Companies Thriving in the “Great Disruption”

It’s tough to describe the current economic state of the world. Most expect a long recession. More pessimistic people are calling it the “Greater Depression” or the “Great Depression II.”

As we looked at in last Thursday’s Prosperity Dispatch, there’s opportunity in every downturn. There will be winners and losers. The winners will have greater market share. There’s just going to be a lot fewer winners. It has always been the survival of the fittest in the business world. Economic downturns just speed up the process – it’s Accelerated Darwinism.

Scott Anthony calls the current period the “Great Disruption.” He predicts:

For many companies, the Great Disruption requires nothing short of transformation. It requires fending off attacks from below and making the creation of new growth systematic. It demands embracing new forms of innovation, such as business model innovation, and dramatically improving the productivity of innovation efforts. Investing in transformational efforts in a brutal market appears difficult, but the alternative isn’t stagnation, it is extinction.

Anthony is the president of Innosight, a consulting firm, and author of the upcoming book, The Financial Crisis’s Silver Lining (due out in June). It’s a historical study on which businesses made the right decisions during hard times and managed to grow market share and thrive when good times returned (given it’s positive nature – a rarity among the shelves in the business/financial section these days – I’m sure it will be a bestseller).

Determining the difference between the two can be challenging. The rewards, however, make the effort very worthwhile. If you can spot just one or two of the survivors and avoid the ones headed for extinction, you’re going to much wealthier when this is all said and done. But first we have to get one thing straight.

Consumers Still Shopped During the Depression

Economically speaking, it’s going to get worse before it gets better. But even if we are headed for a depression, there’s one key thing to remember – people still shopped. During the last depression, unemployment reached 25%. Of course, 75% of the country was still employed. And they spent. The key thing to pay attention to is how their spending habits changed.

As you’ll see in the chart below, sales of durables (big ticket items like washing machines) collapsed. Meanwhile, sales of perishables and services declined significantly less.

Consumer Spending

We’re already starting to see this trend begin again. Sales of autos, washing machines, and kitchen appliances are already in sharp decline (reference GM and Whirlpool shares); yet service companies and food sellers have held up well. A few are even expecting a relatively great year in 2009.

Just take a look at IBM (NYSE:IBM) earnings report last week. IBM successfully changed itself from a hardware company to a service company a few years ago and expects a strong year.

Big Blue isn’t the only one though, here are three companies successfully making the transformation and are taking this opportunity to expand (We’ll look at whether they’re prudent investments to make today and how a very profitable trade coming up in one at the end of this article).

“Out-cheaping” Wal-Mart

Wal-Mart (NYSE:WMT) has established itself as the lowest-cost of the low-cost retailers in the world. It’s the place U.S. consumers go when they want to save some money. Thanks to the store’s legendary efficiency and negotiating power with suppliers (which it isn’t afraid to use); it can beat almost anyone’s prices.

About 15 years ago, Wal-Mart started selling groceries in more of its stores. It took its “out-pricing everyone” strategy to the low-margin grocery industry and it worked out. Wal-Mart now sells more food than Kroger and Safeway.

Wal-Mart has had a great run, but it might be slowing down quite a bit. After all, how much room is left for them to grow? They’re everywhere. 90% of Americans live within 15 miles of a Wal-Mart.

The same is not true for Aldi. The store chain founded by Theo and Karl Albrecht (hence the Albrecht Discount name) is one of the leading retailers in the world. They are the uber low-cost retailer worldwide.

Aldi is taking this downturn as an opportunity to expand. Aldi sees a big opportunity for its private label brands – a.k.a. generic – to an increasingly frugal U.S. consumer. So while hundreds of stores are closing up shop, Aldi announced sales are up 21% in the U.S. and it will be adding 75 new stores this year. That’s an expansion of about 7%. In the worst recession in decades, that’s huge.

It doesn’t stop there. In Australia, where the economy has really suffered from the commodity downturn, Aldi is being even more aggressive. A week ago the company announced it will be spending $500 million to expand from 200 stores to 460 over the next few years.

Aldi is one company that’s making the best of an otherwise bad situation.

Taking a Bite Out of…Microsoft?

It’s not just Aldi whose expanding during the downturn, Apple (NASDAQ:AAPL) is too. The iPod maker recently said it will be opening 25 new Apple stores this year. More than half of those will be in the U.S. It has also worked out a deal with Wal-Mart for other Apple products.

Apple has had a great run over the past few years. It created the portable MP3 industry and still dominates 70% of it. It will probably sell another 30 million iPods next year. The company has carved out a sizable niche in the cell phone market too. The company sold about 4 million of them last quarter.

But here’s the thing, there isn’t much room to grow there. Apple’s big opportunity is in the desktop/laptop market (a.k.a. – operating systems). Apple still has a single-digit market share here and Microsoft isn’t going to give up an inch without a fight. But if the Apple store expansion and other advertising efforts work out…all I can say is watch out. There’s a lot of room to grow in this sector for Apple.

Making the Honor Roll

One more company has been making the best of an otherwise bad situation. Apollo Group (NASDAQ:APOL), owner of the University of Phoenix and other for-profit education entities, has been soaring of late.

Thanks in part to weekly waves of newly unemployed people signing up to increase their “employability” and an increase in federal education grants, this downturn has been a boon for Apollo. Chas Edelstein, Apollo’s CEO says:

“While we cannot quantify the significance of the current economy on our growth, we believe we are experiencing a positive impact.”

Its success didn’t come without a price though. During the most recent quarter, Apollo upped its advertising and promotional budgets significantly. Advertising expenses climbed 23.6% compared to the same period in 2007. The biggest increase was in the “Other Selling and Promotional Expenses” line item. Apollo spent 68.9% more here than it did a year ago.

So far Apollo has made the right moves. The economy is handing the company opportunity and they’re taking advantage. That’s what I like to see, but…

Are These Three a Buy?

These are three companies which are turning downturn into opportunity. That’s a very good thing. However, are they a good buy?

Considering they are focused on the consumer and two are in sectors which can survive a downturn (Aldi – perishables, Apollo -services)and Apple is technically selling durables, but once you consider how often kids “need” the latest iPod, they’re more like semi-durables.

So, they pass the “Would I start this business today,” test. But are they good investments now?

Aldi is a private company. Investing in it is not even an option. However, it does bring up a key point. Too many investors fail to pay attention to private companies even though they can (and often do) have a very big impact on public companies.

Remember back when infrastructure stocks were setting new highs thanks to Obama’s stimulus package? We realized the run in infrastructure stocks like Sterling Construction (NASDAQ:STRL) and Perini (NYSE:PCR) was completely unsustainable. Wall Street failed to realize 91% of the U.S. construction industry was private.

Since then, the world has realized the impact and infrastructure stocks have started to sag. And there’s probably plenty more downside risk there too.

That’s why it is important to pay attention to private companies. Consider this possible scenario. Aldi is goes after more market share. It undercuts Wal-Mart’s prices. Wal-Mart cuts its price to stay competitive. It’s capitalism and the customer is the winner and traditional food retailers (a really long way of saying grocery stores) big losers.

As for Apple, there’s not much this company can’t do. They’ve got the market cornered on MP3 players, the iPhone was a smashing success, and Apple has been slowly eating away at Microsoft’s market share for operating systems for the past couple of years.

But here’s the thing that has me worried. Microsoft is about to bite back…in a big way. Although not too many people are talking about it yet, Windows 7 is on its way.

Early reviews for Windows 7 are very positive.

The Wall Street Journal’s Walter Mossberg says:

Windows 7 is “a pleasure to use” and “much better than Vista.”

Paul Rubens of ServerWatch.com says:

“Windows 7 clearly has nothing to fear from Apple for a long time to come.”

Clearly, Microsoft is coming back strong and Apple’s window of opportunity in the operating system market has probably passed.

As for Apollo Group, they’re actually looking like a great “short” position right now. Apollo’s coming off great earnings, the whole education sector is setting new highs, and analysts have been crowding in with “buy” recommendations and raising their estimates.

In the past few months, analysts have been upgrading this stock left and right. Since June, First Analysis, JP Morgan, UBS, and Bank of America, have all slapped their “buy” seals of approval on Apollo. The average estimate for Apollo’s earnings next year jumped from $4.10 to $4.56 in a matter of weeks. Rah, rah, rah…the cheerleaders are out in force.

Here’s my question: Is there’s anybody left to buy? (Note even the insiders – they sold $26 million+ worth of shares last week).

So far the company has delivered, but it won’t last. Great expectations usually lead to great disappointments. And this is shaping up to be a horrific crash if Apollo doesn’t beat earnings by enough next quarter.

It’s shaping up to be a horrific downfall (yet equally profitable if positioned correctly) over the next few quarters.

You all remember what happened in fertilizer stocks over the summer, right? Well, the same warning signs are popping up around Apollo which preceded the epic fertilizer crash last summer.

It’s a Buyer’s Market

In the end, we can’t forget this is a buyer’s market. These are three companies making all the right moves, but there is no overwhelming reason to buy them today. There’s a lot of shakeout ahead and we’ll be able to get a much clearer picture of who will be the big winners in all of this.

As long as we keep our eyes on the future and stay focused on facts (i.e. how much of the construction industry is privatized and the potential impact of Windows 7 – it’s going to be big), we’ll make it through the Great Disruption (or whatever moniker history gives it) just fine.

By Andrew Mickey

Image: Imedia Connection

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