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Get Four
|  | JANUARY 24, 2006
Analysts' Picks: Energy, Retailers, SteelTop Wall Street pros offer their thoughts and predictions on companies in these industriesThe second part of our survey of top analyst picks for 2006 across a variety of key industries looks at the oil & gas, retail, and steel groups. Part One uncovers top selections in airlines, banking, and biotech, while Part Three zeroes in on the Internet, IT hardware, software, and semiconductors tech groups. Oil & Gas Energy stocks tracked in the S&P 1500 Composite Index rose in value by a stunning 31.7% in 2005, compared to 3.8% for the overall index. How much further can they go? UBS Investment Research Managing Director William Featherston says energy companies underinvested for 15 to 20 years starting from the mid-1980s, as they struggled against setbacks such as turbulent politics in oil-rich countries. Now, production capacity remains so low it leaves little room for error on account of what Featherston calls "unpredictable but recurring" events, such as Hurricane Katrina's damage last summer, Western nations' outcry over Iran's nuclear research program, and recent rebel attacks against Nigerian production facilities. "We have to reinvest and grow capacity for oil prices to return to normalized levels," Featherston says. With oil already trading at around $68 per barrel as of Jan. 20, UBS is one of the few investment banks forecasting that oil prices will remain at around $64 per barrel in 2006. In contrast, consensus estimates for oil amount to $53.83 by the end of 2006, according to the BusinessWeek Economic Survey. For those who want to take on more exposure to those already highly appreciated oil and gas stocks, here are Featherston's top three picks: Occidental Petroleum (OXY ): The Los Angeles-based company finds and sells crude oil and natural gas, and also makes basic chemicals. Instead of trying to increase production by investing in higher-risk areas such as offshore west Africa, Occidental Petroleum has been developing large assets with long-lived reserves since 1997. Occidental is now focusing its efforts on nine countries and five states, down from 27 countries and 17 states in the early 1990s. UBS expects the company to reap benefits in the coming years from other projects, such as the one known as the Dolphin in Qatar, while its Mukhaizna oil field in Oman should ramp up in 2007. UBS expects to see $13 of free cash flow per barrel of equivalent resources in 2005 and $15 in 2006, 40% more than its peers. Occidental reported production growth in the range of 50% this year and 10% in the next, according to a recent research note from UBS. XTO Energy (XTO ): This Fort Worth-based oil & gas company explores and develops properties located mainly in the U.S. XTO has increased its production in recent years, and spent around $1.3 billion on development in 2005, well ahead of the $850 million originally planned in the company's Securities & Exchange Commission filing for the year 2004. They took on more property last year in places such as Texas' Permian Basin and Barnett Shale. XTO also bought 150 onshore properties in areas such as Texas and New Mexico from ChevronTexaco for $1.1 billion in May, 2004. Kerr-McGee (KMG ): Kerr-McGee has had a "dramatic" restructuring and "the market hasn't adequately reflected those changes in the [stock's] valuation," Featherson says. The Oklahoma City-based oil-and-natural gas exploration and production company raised $800 million by shedding its Tronox (TRX ) chemicals business in an initial public offering that closed in late November. It also sold its North Sea assets for about $3.1 billion and divested U.S. onshore properties for about $510 million. Kerr-McGee then paid off $4.25 billion of debt on Nov. 28, reducing its burden to around $2.6 billion (not counting $550 million of debt belonging to Tronox, in which the company retains a 45% stake that it plans to spin off in the coming months.) Meanwhile, Kerr-McGee still hopes to sell reserves in the shallow waters in the Gulf of Mexico, according to UBS research notes and company press releases. UBS disclosed that it owns shares in Kerr-McGee, as does someone close to or on its research team. Kerr-McGee has paid compensation to and been a client of UBS Securities within the past 12 months. Retail What's the hottest trend in retailing? It's not a haute handbag or a must-have sneaker. It's a beefed-up tech infrastructure for leading merchants. Technology investments have been a recent vogue -- and they're finally going to pay off this year, says Deborah Weinswig, managing director and senior retail analyst with Citigroup (C ). She expects the sector to post 18% earnings growth in 2006. New technologies are helping retailers with "optimization." Weinswig explains, "It's getting the right product to the right store at the right time." In addition, stores will know more about customers when they come to the register, thanks to upgraded point-of-sale systems. Private-labeling is also coming even more into fashion. Products sold under stores' in-house brands currently comprise about 15% of the industry. Weinswig sees no reason that couldn't rise to 25% or 30%, driving profit margins higher. Meanwhile, M&A activity is becoming tres chic. Everyone's trying it on for size, and Weinswig suggests more deals could be on the way. Last year, Kmart bought Sears to become Sears Holding (SHD ), two private equity firms bought Neiman Marcus, and Federated Department Stores (FD ) merged with the May Department Store Company. Among the industry members Weinswig likes: Federated:: Following the completion of the May merger, the company, which is Weinswig's top pick in the sector, also recently announced plans to sell its Lord & Taylor division. She likes the way the recent merger combines the company's merchandising strength with May's aggressive cost-cutting. "It's like the best of the best," Weinswig says. The deal also lets Federated expand its private-label sales into May's stores, where such products weren't as prevalent. JC Penney (JCP ):, Weinswig's next pick stands to benefit from new optimization technologies. "Penney has really been on the forefront from a technology-implementation perspective," she says. Another plus is the company's 40% private-label sales and seven strong in-house brands. A possible upgrade of Penney's debt rating to investment-grade could set the stage for an aggressive share repurchase plan, notes Weinswig. Wal-Mart (WMT ): The Behemoth of Bentonville rose in Weinswig's estimation after sweeping senior-management changes last year. "They've done basically everything I could ask them to," she says. Newly promoted President and CEO Eduardo Castro-Wright knows how to localize each store for its customers. A new compensation structure aligns the incentives of the company's 300 market managers with the performance in their markets. Wal-Mart's Sam's Club division, also under new management, has undergone its own turnaround story. Steel In 2006, steel looks sturdier than it has in a long time, says Michael Gambardella, managing director and senior metals & mining analyst at J.P. Morgan. The reason? The business around the essential alloy has undergone some structural improvements. The steel industry has privatized, consolidated, and globalized. In the late 1980s, more than three quarters of the world's steel capacity was owned by governments, a ratio that dropped to roughly one quarter in 2005. Privatized steel companies grew into multinationals -- and recently started scaling back factories that once ran regardless of demand. "The result is significant supply discipline for an industry that never had any discipline," Gambardella says. Steel producers U.S. Steel (X ) and Mittal Steel (MT ) both announced production cuts in 2005. At the same time, higher raw-materials costs may make it easier for U.S. steel producers to compete in a global market. The costs of iron ore, metallurgical coal, and steel scrap have all risen significantly in the last four years. While that may seem like bad news, Gambardella says, it actually means that overseas companies can no longer gain such an advantage from cheaper labor. Gambardella's selections in the industry include: U.S. Steel: This is the analyst's top pick in the steel industry. Gambardella points out that U.S. Steel has the strategic advantage of its own captive source of steel raw materials. The company's valuation is particularly attractive, Gambardella says, in light of a bidding war worth as much as $4.7 billion for Canadian rival Dofasco. "U.S. Steel is a better company than Dofasco," the analyst says. Nucor (NUE ): This is another steel stock to watch, Gambardella says. The company has reduced its cost by rolling out new technologies, such as the Castrip process for casting strip steel. Nucor has a clean balance sheet and good growth opportunities, Gambardella says. Economic indicators suggest the steel producer's end market -- nonresidential construction -- is poised for an uptick of its own. Allegheny Technologies (ATI ): Allegheny is one of the beneficiaries of industry consolidation, notes the analyst. The specialty metal maker acquired second-largest competitor J&L Specialty Steel in 2004. Gambardella also likes the company's exposure to aerospace demand. "Demand for specialty metals in aerospace will be very good well into 2007," he says. 
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