Avoid These Shrinking Market Leaders

By StreetAuthority | September 10, 2013 AAA

Even the best companies are finding it hard to generate solid revenue growth these days.

The slow-growth economy means that the majority of companies in the S&P 500 are expected to boost sales less than 10% in 2013 and 2014. But at least they are growing.

In contrast, for some companies toiling in especially troubled industries, management is trying to figure out ways to survive, let alone thrive.

The computer hardware industry is a perfect example. Leading players managed to boost sales at a double-digit pace in the 1990s and again the past decade. The current decade, however, has been characterized by extended replacement cycles and technology obsolescence (from tablets and smartphones).

Companies such as Dell (Nasdaq: DELL) are still coveted by buyout firms for their large recurring base of revenues, but those bases are slowly evaporating.

For niche tech companies such as printer maker Lexmark (NYSE: LXK) or office equipment supplier Pitney-Bowes (NYSE: PBI), the outlook is even more bleak. The move to a digital paperless world, which gains more ground every year, could spell their death knell.

Not So Defensive
In a similar vein, defense stocks were often sought out for their sold recurring bases of revenues, thanks to long-term contracts and an industry structure that discouraged new competition. Yet major defense suppliers are also being forced to retrench as Uncle Sam tightens his belt.

Still, the PHLX Defense Sector index has risen from 310 to 550 over the past two years. Investors appear to be treating the current woes for the defense sector as purely temporary, and they assume defense spending will rebound once the current budget woes are dealt with.

Yet is such optimism warranted? The current crisis in Syria is very instructive. Even the traditionally hawkish Republican Party has expressed wariness over intervention, signaling a major shift in the sense that the U.S. is the "policeman of the world." If this shift toward isolationism continues, then the entire rationale for a huge Defense Department starts to disappear.

End Of The Landline?
Investors also need to brace for a move to a 100% wireless telecom world. People in their 20s and 30s see little need for a landline phone as they move into their first purchased homes, as a recent Wall Street Journal article noted.

The only source of demand for landlines comes from older customers that are unwilling to "cut the cord." Yet that demographic dichotomy spells clear trouble for companies that are still heavily dependent on a landline business, such as Frontier Communications (NYSE: FTR) and Cincinnati Bell (NYSE: CBB).

Outside of these specific industries, there are many other companies that are projected to see steady sales declines. And it pays to dig not the reasons behind those revenue drops.

Some companies such as Hartford Financial (NYSE: HIG) and News Corp. (NYSE: NWS) are looking to shed underperforming assets, and the end result will likely be a stronger balance sheet and higher profit margins, even if the top line must suffer.

Other struggling companies will need to make bold moves to survive the secular revenue erosion. For example, office supply retailer Staples (Nasdaq: SPLS) will likely benefit only modestly from the proposed merger between rivals Office Depot (NYSE: ODP) and OfficeMax (NYSE: OMX), as demand for high-margin products such as printer ink cartridges continues to weaken and nominal rivals such as Wal-Mart (NYSE: WMT) and Amazon.com (Nasdaq: AMZN) aggressively compete on price for whatever market opportunity remains.

Staples will likely need to close its own underperforming stores, which will create negative operating leverage in terms of national advertising and merchandising pricing power with vendors.

At first blush, it may be easy to draw a similar conclusion about Barnes & Noble (NYSE: BKS), which squandered its cash on an ill-advised e-reader initiative. Its shares trade near 52-week lows, and analysts project modest sales declines in each of the next few years.

Yet a contrarian view may be warranted. First, Barnes & Noble now sees very little competition from major other brick-and-mortar retails, many of whom have gone out of business. In addition, books are unlikely to ever go out of style the way compact discs have. The key for management is to take steps to make sure that every existing store generates positive cash flow. And they must continue to seek out ways to heighten the stores' appeal and increase foot traffic. But this is a business that is more fixable then many realize.

If I had to predict one company on the table above that might shrink its way out of business, it would be online educator the Apollo Group (Nasdaq: APOL). The online education segment appears to be undergoing a massive shakeout in which higher-quality academic institutions are able to boost enrollment but poor-quality operators are quickly losing market share. Apollo Group is falling into the latter group.

Risks to Consider: As an upside risk, some companies will actually be healthier once they are smaller, as operations become more manageable and unprofitable niches are shuttered.

Action to Take--> The fact that these companies are shrinking in a growing economy is worrisome. Some of the blame goes to shifting societal tastes and priorities. The tech and defense sectors are two clear examples where secular shifts are hurting. It pays to assess other industries in this context to see if technological, cultural or political shifts will lead to eventual secular revenue declines.

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