts in industries hard hit by the 2001 downturn


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As every winning baseball club knows, it's not enough to go with your proven winners--you've always got to be on the prowl for fresh talent. Investors hoping to put together a winning team will do well to follow to that advice. True, the BusinessWeek 50 is a good place to start, but smart investors know better than to stop there. This year's BW50 represented 15 of the 24 industry groups in the Standard & Poor's 500-stock index. A majority were concentrated in such areas as health care, financial services, consumer products, and housing--industries that held up well in the downturn of 2001.

Just because a company didn't make the 50 doesn't mean it's a loser. Telecom, for example, got beaten up big-time, but there are still some smart players. Same goes for media and publishing, which were punished by a depression in advertising. And it's the strongest outfits, even in a weak sector, that should lead in the upturn.

That's why we came up with a Best in Class list. We looked at the nine industry groups that didn't send a team member to the all-star BW50, searching for the companies with the best prospects. We settled on companies from six industries, ranging from autos to media, a hodgepodge of businesses that provides service. Some, like General Motors Corp. (GM ) and DuPont (DD ), are well known to investors, while others, such as Univision Communications Inc. (UVN ) and Paychex Inc. (PAYX ), are ones you'll be hearing more of, especially as the economy improves.

So take this as a scouting report on some promising players if the season turns out to be a rough one. It's good to have a deep bench.

SERVICES While Paychex (No. 75) and Cendant (No. 104) may both be in services, no two companies could be more different in the kinds of services they provide. Cendant Corp. (CD ), the biggest hotel franchiser in the world, provides hotel and travel services in addition to mortgage and real estate services through its Century 21 Real Estate unit. Paychex provides payroll, human resources, and benefits services to small and midsize businesses. But what both companies share is the ability to thrive in tough times.

Cendant's diversification in real estate and travel gives the company a natural hedge to weather any economic storm, says Credit Suisse First Boston analyst Scott Barry. Last year, with mortgage rates low and the housing market strong, Cendant's real estate services division grew 27% on the strength of sales as well as mortgage origination and refinancing. This year, with mortgage rates expected to rise, Barry says Cendant's growth will come from a rebound in the travel-and-hospitality business. He calls the stock cheap and projects its free cash flow--an important measure for the performance of service companies--to rise from $0.55 per share in 2002 to $2.20 next year. That's when Cendant will no longer pay into a trust set up to cover a shareholder settlement that followed its disastrous 1997 merger with CUC International.

Paychex has been getting big by servicing small business. In contrast with Automatic Data Processing Inc., which provides payroll services to America's biggest businesses, Paychex' average client has just 14 employees. The beauty of Paychex' business is that there are millions of these small companies and countless more are being created everyday as a fresh crop of entrepreneurs goes out on their own. Last year, revenues at Paychex grew 16%, down slightly from the 20% long-term growth rate, while profits rose 23% on higher margins. Analyst Charles Trafton of Adams, Harkness & Hill has upgraded the stock to a buy, in the belief that the worst of the economic downturn has passed.

TELECOM Say the word "telecom" to some investors, and they're likely to hang up on you. Perhaps no other sector has been so hard-hit by the combination of the downturn and investor disappointment. Net losses among the 21 telecom services-and-equipment providers in the Standard & Poor's 500-stock index were a staggering $43.3 billion last year. But there are signs of life in the telecom junkyard. What's more, the numbers don't tell the whole story.

SBC Communications (SBC ), No. 36 on last year's BusinessWeek 50, dropped to No. 114 this year--a stellar performance compared with its peers. In an industry where companies on average lost 46.7%, SBC's 18.6% decline doesn't look that bad. And while sales fell 11% in 2001, that number is deceiving since it doesn't include results from SBC's wireless operations, consolidated in Cingular Wireless, its 60%-owned joint venture with BellSouth. Add back SBC's piece of Cingular's $14.3 billion 2001 revenues, and SBC's sales growth for the year is positive. More important, profit margins improved slightly for the year, rising to 15.8% from 15.5%. Morgan Stanley Dean Witter analyst Simon Flannery rates SBC a strong buy. Most crucially, 2002 will be the year SBC starts offering long-distance phone service to customers in California.

Wireless also figures strongly in the fortunes of two regional local exchange carriers (RLECs), Alltel (No. 153), and CenturyTel (No. 177). Until 1998, when it bought wireless operator 360 Communications, Alltel (AT ) basically provided local service. Now, it's the largest regional wireless company in the U.S., primarily serving some 6.7 million wireless users in the Southeast. Customers can use phones anywhere in the U.S. through a roaming agreement with Verizon Communications (VZ ). This lets Alltel go head to head with such national operators as Sprint (FON ) and AT&T Wireless Services (AWE ) but also puts it squarely in their sights. That could be a plus later on, assuming wireless goes through a second round of consolidation.

CenturyTel (CTL ), recognizing it couldn't compete with the national wireless carriers, decided to go back to its roots as a traditional phone company. The company paid $2.2 billion to acquire 675,000 lines in Missouri and Alabama from Verizon, planning to pay for them by selling wireless properties. The drawback? No buyer. Are CenturyTel and Alltel double-digit growers? No, says Mark Hall of Legg Mason Wood Walker, who rates the two RLECs a strong buy and a buy, respectively. But they offer an opportunity for price appreciation, since RLECs are shielded from competitive pressures.

MEDIA & PUBLISHING The recent recession may have been mild as measured by economists. But try telling that to anyone in the media business, where advertising revenue declines reached Depression-like levels. And although Univision Communications, No. 241, saw ads slip, it's still the envy of other media companies. That's because in Spanish-language broadcasting, Univision, with 80% audience share, reigns supreme.

What excites analysts about Univision is the potential of that audience. The Hispanic community, around 36 million in 2001, is expected to exceed 48 million in 2010--15% of the U.S. population. And buying power, today around $500 billion, is expected to double.

According to UBS Warburg, ads aimed at Hispanics grew 1% in 2001, vs. a 5% decline in the U.S. overall. And Hispanic ad revenues should continue to outstrip mainstream ads as the gap in buying power between Hispanics and the rest of the population narrows. On the other hand, as they assimilate into the mainstream, Hispanics may become a less distinct cultural group--and their potential as a specialty sector could diminish as well.

CHEMICALS DuPont, the top-ranked chemical outfit and No. 63 overall in BusinessWeek's rankings, showed good chemistry with investors last year. No other chemical maker came close: Praxair Inc. (PX ), the nearest, ranked 135. DuPont stock returned 11% from Feb. 28, 2001, to Feb. 28, 2002, and profits rose 87%, despite a 13% revenue decline. You might wonder what chemicals DuPont was mixing, given these conflicting numbers. There's a simple explanation behind the jump: a one-time gain from the sale of the company's drug business to Bristol-Myers Squibb Co. (BMY ) Without it, earnings would have slipped 54%.

So what's driving DuPont shares? In part, it's the belief that a U.S. economic recovery is under way. DuPont sales fell more sharply last year in the U.S. than worldwide--down 17% domestically, vs. an overall decline of 13%. As the recovery takes hold, sales and profits should rebound. "The market is underestimating DuPont's leverage to a recovery," says Merrill Lynch & Co. analyst Donald D. Carson, who rates it a long-term buy. The 2.9% dividend gives the stock some added kick.

DuPont is not just relying on a rebound. Founded in 1802 as an explosives maker, the company is shaking up its businesses. Although famous for inventing nylon, polyester, and Lycra, DuPont is consolidating those slow-growing lines into a $6.5 billion sales subsidiary that will be spun off or sold. The rest of the company will be reorganized into five divisions: electronics and communications materials; performance materials such as film and engineering materials; coatings and color technologies; safety and protection materials; and finally, its $4.3 billion agriculture and nutrition division.

Questions about DuPont remain: It paid $7.7 billion in 1999 to buy the rest of Pioneer Hi-Bred International, the leading developer of seed products--a heavy bet now that genetically modified plants are coming under scrutiny. And the other divisions depend on growth in telecommunications and computers, industries whose prospects have dimmed. Finally, DuPont has a history of reversing strategy: In the '80s, it got into the energy business, buying Conoco Inc. at the market top. In the '90s, DuPont tried to remake itself as a drug company before realizing it lacked the scale to keep up with Big Pharma outfits such as Merck & Co. (MRK ) and Pfizer Inc. (PFE ) If, however, management can realize its vision this time around, DuPont will emerge a very different company: a research-driven outfit supplying the high-tech and agricultural sectors.

TRANSPORTATION Given the economic slowdown that took place even before the terrible events of September 11, few industries were hit harder than transportation. That only makes the results of Union Pacific (No. 138) so much more impressive. UP (UNP ) managed to do what few companies outside hot industries were able to do: make more money in a depressed economy than it did the year before. Not only that--margins jumped to the top of the railroad industry.

How did UP do it? With lower fuel costs, tighter expense controls, and an increasing share of business in the unglamorous but profitable area of hauling carloads of coal and grain. In fact, without UP's coal and grain business, carloads in the fourth quarter of 2001 would have declined 2.6% from a year earlier; instead, total carloads increased 1.4%, according to Thomas Wadewitz, an analyst who follows railroads for Bear Stearns.

What's on track for 2002? Bear Stearns projects better earnings for UP, in part because Wadewitz thinks fuel prices will remain low. More important: The emergence of a stronger economy will surely help this cyclical industry stay on track.

AUTOS General Motors' Corp. (No. 331) new slogan may be "Keep America Moving," but its real message is Keep Motown Competitors on the Run. In this case, the opponents are Ford Motor Co. (F ) and DaimlerChrysler (DCX ). Beginning in October, 2001, when GM (GM ) introduced 0% financing for buyers and extended the offer until the end of the year--following with its $2,002 rebate-per-vehicle offer--the carmaker has shown its determination to win the battle for market share.

Although GM bested earnings expectations in the fourth quarter of 2001 and projected better results for 2002, investors remained skeptical. For years, the auto giant has promised to become more competitive, only to disappoint again and again. The surprise this year, though, was that GM delivered--and then some. Says Scott Merlis, an analyst who covers autos for Dresdner Kleinwort Wasserstein: "A year ago, no one would have believed GM could make money in a recession." The key to the turnaround? Merlis says it's a more profitable mix of trucks and sport-utility vehicles, a leaner production system, and hot new models like the Chevy Avalanche.

Of course, after the sales runup at the end of 2001, industry watchers wondered if there were any buyers left. The good news: Americans still are buying cars. Seasonally adjusted sales rose from an annualized rate of 15.8 million vehicles in January, 2002, to 16.7 million in February. And GM sales in that same month were up 8%, with trucks rising a robust 27%.

Still, the North American car line needs to be revamped. European car operations are in the red, too. And there remains the matter of GM's pension and health-care liabilities--$10 billion at last reckoning. But, says Merlis, if European operations can move from a $600 million loss to $400 million in profits, and if GM maintains its momentum in trucks and boosts the car line in the U.S., GM can earn up to $10 per share by 2005 and carry a $90 share price. That's up about 50% from current levels.


APRIL 2, 2002



By Robert J. Rosenberg


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