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Source: BusinessWeek Online
 
What's ahead for key industries in the year ahead, according to Wall Street's seers? And which stocks are at the top of their lists? BusinessWeek Online reporters Alex Halperin, Marc Hogan, and Sonja Ryst surveyed top analysts who cover a wide variety of industries for their insights and top picks for 2006 within the groups they cover.

The first part of our survey looks at the airlines, banking, and biotech groups. Part Two uncovers top selections in oil and gas, retail, and steel, while part three zeroes in on tech groups Internet, IT hardware, software, and semiconductors.

Airlines

Glenn Engel, an analyst at Goldman Sachs, is pessimistic about U.S. airlines. He recommends buying only 4 of the 20 or so stocks that he follows: Houston's Continental Airlines (CAL ) the Oak Creek (Wis.)-based Midwest Air Group (MEH ), Seattle's Alaska Air Group (ALK ), and Dallas' Southwest Airlines (LUV ).

Airlines have struggled for years with their labor unions and rising fuel costs, among other things. Delta Air Lines (DALRQ ) and Northwest Airlines (NWACQ ) plunged into bankruptcy in September, following other major carriers such as UAL Corp.'s (UALAQ ) United Airlines and ATA Holdings, the parent company of ATA Airlines.

As airlines slash costs and analysts predict falling jet-fuel prices, airline stocks tracked in the S&P 1500 Composite index have seen an uptick of 4.5% over the past 13 weeks, in a deviation from their 15.7% average yearly decline during the past five years. But they've slipped 3.1% year to date through Jan. 13, as oil prices surged following news about Nigerian rebel attacks on oil facilities and Iran's nuclear research program.

"The problem in airlines is that people don't fail," Engel says. "It's not a good industry." He says the airlines will never raise their prices except to save themselves from going out of business, which never happens. Among other things, he pointed out that it's a regulated, taxed business, and fuel prices are volatile.

When someone like Engel sees hope, where is it?

Continental: Engel has rated this stock "outperform" since early 2005, when he upgraded it from "in-line." In the universe of decades-old airlines that have struggled for years with their inefficient, sprawling businesses, Continental is among those closest to the holy grail of profitability. Continental managed cost cuts such as closing its main departure runways at Houston's Bush Intercontinental Airport last year.

After winning concessions from unions, hiring flight attendants and making better use of its capacity by flying planes for more hours per day, Continental said on Jan. 17 that it lost $1.58 per share in the fourth quarter, beating analysts' consensus estimates of a $1.80 loss. During the same quarter of 2004, Continental had shed $3.14 per share.

The battle isn't over yet. "We continue to face significant challenges," Chairman and CEO Larry Kellner said in a press release. Among other things, he noted high oil prices and the "bankruptcy advantage" enjoyed by rivals Delta and United Airlines, which is exiting its recent submergence in Chapter 11 with $3 billion in financing.

Midwest: Beginning July 1, 2003, the Minneapolis-based giant Northwest began offering nonstop flights from Milwaukee to Boston, Las Vegas, Los Angeles, New York (LaGuardia), Orlando, Fla., and Washington, D.C. (Reagan National). That had spelled trouble for Midwest Airlines, which was Milwaukee's largest carrier as of December, 2004, and whose only other base of operations was Kansas City. Now, as Northwest grapples with its own bankruptcy, it has withdrawn more than 40% of its Milwaukee departures in recent months, giving Midwest more room to breathe.

Midwest's stock price has risen to around $4.31 from around $2.25 in late September. Goldman upgraded the stock to outperform from in-line in early December.

"Northwest Airlines tried to attack them when they were close to bankruptcy by adding new flights in Milwaukee," Engel says. "Instead Northwest went into bankruptcy first."

Kurt Ebenhoch, a spokesman for Northwest, disagrees. He says that Northwest has been serving passengers in Milwaukee since 1927, before Midwest "was ever conceived." (Midwest's Web site says the company indeed started decades later as Kimberly-Clark's corporate air shuttle.) He added that Northwest's recent withdrawals from Milwaukee were "the result of the run-up in oil prices" and other economic challenges.

Southwest: Engel thinks Southwest manages its business better than most other airlines. "They'll outperform on revenues," he says. He moved his rating on the stock to outperform from in-line in September.

Southwest has made shrewd moves in the past, such as predicting the recent surge in fuel prices early enough to be able to buy hedging investments that protect the airline from losses. Such moves have helped Southwest manage to use its own internal funding for its expansion, unlike most other airlines. But take heed: Southwest's hedging agreements have expiration dates. They covered 85% of its fuel needs at $26 per barrel of oil in 2005, and only 70% at $36 per barrel in 2006. They continue decreasing each year and will only cover 30% in 2009.

The airline has been steadily dogging its competition in recent years as it adds new routes and services. It has aggressively increased capacity at Chicago Midway since 2004, for example, and just took four additional gates at the airport from ATA Airlines in December 2005 (in exchange, it gave the bankrupt airline a $20 million reduction in the debt it owed to Southwest.) Southwest has added services to new cities in recent years such as Denver, Ft. Myers, Fla., and Pittsburgh. Among other things, Southwest plans to add more than 30 aircraft in 2006 to its 445-sized fleet.

Southwest Airlines, Continental Airlines, and Midwest Air Group are Goldman Sachs clients.

Banking

Jason Goldberg, a senior research analyst at the investment bank Lehman Brothers, sees more prosperity for the banking industry. "We're constructive on larger banks for 2006," Goldberg says. He continues expecting banks to grow their commercial loan businesses and thinks their profit margins are close to stabilizing, among other things.

Financial services stocks in the S&P Composite 1500 have improved their value by 2.6% year to date through Jan. 13, close to the 3.3% increase for the overall index. During 2005 they gained 3.8%, the same as the index. Banks have been benefiting from the strengthening U.S. economy. Many have fewer unpaid loans on their books now.

And the new Bankruptcy Abuse Prevention & Consumer Protection Act of 2005 aims to make it tougher for creditors to obtain court protection from their lenders, which could mean lower bad-credit losses for the banks long-term.

Still, pundits continue debating about their forecasts for inflation, interest rates, and economic growth in the coming months. (If you want to compare the projections from 54 forecasters on the economy's performance, see BW, 12/26/05, "Entering The New Year With A Head Of Steam" and "What The Seers See"). On average, they expect the economy to grow 3.3% from the end of 2005 to the end of 2006. That's a shade slower than the expected 3.7% pace for 2005.

"Clearly, a slower economy could lead to reduced or higher unemployment, which adversely impacts credit quality," Goldberg says. "A modest slowdown isn't necessarily a bad thing [for banks]. A more dramatic slowdown and recession could be."

Goldberg's top picks in the group:

Wachovia (WB ): Goldberg upgraded Wachovia to overweight from equal weight in October, 2003. He likes the financial services outfit's "above average" commercial and capital markets exposure, among other things.

Wachovia has gobbled up companies in recent years, including the insurance brokerage firm Palmer & Cay in May, 2005 and AmNet Mortgage (AMNT ), the parent company of the wholesale mortgage banker American Mortgage Network in December. It also swallowed Birmingham (Ala.)-based bank SouthTrust last year after announcing completion of the merger in November, 2004.

"One of the things weighing on investors' minds is that it's an acquisitive company, which scares off investors sometimes," Goldberg says. He thinks the company's recent acquisitions have gone "smoothly to better-than-expected." As for Wachovia's acquisition program, Goldberg says, "It has been and will continue to be disciplined."

For example, Wachovia said it gained $214 million after-tax from discontinued operations related to the sale late last year of its corporate and institutional trust businesses to U.S. Bancorp (USB ), according to its fourth-quarter results announced Jan. 12.

Bank of New York (BK ): Goldberg has rated the New York-based bank at overweight since he started covering it in March, 2004. "They're not your plain-vanilla" bank, Goldberg says. "They're less exposed to consumer demand."

The Bank of New York earns most of its revenue from back-office services such as securities processing, unlike more traditional banks. The firm also does foreign exchange trading and processes American Depositary Receipts.

Lehman thinks the bank will benefit from factors such as growth in ADR trading activity.

Citigroup (C ): Goldberg expects the financial services heavyweight to benefit from its global presence. Citi generates around 40% of its revenues outside the U.S., which gives it exposure to economic growth trends outside the country. Goldman has had his overweight rating on Citi since he started covering the stock in March, 2004.

Citi has exposure to most areas of the world. North America still provides the lion's share of the company's net income, accounting for $7.7 billion of the total in 2004, according to the bank's most recent annual Securities & Exchange Commission filing. But Citi also generated $2.4 billion of net income from various countries within non-Japanese Asia, Europe, the Middle East, and Africa. Japan accounted for $616 million. Another $979 million came from Mexico.

What about the regulatory problems that Citi has faced in recent years? For example, the company forked over $2.6 billion in May, 2004, to settle claims that it misled the investors who lost their shirts on the telecommunications provider WorldCom. It also paid billions to Enron investors who sued in recent years on charges that lenders including Citigroup conspired with the former energy company to mislead them.

"The bulk of that is [already] behind us," Goldberg says. "We expect 2006 to be relatively clean."

Biotech

After a stellar 2005 from industry leaders such as Genentech (DNA ) and Genzyme (GENZ ), Citigroup analyst Yaron Werber sees 2006 as the year smaller biotech stocks will shine. Lesser-known stocks, he says, may be better positioned to capitalize on product pipeline advancement.

"A new product launch for a mid-cap company is much more meaningful than for an Amgen (AMGN )," while also making them smart acquisition plays for big pharma. Werber also points out that the midcap biotech segment is "underowned" by general investors, and perhaps trading below its true value.

Among the stocks Werber likes for 2006:

Celgene (CELG ): The Summit (N.J.)-based outfit's primary revenue driver is Thalomid, a reincarnation of thalidomide, the morning-sickness drug that caused horrific birth defects in the 1950s and 1960s. The drug is now used to treat diseases including the blood cancer multiple myeloma, and leprosy.

Werber says that in 2006 the company could escape thalidomide's shadow. The company's Revlamid, a next-generation drug that recently won approval for treating patients with the cancer-related blood disorders known as myelodysplastic syndromes.

This year Werber expects the company (in which Citigroup has a greater than 1% position) to win Food & Drug Administration clearance approval to use Revlamid to treat multiple myeloma. He says the drug could hit the triple whammy offering more potent and safer treatment while generating higher margins for Celgene. "It's a better version of what's out there," he says. In the future, the drug also has the potential to treat more diseases including leukemia.

Gilead Sciences (GILD ): Werber describes Gilead as a "good large cap stock for growth investors." The company's top seller, Truvada, combines two of the company's HIV treatments in a single pill. In 2006, the company hopes to take it a step further. A "triple pill" that includes Truvada and the Bristol-Myers Squibb (BMY ) HIV drug Sustiva is in late stage clinical trials and could be available as early as the fourth quarter.

It's an attractive partnership for Foster City (Calif.)-based Gilead; two sales teams will be hawking the drug, with revenues split between Bristol and Gilead, based on the Truvada and Sustiva's current prices. If approved, Werber suggests it the new pill would be a formidable competitor to GlaxoSmithKline's (GSK ) Combivir HIV drug.

Human Genome Sciences (HGSI ): As for companies with earlier-stage products, Werber likes Rockville (Md.)-based Human Genome. (Citigroup holds more than 1% of the company and has a banking relationship with it.) The analyst says there's still some investor resentment toward Human Genome, founded in 1992, since the company "promised to change the world" and hasn't yet delivered.

Still, Werber sees plenty of potential in the company. His buy rating is based on Albuferon, a treatment for hepatitis-C. The drug is aimed at the Roche drug Pegasys. Both are injections that leave patients sick for several days, but the Human Genome drug would not have to be injected as often.

The company has other things cooking too. With Glaxo, it's developing LymphoStat-B, a treatment for lupus and rheumatoid arthritis. The compound stumbled in a fall clinical trial, but the company is still advancing the drug, in a smaller patient population. The small company is also entitled to royalty payments on a potentially blockbuster Glaxo cardiac drug that's in late stage clinical trials. "At which point does Glaxo opt to buy them out?" Werber wonders.

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