Jubak's Journal 10/2/98 -4 stocks likely to thrive amid deflation [DELL at the top - see about 1/3 down the article]
Not everyone will be hurt by the coming global shift to a deflationary economy. I've picked some key names likely to prosper.
By Jim Jubak
What companies -- and what stocks -- will thrive despite deflation?
In my last column, after I'd laid out my belief that major parts of the domestic and global economy are facing an extended period of falling prices ("Is deflation now the real worry?"), I promised to tackle that question.
There are a lot of ways to go about the job. You could, for example, take apart the causes of our current deflation and then look for companies that should benefit from those trends. (Economist A. Gary Shilling does a good job of running through the causes in his recent book, "Deflation: Why It's Coming, Whether It's Good or Bad, and
How It Will Affect Your Investments, Your Business, and Your Personal Affairs," from Lakeview Publishing.
But I prefer starting with companies and working backward to the trends. A global economy doesn't go from inflation to deflation overnight, and the transition doesn't occur across all industries at once. Some industries have been living with deflation for years. The companies that have thrived in those "early deflator" industries can help investors understand what strategies, assets and corporate structures will be most valuable as deflation spreads to other parts of the global economy.
At the end of my last column, I mentioned four companies -- Dell Computer (DELL),Wal-Mart (WMT), Charles Schwab (SCH), and General Electric (GE) -- which I think will likely be winners in deflationary industries. I tagged them because they've already done such a great job of coping with deflation. An investor worried about deflation could just invest in these four -- though, since they've been so successful, their stocks aren't exactly cheap.
Or you could analyze what has made these four companies so successful at coping with deflation and then look for relatively undiscovered companies with similar products, strategies and cultures. I'm going to take this second route.
First, I'll tell you what I think makes each of those four companies a model worth emulating in a deflationary environment and then I'll suggest a company or two that seems to share that trait. (As always, second-guessing is thoroughly encouraged. Just go to the "Discuss it" link at the end of this story to add your quibbles and caveats.)
Let's start with Dell
In a deflationary world, inventory costs you money. A company wants to buy its raw materials at the last minute and deliver its finished products to customers with as little delay as possible. Let's take two companies, both selling personal computers. One buys a disk drive for $100 and keeps it in inventory for two months before it goes into a
computer. Because disk-drive prices are falling, the second box maker, Dell, buys the disk drive for $90 just five days before the computer is assembled. The first company ships its assembled computer to a dealer where it sits on a shelf for a month before being sold. In that time, the selling price drops from $950 to $800. Dell, on the other
hand, takes an order and ships the assembled machine in just a week and collects the full $950 price. Dell has saved $10 in manufacturing cost and received an extra $150 from the consumer.
How do you get profit-devouring inventory off your books? Part of the answer is in distribution. Dell sells directly to consumers and businesses, eliminating the system of dealers, resellers, and consultants -- and their inventory -- used by IBM (IBM)Compaq (CPQ), and Hewlett-Packard (HWP).
But you have to also look at how Dell differs from the traditional manufacturer. Dell doesn't make disk drives or chips or monitors. It doesn't buy the components for motherboards or keyboards and build them itself. Actually, it would be more accurate to call Dell an assembler than a manufacturer. Dell buys subsystems -- designed so
they can be mixed and matched to produce the different models that customers order -- and then puts those together. It takes Dell so little time to make a computer because someone else has done much of the manufacturing.
That's a trend that's not limited to the computer industry, and deflation will make this kind of modular manufacturing even more crucial.
Take the auto industry. When I was 12, my Boy Scout troop went to visit the local Ford plant. I still vividly remember the assembly line where workers crawled into the chassis to connect wires under the dash or hefted seats into place and then bolted them to the floor.
If I went to a state-of-the-art auto factory today -- Mercedes-Benz's Vance, Ala., plant, for example -- I would see very little of this kind of nuts-and-bolts manufacturing. For example, the dashboard for the Mercedes sport-utility vehicle built in Vance arrives
already assembled -- complete with air bags, instruments and glove compartments. At Chrysler's Brazilian factory, Dana (DCN) delivers a complete chassis for the Dodge Dakota pickup. Ford (F) estimates that modular assembly -- and the tight delivery schedules that go with it -- have saved $9 million annually at one Lincoln plant.
To play this deflationary trend in the computer industry, take a look at Jabil Circuit (JBL) and Solectron (SLR), the Nos. 2 and 3 manufacturers of computer circuit boards. To play it in the auto industry, take a look at Federal-Mogul (FMO), Magna International (MGA) or Lear (LEA). [You can find a complete rundown on these and
other companies in the auto sector in Mark Thompson's June 22 article, "Auto parts makers shift into high gear."] At the moment, Lear is the best play here -- I'm adding it to Jubak's Picks.
On to Wal-Mart
In a deflationary world, companies that can cut costs to the bone and still make a profit will do quite nicely, thank you. That much is obvious -- and so is Wal-Mart's ability to deliver that combination. How does the company do it? Information. Wal-Mart has invested in computer disk storage systems and databases with a total capacity of
43 terabytes. That's a large but meaningless number to most of us. But put it in this context, Wal-Mart owns more computer disk storage than the Internal Revenue System.
Wal-Mart is using all that capacity to move to Stage Two in the ongoing revolution in retailing. In Stage One, Wal-Mart built the best computerized system in retailing for controlling inventory. Using that system, Wal-Mart knew when stocks were running low, how much to order, and what to order. This system helped Wal-Mart build a centralized distribution system that was far more cost-efficient than that of most of its competitors.
Now, in Stage Two, Wal-Mart is storing every bit of data it can get on its customers and their buying preferences, then using its analysis of that data to fine-tune its inventory and marketing. For example, individual store managers use this information to choose which items to display and how much shelf space to give to a product category and to individual brands within a category. Thanks to its information systems,this huge retailer can customize its product offerings. That cuts down on costs by reducing slow-moving inventory and builds revenue by increasing sales.
Companies that want to keep pace with Wal-Mart will have to invest in storage systems and software to organize and analyze their data. So how do you as an investor profit from that? You could buy shares in EMC Corp. (EMC), the leading company in the high-capacity disk storage business. But even in this market, the stock trades at almost 50 times trailing earnings for the last 12 months -- a steep premium to the projected 1999 earnings growth rate of 27%. Another possibility:
stocks of the companies that build the software that manages and analyzes this data. Prices of these stocks have been pounded on fears that earnings growth will fall to 30%-40% annually from the current 60%. My favorite in this sector is SAP AG (SAP). The company's database software is a favorite among the world's biggest companies,
but most of those (85%, according to Lehman Brothers) only use it for financial accounting. That gives SAP big growth potential as the company rolls out more applications for human resources, supply chain management, and electronic commerce. I'm adding the stock to Jubak's Picks.
What put Charles Schwab on this list?
I'm impressed by this company's relentless quest for distribution. Schwab sells in brick-and-mortar offices, over the phone using human sales representatives, over an automated phone service, on the Internet, and through a network of financial advisers. Each of these channels helps the company reach a different segment of the market at
a distinct price point.
Schwab does so by taking much the same approach as Dell or Ford when they use modular manufacturing to customize a product -- it starts with its basic commodity service, then mixes and matches additional components to customize packages for different distribution channels and different price points. Effectively, it can be all things
to all customers.
That's important in a deflationary world. As prices decline, consumer willingness to pay a specific price -- and hence consumer demand -- changes in unpredictable ways. Exactly what features will a consumer buy at what price? And how many customers will buy that package at that price? A company that guesses wrong and mis-prices a product risks losing a customer to a competitor. The goal is to keep customers in the family -- even as prices fall -- by allowing them to migrate to a different price point inside the product line.
This is only an effective strategy if a company is willing to cannibalize its own sales of higher-margin products depending on market demands. Schwab has been willing to offer $29.95 electronic trades, for example, even if it means that the company will conduct fewer trades at $50. Keep the customer, the company is saying, and then figure out a way to manage costs and volume to still make money at the lower price point.
Qwest Communications International (QWST) has aggressively rolled out this kind of "try every channel and every price point" strategy. The company's recent deal with Netscape Communications (NSCP) -- you'll be able to sign up with Qwest for long distance, Internet access, conference calling, faxing, e-mail and voice mail on the Netscape Netcenter portal -- gives Qwest another way to reach a segment of the
market. The average price per minute for this channel is likely to be somewhere around 9 cents per minute -- less than Qwest can expect from customers signed up by the sales force it recently acquired in its purchase of LCI International. But the company believes it can still show higher margins in this channel thanks to lower costs for customer acquisition, billing and bad debt.
Qwest was even willing to cut deals with US West (USW) and Ameritech (AIT) to resell Qwest long-distance service to their own customers. The courts have blocked this effort, ruling that it violated the 1996 Telecommunications Act. But I like Qwest's willingness to try anything to reach new customers, even if it means cooperating with potential competitors and competing with the in-house sales force. I'm also adding Qwest to Jubak's Picks.
Finally, General Electric
I put this company on my list of deflationary models because of what it doesn't do. Everyone praises GE's drive to be No. 1 in every business it owns. That's important, no doubt about it. But I'm actually more impressed by the company's willingness to exit businesses when it thinks it can't make enough profit. I think that will be crucial in a deflationary economy.
GE sold off its air-conditioning business in 1982, its housewares operation in 1984, and its semiconductor division in 1988. Least sentimental of all was the sale of the RCA brand to Thomson of France. GE had been one of the original founders of RCA, and, after being forced to cough up the company by an antitrust action in 1930, had
even reacquired it in 1986. But the profit margins from televisions and other consumer electronics weren't high enough. So despite the sentimental ties, the company exited the business.
Deflation will lead to consolidation in industry after industry. Companies will need to dominate their markets to make much money. They'll need to concentrate on what they do best. And they'll need to focus their energy and capital.
The example of GE doesn't lead me to a specific stock pick. I don't know of any company that's manufacturing this kind of management discipline and selling it on the market.
Too bad, actually. Because thriving in deflation is going to be tough without it.
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