joy global: a misunderstood cyclical?

7/31/2019 Joy Global: A Misunderstood Cyclical?

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Joy Global: A Misunderstood Cyclical?

Published on July 24, 2012

Article URL: http://www.rationalwalk.com/?p=12709

Copyright 2009-2012 The Rational Walk LLC, All Rights Reserved.

Joy Globalis a leading manufacturer of underground and surface mining

equipment used in the extraction of coal and other minerals. The company

manufactures essential and highly specialized products such ascontinuous

miners,longwall shearers, androof supportscritical for safety in modern

mines.

Such equipment carries high price tags and requires continuous maintenance and support. In

recent years, original equipment has accounted for approximately 40 percent of Joy Globals

sales with the remainder accounted for by aftermarket parts and services. Based on reading

this description, Joy Global should be categorized as a cyclical company that can be expected todo well in times of economic strength and face headwinds during recessionary periods. The

market certainly agrees: At around $50, Joy Global trades at under eight times trailing

earnings.

Alexander Roepers, founder and Chief Investment Officer of Atlantic Investment Management

recently described his bullish views on Joy Global in the Spring 2012 issue ofGraham &

Doddsville(pdf). Graham & Doddsville is a free newsletter published by Columbia Business

School students and is well worth reading. Note that Joy Global was trading at a significantly

higher price at the time the Graham & Doddsville article was published. Mr. Roepers concluded

his bullish thesis as follows:

For the bears, Joys shares are pricing in peak earnings per share of $7 or $8, so

its trading at 10x peak earnings. But, in our view, these are not peak earnings.

We see Joys earnings trending up over time. They had one flat year in earnings in

the Great Recession. Caterpillar earnings were down 60%. Sales were down

nearly 40% at Caterpillar, while sales at Joy were flat.

Interestingly, Wall Streets consensus estimates for the current fiscal year still reflect healthy

earnings growth. Value Lines June 8 coverage of the company forecasts earnings of $10.65 by

2015-2017. Putting aside the questionable accuracy of earnings estimates years into the future,we can see that market participants have not explicitly called for a drop in earnings yet,

although the stock price seems to foresee a decline. Intrigued by Mr. Roepers thoughts on Joy

Global and the subsequent decline in the companys stock price, we decided to take a look at

the fundamentals to determine both the upside potential and downside risk.
http://www.rationalwalk.com/?p=12709http://www.rationalwalk.com/?p=12709http://www.joyglobal.com/Joy_Global.htmhttp://www.joyglobal.com/Joy_Global.htmhttp://www.joy.com/en/Joy/Products/Continuous-Miners/14CM-Continuous-Miner.htmhttp://www.joy.com/en/Joy/Products/Continuous-Miners/14CM-Continuous-Miner.htmhttp://www.joy.com/en/Joy/Products/Continuous-Miners/14CM-Continuous-Miner.htmhttp://www.joy.com/en/Joy/Products/Continuous-Miners/14CM-Continuous-Miner.htmhttp://www.joy.com/en/Joy/Products/Longwall-Systems/Longwall-Shearers.htmhttp://www.joy.com/en/Joy/Products/Longwall-Systems/Longwall-Shearers.htmhttp://www.joy.com/en/Joy/Products/Longwall-Systems/Longwall-Shearers.htmhttp://www.joy.com/en/Joy/Products/Longwall-Systems/Powered-Roof-Supports.htmhttp://www.joy.com/en/Joy/Products/Longwall-Systems/Powered-Roof-Supports.htmhttp://www.joy.com/en/Joy/Products/Longwall-Systems/Powered-Roof-Supports.htmhttp://www4.gsb.columbia.edu/null/download?&exclusive=filemgr.download&file_id=7310999http://www4.gsb.columbia.edu/null/download?&exclusive=filemgr.download&file_id=7310999http://www4.gsb.columbia.edu/null/download?&exclusive=filemgr.download&file_id=7310999http://www4.gsb.columbia.edu/null/download?&exclusive=filemgr.download&file_id=7310999http://www.joyglobal.com/Joy_Global.htmhttp://www4.gsb.columbia.edu/null/download?&exclusive=filemgr.download&file_id=7310999http://www4.gsb.columbia.edu/null/download?&exclusive=filemgr.download&file_id=7310999http://www.joy.com/en/Joy/Products/Longwall-Systems/Powered-Roof-Supports.htmhttp://www.joy.com/en/Joy/Products/Longwall-Systems/Longwall-Shearers.htmhttp://www.joy.com/en/Joy/Products/Continuous-Miners/14CM-Continuous-Miner.htmhttp://www.joy.com/en/Joy/Products/Continuous-Miners/14CM-Continuous-Miner.htmhttp://www.joyglobal.com/Joy_Global.htmhttp://www.rationalwalk.com/?p=12709


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Coal: Perception and Reality

To understand Joy Global, it is necessary to step back and look at the high level dynamics

driving the coal industry. Coal is probably the most hated fossil fuel in existence because it is

dirty compared to alternative forms of energy, particularly natural gas. According to the EPA,

natural gas fired power generation produces half as much carbon dioxide, less than a third asmuch nitrogen oxides, and one percent as much sulfur oxides compared to coal.

Much to the chagrin of environmentalists, the use of coal has increased significantly over the

past few decades both in absolute terms and as a percentage of total primary energy supply

according to the International Energy Agencys2011 Key World Energy Statisticspublication.

The following chart taken from the report shows world total primary energy supply from 1971

to 2009 by fuel type:

In 1973, coal and peat accounted for 24.6 percent of the total versus 27.2 percent of the total in

2009. As the reader may guess, this trend has been driven by emerging economies. Use of coal

use within the OECD group of richer countries fell from 22.6 percent of the total in 1973 to 20.2

percent in 2009. The majority of the increase in coal use has been in the poorer parts of the

world with China being the most notable example.
http://www.epa.gov/cleanenergy/energy-and-you/affect/natural-gas.htmlhttp://www.epa.gov/cleanenergy/energy-and-you/affect/natural-gas.htmlhttp://www.iea.org/publications/freepublications/publication/name,26707,en.htmlhttp://www.iea.org/publications/freepublications/publication/name,26707,en.htmlhttp://www.iea.org/publications/freepublications/publication/name,26707,en.htmlhttp://www.iea.org/publications/freepublications/publication/name,26707,en.htmlhttp://www.epa.gov/cleanenergy/energy-and-you/affect/natural-gas.html


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The following charts show the breakdown of worldwide energy use by region/country:

According to the IEA, China is the largest producer of coal in the world at 3,162 million tons of

production in 2010. The United States was in second place at 932 million tons with India in

third place at 538 million tons. Chinas world leading production is not even sufficient to keep

up with demand and the country imported an additional 157 million tons in 2010. According to

Mr. Roepers, 70 percent of Chinas electricity is generated from coal.


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What About Cheap Natural Gas?

Cheap and abundant natural gas clearly poses a threat to coal fired electricity generation in the

United States. However, as The Economists recentsurvey on natural gasmade clear, the

supply and demand dynamics that have created low natural gas prices in the United States are

not present in most other parts of the world. Natural gas prices in Asia are far higher than inthe United States and the cost of liquefying and shipping natural gas is not only expensive but

requires extensive infrastructure to support. Clearly coal will not be going away anytime soon

as a primary energy source in China. The inexorable rise in energy demand in China could very

well slow in an economic recession but the secular trend demonstrates rising demand over time

and much of that demand will be fueled by coal for years to come.

Joy Globals Track Record

Readers are encouraged to review the business summary section of Joy Globalsfiscal 2011 10K

for general background information on the company and its long history. The company went

through a bankruptcy reorganization and emerged from the process in July 2001. Since that

time, the company has posted strong results with revenues rising from $1.15 billion in fiscal

2002 to $4.4 billion in fiscal 2011 (year ended October 28, 2011). Net income rose from a loss

of $28 million in fiscal 2002 to a profit of $610 million in fiscal 2011. The following exhibit

shows the steady margin expansion driving these results:

The company has delivered attractive returns on equity and total capital over the past decade.

As of April 27, 2012, total debt was 41 percent of capital.
http://www.economist.com/node/21558432http://www.economist.com/node/21558432http://www.economist.com/node/21558432http://www.sec.gov/Archives/edgar/data/801898/000114036111058698/form10k.htmhttp://www.sec.gov/Archives/edgar/data/801898/000114036111058698/form10k.htmhttp://www.sec.gov/Archives/edgar/data/801898/000114036111058698/form10k.htmhttp://www.sec.gov/Archives/edgar/data/801898/000114036111058698/form10k.htmhttp://www.economist.com/node/21558432


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Consistently high returns on capital often indicates the presence of an economic moat. In the

case of Joy Global, this may come from the fact that the mining equipment industry is

essentially a duopoly with large barriers to entry according to Mr. Roepers:

Joy Global has a strong competitive position with enormous barriers to entry. Two

Milwaukee based companies, the other being Caterpillar subsidiary Bucyrus

International, control the marketits a duopoly. No one else in the world can

make these pieces of equipment. At Joys factory, in order to support the

stamping equipment used to construct the equipment, JOY has a 200 feet deep

concrete foundation beneath their machines. Regulators will not provide approvaltoday for a plant requiring 200 feet of concrete.

During the 2008-2010 economic downturn, Joy Globals results barely missed a beat with only a

modest decline in revenue from fiscal 2009 to fiscal 2010. Margins were maintaining along with

profitability. Despite having many characteristics of a cyclical company, Joy Global did not post

steep revenue declines and ruinous losses when the world economy misfired.

Aftermarket Parts Stabilizing Factor

There are probably many contributing factors to Joy Globals robust record even during times ofeconomic slowdown. One factor is likely to be the companys revenue mix by product type.

The companys original equipment products are clearly high dollar purchases for customers and

the timing is likely to be somewhat discretionary in nature. If a mining company is breaking

ground on a new mine, it is likely to require new equipment but aging equipment in existing

mines can often be coaxed into additional years of service during tough economic times.


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Joy Global maintains an extensive network of service and distribution centers capable of

rebuilding and servicing equipment and selling replacement parts and other consumable items.

As the installed base of equipment grows, so does the opportunity to service the equipment

over time. Such equipment is very expensive and specialized and customers are probably

reluctant to choose a bargain priced company to service the equipment. As a result, Joy

Global enjoys a moat when it comes to servicing its installed base. The following chart showsthe mix of business between original equipment and aftermarket over the past decade:

The company does not provide operating income and margin data by product type but it is

possible that certain aftermarket services and parts could command attractive margins relativeto original equipment. On the other hand, the percentage of Joy Globals sales attributable to

aftermarket equipment has fallen in recent years during a period in which operating margins

have been expanding which points to the opposite conclusion. However, the important point is

that orders of new equipment could fall substantially in a recession but aftermarket parts and

services probably will not and could potentially behave in a counter-cyclical manner if more

customers choose to repair old machines rather than buy new ones.

Regional Results

The Euro-area is a basket case with the core countries barely treading water and the

periphery firmly mired in recession. China may be on the brink of a serious slowdown, although

few forecasters would predict an actual contraction in GDP. Meanwhile, the United States

plods along with substandard GDP growth and the prospect of the fiscal cliff pushing the

economy into recession in 2013. In light of these problems, lets take a lookat Joy Globals

results by region.


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The following chart displays the companys sales by region from 2005 to 2011. During most of

this time frame, the United States accounted for between 45 and 50 percent of total sales.

Europe has hovered at around 7 percent over the past three years with Australia between 14

and 16%. Other Foreign makes up the balance and has risen from 22 percent of total sales in

2005 to 35 percent in 2010 and 31 percent in 2011. It is likely that China is driving changes in

OtherForeign revenue.

The following chart displays operating income by region:


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We can conclude that the United States is clearly the most important market for Joy Global and

that Europe is relatively insignificant in comparison. Although China is grouped in Other

Foreign, the Australia region is also impacted by conditions throughout Asia and would be

affected by a slowdown in China. It would be interesting to have a breakdown of original

equipment vs. aftermarket by region but this is not available based on the companys filings.

Cash Flow and Acquisitions

We compiled a record of Joy Globals cash flow from fiscal 2002 to the first half of fiscal 2012

which ended on April 27, 2012. During this ten and a half year time frame, the company

generated $3.2 billion of net income and $2.8 billion of free cash flow (with free cash flow

calculated as operating cash flows less net purchases of property, plant, and equipment). Over

this period, the company also issued nearly $1.3 billion in net debt. Dividends paid to

shareholders accounted for $489 million with share repurchases (net of stock option related

issuance) of $835 million. $2.4 billion was used for acquisitions (net of proceeds from

dispositions).

The following chart displays free cash flow and net income over the past decade:

Clearly the trend is in the right direction and most net income converts to free cash flow overtime. The company has devoted the majority of free cash flow along with considerable debt

toward acquisitions with the most recent being the acquisitions of LeTourneau and

International Mining Machinery (IMM). LeTourneau produces earth moving equipment and

historically manufactured drilling equipment. Joy Global divested the drilling equipment

division shortly after the acquisition.


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IMM is a leading designer and manufacturer of underground coal mining equipment in China.

Since the IMM acquisition was completed in early fiscal 2012, the financial results discussed in

this article do not reflect IMMs operations. IMM reported revenues of RMB 1,942 million

($306.3 million) and operating profit of RMB 417 million ($65.8 million) for its fiscal year ended

December 31, 2010. Based on the purchase price allocation for IMM presented in Joy Globals

fiscal Q2 10-Q, the total cost was $1.4 billion. It remains to be seen whether this cash wasallocated wisely but the purchase price certainly doesnt seem cheap based on IMMs 2010

results.

Risks

It seems clear that the current valuation of Joy Global is pricing in a significant decline in

results. Although the company has demonstrated resiliency with respect to economic

downturns in the past, a severe recession, particularly in the United States, could impact results

given the fact that the United States is the companys most important market. If an economic

collapse, perhaps driven by the 2013 fiscal cliff also coincides with a further decline in natural

gas prices, the shift from coal to natural gas electricity generation could accelerate.

There are many vocal bears when it comes to the Chinese economy. If China experiences an

actual decline in GDP rather than a slowdown in growth for any extended period of time, Joy

Globals results will definitely be impacted and the performance of newly acquired IMM will

suffer as well. Another major risk involves the potential for China to develop methods to

harness advances in fracking to increase the production of domestic natural gas. Although

China may face certain obstacles in tapping its shale resources (see The Economists survey

referenced earlier), a breakthrough in natural gas production cannot be ruled out.

Although Europe is a small part of Joy Globals business, the Euro-area seems on the verge of ameltdown (then again, this has been true for a couple of years now). Sales and operating

income in Europe were hit hard in fiscal 2010 and this could easily happen again if the Euro

zone falls apart in a disorganized manner.

Debt service has not been an issue for Joy Global in recent years, but it must be noted that

significant debt is on the balance sheet due to the acquisitions described previously. In

addition, the company has underfunded pension plans in place that should be treated as long-

term debt when valuing Joy Globals equity.

Summary

The market consensus clearly indicates that Joy Global should be classified as a traditional

cyclical company and that its recent results are somewhere approaching peak earnings.

Oddly enough, Wall Streets consensus estimates disagree with this assessment and forecast

higher earnings for fiscal 2012 and fiscal 2013.
http://www.sec.gov/Archives/edgar/data/801898/000119312512258788/d339837d10q.htmhttp://www.sec.gov/Archives/edgar/data/801898/000119312512258788/d339837d10q.htmhttp://www.sec.gov/Archives/edgar/data/801898/000119312512258788/d339837d10q.htm


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It is almost certainly useless to come up with a macro forecast and probably useless to attempt

to forecast Joy Globals results with precision. However, a back of the envelope valuation

could take a rough estimate of the companys likely fiscal 2012 revenues ($5.4 billion run-rate

based on first half results) and apply various operating margins to estimate operating income.

Although operating margins have been above 20 percent recently, if we use a more

conservative 17 percent, this would indicate operating income of about $900 million for fiscal2012. Using a 8x multiple would lead to an enterprise value of $7.2 billion. Subtracting net

debt of $1.25 billion and pension liability of $245 million leads to an equity valuation of $5.7

billion, or about $54 per share.

This back of the envelope exercise seems to indicate that Joy Global is not radically

undervalued based on its recent price of around $50 per share. However, the assumptions

used seem quite conservative, especially the 17 percent operating margin. If we use a 20

percent operating margin and leave all other variables the same, we would arrive at a valuation

of about $68 per share, meaningfully higher than the current quote. It seems likely that if the

world doesnt completely fall apart, Joy Global represents a bargain at its current price. At the

very least, the company is worth keeping on the radar as a potential opportunity in case

emotionally driven selling occurs in a market panic.

Disclosure: No position in Joy Global.

joy global: a misunderstood cyclical?

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