By Adam Fleck, CFA
Mining equipment manufacturer Joy Global's (JOY) stock price has fallen more than 40% from its high earlier in the year, while Caterpillar (CAT) has seen a slide of its own, owing primarily to its increased exposure to mining end markets, in our opinion; the business now constitutes roughly 30% of total revenue and nearly half of operating profits. While the near-term picture is still clouded by weak mined commodity prices, slowing Chinese economic activity, and low U.S. natural gas prices, we believe the problem for these two key equipment manufacturers is a cyclical downturn rather than a secular shift. If we're wrong and the United States makes a more permanent shift away from coal while China's economy takes a step down the long-term growth ladder, these firms' results would certainly suffer, but we believe the companies' lofty profitability and solid stream of aftermarket sales opportunities will help to buffer earnings volatility. We also think the market is already pricing in a good amount of this potential bear-case scenario. We continue to believe a wide economic moat and more diversified revenue stream separate Cat from its peer, although Joy's valuation also seems palatable based on our discounted cash flow analysis.Coal Demand Weak, but Should Improve Long-Term
Commodity demand has suffered over the recent past. Slowing Chinese fixed-asset investment growth coupled with low U.S. natural gas prices has driven down the average prices of coal, copper, and iron ore compared with year-ago levels for three straight quarters. Perhaps not surprisingly, the stock prices of two of the largest mining equipment manufacturers, Joy Global and Caterpillar, followed suit, as machinery orders at Joy have seen a sharp negative reversal from earlier in the year, while Cat has reported declining bookings as well.
What does this mean for Joy's and Cat's future, both short-run and longer-term? In the near term, the picture looks bleak; many leading indicators for China's industrial economy have slowed materially over the past few months, and although U.S. natural gas prices have rebounded from their recent nadir, U.S. coal miners (especially those in the thermal coal Appalachian hotbed) have announced capacity expansion delays and shuttered production in the face of shifting electricity production toward gas and away from coal. To some degree, we believe we've seen this before. Most recently, in 2009, coal, copper, and iron ore prices declined year over year for 12-15 months as natural gas prices in the U.S. dipped below $3 per BTU, electricity usage fell both domestically and in China, and Chinese steel production slowed (and declined in late 2008).
We think one of the main issues surrounding these companies' stock prices is whether the prevailing commodity weakness is another cyclical downturn or a secular shift away from increasing coal-fired electricity and rapid Chinese steel production growth. The near term is likely to remain weak, but we believe the market has room to recover. China is still one of the world's largest users of coal, as it produces nearly half of the world's steel while housing 27% of the globe's coal-fired power plants, and slower steel production and electricity demand growth has led to increasing inventories of the commodity and declining prices. In response, however, many smaller Chinese iron ore and coal mines that are higher-cost and more dangerous than their larger domestic and foreign peers shut down due to lack of profitability as well as safety concerns, and even many large global miners have announced delayed expansion plans and reduced production levels. We expect this to eventually lead to reduced supply and a recovering environment for Joy and Cat as the market works through this situation.
Longer-term, we remain relatively upbeat about these companies' prospects. For instance, Joy estimates that there are 375 gigawatts of coal-fired power under construction around the world, with 90 GW coming on line in the next 12 months; the incremental demand potential is almost 1 billion tons of coal over the next five years and 300 million in the next 12 months, representing a roughly 5% growth rate for the year and a 3% five-year compound annual growth rate. In addition, commodity prices rebounded in 2010, led by increased Chinese industrial activity due to the country's economic stimulus package. China's economy will probably continue to experience slower growth, but we've already seen the Chinese government recently approve infrastructure programs that should help to boost industrial economic activity, the resulting steel production, and demand for coal and iron ore. As such, we expect continued swift government reaction in cases of slowing growth, preventing a negative shock and sustained weakness of mined commodity prices.
In addition, both Joy and Cat believe continued safety concerns and shifting economics could lead to consolidation among China's miners. In this case, the companies are likely to benefit greatly, as the larger, state-owned enterprises tend to favor the firms' higher-quality offerings rather than those from lower-tier domestic manufacturers. Moreover, the management teams see a potential to increase market share in aftermarket support, as miners in the region have historically ordered only parts rather than full servicing options. Still, the firms have also increased their exposure to the lower-end portion of the market, with Joy's purchase of domestic original-equipment manufacturer IMM and Cat's acquisition of ERA Siwei, which could lead to increased market share and customer relationships.
However, U.S. coal production will probably be down 10%-15% this year, as we'll likely see a continued shift toward natural gas and away from coal for electricity production in this country. Nonetheless, we believe the aforementioned closure of China's high-cost mines could lead to export opportunities for U.S. miners (assuming continued growth of China's fixed-asset investment), which would present some tailwinds for Joy Global and Caterpillar. In 2011, exports were 105 million short tons of coal (about 10% of coal produced), nearly double the 10-year preceding average. This year, they are at a run rate of about 130 million tons (roughly 13% of coal produced), and while China is still a minimal piece of this pie, Joy estimates that there is capacity under construction today will take this potential to 270 million tons by 2016. These rapidly increasing exports would mitigate declining domestic consumption. While part of this increase is predicated on developing coal export facilities along the U.S. West Coast and market share gains from Australia, China's continued reliance on imported coal volume would most likely allow opportunities for increased production around the world.
The success of U.S. coal mines is particularly important for Joy Global, as roughly one fourth of its business stems from the end market. In comparison, domestic coal mining constitutes only about 10% in Cat's mining business. We think long-run global demand growth for the commodity will remain decent, but continued weakness in the U.S. compared with global miners would harm Joy's original equipment and aftermarket sales opportunities more so than Cat. Moreover, Cat’s acquired Bucyrus operations historically had a larger exposure to surface mining markets, whereas Joy has garnered more revenue from underground applications. If our thesis is correct that U.S. coal exports to Asia will increase over time (again, assuming proposed capacity additions to the West Coast can move past the permitting phase), miners in the western Powder River Basin would probably benefit over their Eastern competitors in Appalachia. Because the PRB comprises surface mines versus Appalachia's 63% underground exposure, Caterpillar may have an opportunity to increase its aftermarket service sales at a greater clip than Joy.
We also take some solace in the fact that we've already seen improvement in China's end markets. The country's electricity demand, while materially slower than in recent years (outside the recession-led 2009 period), has continued to post positive year-over-year growth on a rolling-three-month basis. Although thermal coal has slipped in share this year due to increased hydroelectric power generation, it is still up year to date. Similarly, steel production has seen a similar growth rate in recent months, with low-single-digit year-over-year gains. Although neither metric is particularly stellar, it is still a far cry from the weakness seen in the Great Recession, and the generally upward trend of both series over time means that lower growth rates still represent decent gains in absolute terms.
Overall, we believe the mining market faces near-term headwinds, but a continued rebound in U.S. natural gas prices, domestic coal exports, global coal electricity generation, and Chinese steel production should lead to longer-term success for both Joy and Cat. More difficult-to-reach ores could also spur new equipment purchases, and closures of high-cost mines could boost prevailing commodity prices while supporting Joy's and Cat's service and parts revenue. But we could be wrong, and it's important to examine what these companies' shares could be worth in a downside scenario.
Joy's and Cat's Revenue and Earnings More Stable Than Orders Suggest
Although commodity price changes tend to drive both Joy's and Cat's original equipment orders, the firms' underlying revenue has actually proved far less volatile than these bookings. We attribute this factor to the companies' strong aftermarket sales stream, which constitutes around half of the businesses' total revenue.
Joy historically garnered a higher percentage from service and parts versus Bucyrus, although Cat has an opportunity to increase this factor by leveraging its strong global dealer base and improving vertical integration with the installation of Cat engines (rather than Cummins) and drivetrains (rather than General Electric). Caterpillar will give up some of this business by selling the distribution arm to dealers, but should make up for this with immediate cash transfers back to Cat (in exchange for the dealers' rights to provide equipment servicing) and high-margin parts sales, which historically made up most of Bucyrus' aftermarket business.
Both firms also outsource a good deal of production, helping to reduce cyclicality and maintain profitability. During the last downturn in 2008-09, for instance, Joy reduced its outsourced manufacturing to about 20% from 35%; the company finished its most recent quarter at just over 30%. Similarly, Bucyrus ramped up its outsourced manufacturing to about 35% at the market's peak and brought it back to about 10% in late 2009. While this strategy prevents some operating leverage gains when volume increases materially, it also prevents sizable margin degradation from factory underutilization.
Nonetheless, a weaker end market than we currently project would certainly hold negative long-term consequences for these companies. In particular, overbuilding in China since the 2008 stimulus, combined with government inaction (to reduce potential long-run inflation), could permanently limit the country's fixed-asset investment growth. This would lead to reduced steel demand, in turn resulting in lower metallurgical coal and iron ore needs. Similarly, a long-term shift in the U.S. toward natural gas and other non-coal-related power sources seems likely; there is currently more than 58 GW of planned natural gas generation installations compared with just 16 GW of coal, and even these later facilities face uncertainty over their eventual completion; our utilities team estimates that potential further reduction in coal electricity capacity due to emission-control requirements and other environmental concerns could lead to an additional 50 million tons or so of demand degradation by 2016. Although there is a possibility the aforementioned pickup in coal exports could help to offset this weakness in our base case, difficulty with domestic plant installations, a downturn in China's economic activity, or lack of available U.S. port capacity would limit demand for the commodity in our bear case.
Joy's and Cat's aftermarket business would help to offset this weakness to some degree in the near term, but sharply reduced original-equipment sales and commodity production would most likely eventually lead to lower aftermarket work; the backlog in this latter part of business is measured in just weeks, not months. In this case, however, we think Bucyrus may be a bit better positioned. Cat's mining business is more diversified, with only about 30% of its revenue exposed to coal mining versus two thirds at Joy. While iron ore is a sizable piece of each firm's pie that would suffer if China's steel manufacturing dipped substantially, Cat also holds good exposure to copper, Canadian oil sands, and other mining end markets that could still enjoy growth.
Still, we're encouraged that we don't foresee potential balance sheet headwinds for these companies. We rate both as investment-grade, with Caterpillar's corporate rating at A- and Joy Global's at BBB. Neither faces any required debt payments totaling more than 50% of our projected free cash flow (cash flow from operations less capital expenditures) over the next five years, and we don't expect any liquidity challenges for the firms. As a result, we think both Joy and Cat could afford to stay patient during the weak economic backdrop, with potential further increases in dividend payouts.
Both Look Undervalued, but Caterpillar's Better Positioned
In our base case, we project slowing top-line growth for Caterpillar's resource industries segment (of which mining constitutes roughly 90%) and declines for Joy Global's sales; the dichotomy stems from Joy's higher reliance on U.S. coal than Caterpillar and the potential for Cat to gain share in aftermarket sales. Nonetheless, we assume operating profitability will remain relatively steady for both firms, owing to a positive mix shift toward higher-margin parts and service revenue and continued cost improvements.
We think the market is currently offering mild margins of safety in these names and is probably already pricing in a good amount of the negative news we've discussed. Investors will probably require some patience, however, as the timing surrounding rebounds in global electricity usage, U.S. natural gas prices, and Chinese fixed-asset investment relies heavily on uncertain situations such as weather conditions and government stimulus actions. In addition, our downside scenarios still outline a worse intrinsic valuation than the current market quote, but we believe the current market multiples to our estimate of these firms' long-run earnings power offer a decent margin of safety.
Between these two companies, we generally view Caterpillar's business prospects as lower-risk. The company garners half of its operating profits from mining, rather than 100% at Joy Global, and could benefit from this diversification as North American construction markets continue to recover. Moreover, Cat enjoys exposure to the natural gas compression and distribution market through its engine segment and also benefits from increasing buildouts of new electricity plants. Both firms have generated solid returns on invested capital in recent years, but we think only Caterpillar has carved a wide economic moat because of its dominant market positions, solid dealer network, and diversified revenue base.