2006 Industry Outlook

Equipment producers and food products manufacturers will see growth, but at slower rates. Prospects for health care are excellent, and pharmaceutical sales are promising.

The director of the Selig Center for Economic Research at the University of Georgia’s Terry College of Business looks at prospects for some selected Georgia industries.

Lumber and Wood

The large-scale rebuilding of homes and commercial properties after Hurricanes Katrina and Rita will be an important driver for lumber and wood products producers. This will be the largest natural-disaster rebuilding effort in U.S history. Because it will take several years to rebuild and repair the damaged properties, demand for lumber and construction materials will be high for several years

The price spike that immediately followed the hurricane will recede somewhat, but prices still will be higher than if neither Katrina nor Rita had come ashore. Residential construction is the industry’s most important final market, and it’s almost impossible for lumber prices not to move in tandem with the pace of new home construction, which I expect to slow in 2006 and 2007.

Paper And Pulp

The price of most paper products and pulp was at extremely depressed levels for several years, prompting significant capacity reductions in many parts of the paper industry. In 2004, prices finally stabilized, reversed course and then rose rapidly.

In 2005, prices remained relatively high, but late in the year huge supplies of salvage trees damaged by the hurricanes came to the market and dampened prices. Improving economic conditions coupled with recent capacity reductions should keep prices firm in 2006.

Support for paper and pulp prices also will come from the declining value of the U.S. dollar, which will restrict pulp and paper imports and stimulate exports. Higher exports to China will keep pulp prices from declining too much. Paper prices will be high enough to stop further capacity reductions, but probably will not stimulate significant new investment. Prospects are better for coated papers than for newsprint, uncoated paper and pulp.

Furniture

Job gains, growth in disposable personal income, the lagged benefits of the strongest housing market in the nation’s history and the need to replace furniture destroyed by the hurricanes will power furniture sales to households. Consumers’ confidence will be at levels that provide additional stimulus.

Higher interest rates and fewer opportunities for cash-back refinancing of home mortgages will be headwinds for the furniture industry. Nonetheless, the main problem facing domestic manufacturers will be intense overseas competition. Imports – especially inexpensive ready-to-assemble furniture – will continue to take market share from domestic manufacturers.

Manufacturing Equipment

Equipment producers will continue to enjoy cyclical increases in demand as well as demand stemming from the need to replace equipment damaged by hurricanes. Nonetheless, after two strong years, the gains in sales will come more slowly. High levels of corporate profits will give businesses the wherewithal and the confidence to purchase more manufacturing equipment.

The upturn in nonresidential construction will drive sales of construction machinery, even as residential construction’s contribution diminishes. Meanwhile, strong shipping volumes will power demand for related machinery and equipment. As the economic recovery and expansion ripples across the globe, U.S. exports of machinery and manufacturing equipment will strengthen, increasing overseas orders. The lower value of the U.S. dollar will help to reinforce exports of manufacturing equipment.

Higher raw materials prices will increase cost pressures on the machinery and manufacturing equipment industry, but also should increase demand from industries that produce basic commodities such as agricultural products, oil and natural gas. The net effect should be positive.

Food Products

Accounting for more than 23 percent of Georgia’s manufacturing gross state product, food product manufacturing is the state’s largest manufacturing industry. In 2006, demand for food products will grow moderately. Food processing is highly competitive and faces very demanding consumers, so firms will have limited flexibility in pricing, and profit margins will be thin. High agricultural commodity prices have put additional pressure on food processors’ margins. They will find it difficult to pass on higher costs for energy and packaging. Branded foods will continue to lose market share to private labels, which are far less profitable for food processors.

Sales growth will come from small increases in disposable personal income, population gains and the development of niche products with higher value-added margins. Since many consumers are expected to trade up to more expensive foods, an increasing proportion of households’ new income gains will go to food purchases. The U.S. population is expanding by about 1 percent per year, so the industry can’t rely on population increases for dramatic growth. Due to growth of the global economy and a weaker dollar, exports should grow modestly in 2006. Over time, foreign markets will expand much more rapidly than the domestic consumer market.

Chemicals

The primary driver behind gains by chemical manufacturing will be higher usage by the industrial sector. Since chemical inventories are lean, inventory building is also expected to contribute to sales. Chemical sales for consumer use will contribute to demand growth; more nonresidential construction bodes well for chemical manufacturers. Declining auto sales and less new residential construction will diminish the industry’s performance somewhat.

High natural gas and oil prices squeezed chemical manufacturers’ net margins in 2003-05, and this pattern may be repeated in the coming year. Manufacturers have not been able to raise prices enough to entirely offset the increased price of these basic raw materials. Recently, U.S. natural gas prices have been among the highest in the world, putting our chemical manufacturing industry at a competitive disadvantage in global markets.

One factor that has helped U.S. manufacturers is that oil prices rose even faster than natural gas prices. This was an advantage to domestic manufacturers because many foreign chemical manufacturers use oil rather than natural gas as feedstock. Nonetheless, natural gas prices are much higher in Georgia than in many other parts of the world due to environmental policies that strongly encourage electric utilities to use natural gas rather than less expensive coal to generate electricity. Exacerbating the situation are limits on the development of some of the nation’s gas reserves.

Several factors will cause chemical production to gradually relocate to developing countries. Natural gas prices are likely to remain much higher in the States than in many other regions of the world. The costs of complying with U.S environmental regulations are relatively high; many of the chemical industry’s largest industrial customers already have moved to the developing world. Over time, chemical production is likely to follow suit.

Pharmaceuticals

Favorable demographics and cost effectiveness enhance prospects for pharmaceutical and medical supply firms. The pharmaceuticals industry is not particularly cyclical, and will benefit less from solid GDP and employment growth than will many other industries. Nonetheless, sales will expand, but profit margins probably will narrow: sales of generic drugs and over the counter drugs will rise faster than sales of branded products.

The industry will continue to benefit from its new focus on marketing products directly to the consumer; and the Medicare prescription drug coverage plan will allow seniors to obtain prescription drug benefits for a monthly premium. The overall impact on the pharmaceutical industry’s top line – revenue – will be positive, but due to margin compression the program probably won’t contribute much to profits.

A number of new niche drugs – albeit fewer obvious blockbusters – in the development pipeline, better research and development techniques, faster FDA approval of new drugs, and the 1994 GATT agreement, which effectively extended the patent life of many drugs: These all favor the industry’s long run prospects. Problems include political pressure to reduce the price of popular prescription drugs, the shorter time it takes for rival companies to produce similar drugs, the lingering fallout from Merck’s 2004 Vioxx recall and more re-importation of prescription drugs by consumers from Canada.

Trucking

Higher demand coupled with the exit of several companies from the industry should give trucking firms the pricing power they need to raise rates. The recent flurry of mergers and acquisitions will help keep rates firm, but that will be offset somewhat by continuing retail consolidation. More outsourcing of products from overseas, especially China, favors carriers that can manage domestic and global distribution. Large retailers often prefer to work with select trucking firms that offer the broadest range of services; and large trucking companies can achieve economies of scale in distribution, especially when it comes to managing global supply chains. In the wake of 9/11, shipping regulations are more complex.

Homebuilding

I expect the number of new single-family homes authorized for construction to decline by about 7 percent; the drop in actual starts probably will be one or two percentage points higher. Although the chief culprit will be higher mortgage rates, there are other factors. Three consecutive bad years for the stock market increased the appeal of purchasing second homes as an investment, but the inclination to shift investment portfolios toward residential real estate will diminish in 2006. Only a few qualified buyers remain on the sidelines, because practically everyone who could afford to do so took the Federal Reserve’s bait and bought a house.

Georgia’s housing market will cool down, but demand and supply conditions will not shift drastically. Speculative overbuilding currently isn’t a factor, but inventories are expected to increase as demand tapers off. As the financing costs of carrying a finished home escalate and the time required to sell a home lengthens, builders’ margins probably will narrow. Many years of robust housing sales drastically reduced the number of desirable older homes on the market, so new construction should account for a greater proportion of a diminishing volume of total sales.

Banks

Bankers should benefit from slightly higher demand for consumer revolving credit, improvements in consumer loan quality and faster growth in corporate lending. Georgia’s banks will continue to benefit from positive demographic trends, including population growth and household formation; the steady influx of new residents increases the demand for banking services, props up asset prices and encourages new business formation.

Banks operating in Georgia, however, generally depend less on earnings derived from mergers and acquisitions, IPOs and trading stocks than do large banks in the nation’s major financial centers. Georgia’s subpar rate of economic growth also lessens the immediate prospects for banks operating primarily within the state.

There don’t appear to be any major home price bubbles in Georgia, but should bubbles burst simultaneously in several large markets elsewhere, home valuations in Georgia probably would be affected. Nonetheless, because home values have risen very slowly in Georgia, the risk of a significant decline here is minimal. Banks operating primarily in Georgia won’t have to wrestle with significant deterioration in the quality of their assets. The growth rate of non-performing loans in Georgia won’t rise significantly in 2006. It’s true that Georgia’s banks issued many more credit cards and expanded these lines of credit, but improved labor market conditions should keep loan default rates relatively steady.

Insurance

Barring another catastrophic occurrence, like a destructive hurricane, conditions will improve for traditional property and casualty insurers. Insurers will continue to emphasize premium growth over market share, which is a major reversal of the pricing policies that prevailed during much of the 1990s. This turn in pricing policy actually occurred in late 2000, and was prompted by slumping income from investments and soaring costs associated with toxic mold, asbestos, litigation and home repairs.

The 9/11 attacks as well as recent hurricanes intensified the industry’s efforts to re-focus on fundamental underwriting standards. This focus will be maintained in 2006, but insurers’ pricing power will diminish. I expect the rate of premium price hikes to slow, but premiums are unlikely to soften except perhaps for the most commodity-like insurance products.

Higher returns on investments constitute the second beneficial shift – one that stems from higher equities prices, increases in overall corporate profits and interest rate hikes. Recent and continued growth in investment income is especially welcome given the unusually sharp and prolonged drops in equities prices, corporate profits and interest rates which had eroded investment income in 2001-2003.

Computer Services

The demand for computer and information services is poised for recovery in 2006. Professional design, processing, support, training and consulting services all will benefit from higher demand; companies that facilitate outsourcing of computer services will experience the fastest growth. Recent hefty increases in businesses spending for new equipment and software presage better times for companies that provide computer services.

The short- and long-term outlooks for information technology consulting as well as other consulting firms are positive, because business and governmental operations and decisions are increasingly complex; and maintaining a range of in-house experts is expensive. The economic expansion, high corporate profits and improved revenue collections by local and state governments will bring full-fledged recovery to consulting firms.

Law

Lawyers and law firms operating in Georgia will benefit from a cyclical increase in demand for legal services. Firms that provide legal services to households will benefit from growth in personal income and employment. Similarly, firms that provide services to businesses will benefit from advances in Georgia’s gross state product, more business startups, and more mergers and acquisitions.

Large firms will find the best opportunities in Metro Atlanta and Savannah, but independent lawyers probably will fare best in the rapidly expanding suburbs or in smaller towns. The growth of Georgia’s population of well-heeled retirees bodes well for lawyers who specialize in planning estates and drafting wills.

Health Care

The outlook for Georgia’s health care providers remains excellent. Rapid population growth, stable funding for Medicare, the new Medicare prescription drug insurance plan, more use of health services, better management of operating expenses and the increasing market power of health care providers all will help the industry’s bottom line. Hospitals’ outpatient care facilities and specialty care centers will experience exceptionally strong growth in demand; inpatient facilities will see moderately higher demand.

Legislation passed in 2005 that caps non-economic damages awarded in medical liability actions might help rein in medical malpractice awards and settlements. The institutional side of medicine, however, will remain vulnerable to government efforts to contain Medicaid costs.

The proportion of Georgians with health insurance is poised to rise in 2006. This will help the industry, because it’s easier to collect funds from insured patients than from self-pay and uninsured patients. As the labor market gradually heals, an increasing proportion of Georgians will be eligible for employer-provided health insurance plans, which will lower bad debt expenses. A more stable business environment should keep most employers from further reducing health insurance coverage. Two factors will limit access to employer-provided health insurance: Many of the newly created jobs will be in smaller firms that are less inclined to provide generous medical benefits, and employers will hire more temporary workers, for whom they are not obligated to provide insurance.

Lodging

Business travel will be fueled by the sustained growth of corporate profits, rising markets for most goods and services, increases in business investments, further globalization of markets and more business formation. Leisure travel will be powered by growth in employment and disposable personal income, favorable demographics, fast-paced growth of the African-American travel market, the opening of the Georgia Aquarium, and an expanded World of Coca-Cola.

Georgia will continue to pick up national conventions, trade shows and smaller business meetings; vacationers who might have gone to New Orleans or other destinations on the Gulf Coast will continue to opt for substitute destinations, such as Savannah and the Golden Isles.