Joy Global Inc. (NYSE:JOY) reported earnings on February 27, and as discussed in my last article on JOY (Jumping for JOY), this could be a near-term catalyst for unlocking value in the shares. The purpose of this article is to review our initial investment hypothesis in JOY, and confirm or reject the value opportunity in the shares based upon the new information received in the earnings release.
Investment Hypothesis Review:
I recommended shares of JOY as a buy with significant upside based on the following:
- Strong consistent earnings power measured by ROE relative to peers
- Attractive valuation relative to peers
- Positioned in a highly cyclical industry with very bleak fundamentals that are beginning to turn positive
These upsides to the shares were tempered by the following risks:
- Potential for a large write-down associated with IMM acquisition
- Slower than expected demand for mining equipment
- Increased competition and margin pressure following recent industry consolidation.
2013 Q1 Earnings Review
- Top line (Revenue) and Bottom line ('EPS') beat the street estimate by 6.5% and a fantastic 17.7% respectively
- To confirm these were truly earnings "surprises," confirmation based upon share price response is very useful. In this case the shares were up strongly immediately following the announcement and continued to get stronger throughout the day as the market digested the details of the announcement before closing up 6.91%.
- EPS beat was driven by a 70bps of operating margin expansion largely driven by the surface and IMM operations
- All regions except China and NA showing growth
- Book to Bill increased to .89 compared with .83 the previous quarter
- The best way to put this number in context is Book to Bill is best described as the rate at which future revenue is changing. For Q4 2012 the number tells us that for every $1 in revenue, there was 83cents in new orders. For Q1 2013, this improved to almost 90cents in new orders for every $1 in revenue.
Digestion of New Information
While the market may have been a bit euphoric over the short-term earnings beat, I view it primarily as confirmation that JOY is being run by superior management to its peers, a fundamental part of our investment hypothesis. The ability to control costs in the face of volatile Coal demand and slow new orders shows the kind of discipline that is all too uncommon among executive management of public companies. This disciplined management means the company will be in position to be even more profitable when overall economic trends begin to move more strongly in their favor. That brings up the next major point in the investment hypothesis. When can we expect the undervaluation to be recognized?
In highly cyclical names such as JOY, investors will generate the most return when they invest when the economic outlook looks bleakest, and sell when the outlook becomes the rosiest. This is something that requires a very strong 'investing stomach' due to the fact it's likely your psyche will have to deal with frequent and multiple negative reports on your shiny new investment. This is another reason why being confident in superior company management is crucial. Think of it as Pepto Bismol for the contrarian investor. Besides the comforting effect of strong management, the primary soothing agent I look for are signs of the economic environment to begin turning positive, which allows a well-positioned company to take full advantage. My last article noted that the first few indicators had begun to turn positive such as China Steel PMI turning positive, Iron Ore prices responding to this increased steel production demand, and natural gas prices being high enough to justify Coal as the preferred energy source in the U.S. The earnings release provided the opportunity for the company to further update investors with its outlook:
"Although there are growing examples that commodity fundamentals are beginning to turn positive, we expect some delay in translating that into increased mine expansion projects due to a much more cautionary stance on capital deployment by our customers. Despite the current challenges, we see this as an opportunity to streamline and improve the efficiency of our business, and that continues to be our focus. We have demonstrated our ability to respond to growth, and our focus on lowering our cost base will not cause us to miss upside opportunity." - Mike Sutherlin, CEO
- Key indicators cited:
- Electricity demand
- Chinese steel production
- Construction activity in the U.S.
It seems the CEO would agree with our thesis that things are beginning to turn positive from an economic fundamentals point of view. However, he tempers expectations of this translating immediately into new orders due to the changing industry norm of a more cautionary approach to capital investment by miners. I've read a lot of discussion surrounding this new cautionary approach to capital investment by miners, and the analysis seems to be that this will translate into less capital investment by mining companies. I would disagree with this analysis as short sighted and incomplete. In my view, a more cautionary approach will simply lead to less volatility in the new order book. Whereas the previous capital spending regime was quick to order and quick to cancel based on the volatility of the relevant commodity, I would expect much more confidence that an order placed will not be cancelled. From JOY's perspective, I would view this actually to be a beneficial trend and it should help keep larger operating margins stable.
Mining Expansion Project Tracking List
"The timing of mine expansion projects has a major impact on our company outlook, and we expect these projects to continue to move slowly and to be lumpy. Many of our customers have new management, and their focus has moved from volume to returns. They are systematically re-evaluating all of their capital expenditures, and this continues to delay decisions. We maintain a project list of mine expansion prospects that we expect to reach equipment selection in the next twelve months. Our customers' reassessment of their capital expenditures has created increased activity with the projects on this list. A number of projects have been delayed outside the horizon tracked by this report, but there have also been a significant number of projects moved onto the list. As a result, this list has stabilized during the current quarter, after several quarters of sequential declines. The quality of the list has also substantially improved. In combination, this raises our outlook."
This discussion on future business prospects seems to confirm the reorganization of capital expenditure decisions to a regime based upon stability. This has resulted in a list of prospective new business of higher quality in addition to finally stabilizing multiple quarters of sequential declines. I quite agree with the CEO in that this raises the outlook and would expect to see this reflected in improved book to bill ratio numbers over the next two-three quarters.
U.S. Coal - "We are seeing encouraging signs from the U.S. coal market. After four quarters of sequential decline, both original equipment and aftermarket orders stabilized over our first quarter. U.S. aftermarket orders have declined more than end-use consumption as our customers reduced the parts inventories they hold at mine site and stretched the time between rebuilds. Parts orders should continue to return to end-use consumption levels, and delayed rebuilds require increased work and therefore their impact is mostly timing."
U.S. Gas-to-Coal Switching - "During 2012, the U.S. coal market faced headwinds, primarily due to low natural gas prices. It is estimated that U.S. coal production declined 70 million tons in 2012, a 7 percent drop, as reduced U.S. power generation was only partially offset by increased coal exports. Increasing natural gas prices from their April lows contributed to a switch back to coal for electricity generation. After the share of power generation from coal dropped to a low of 32 percent in April of 2012, coal generated 42 percent of U.S. electricity in November. This trend of natural gas to coal switching is likely to continue in 2013. While coal-fired generation declined 13 percent in 2012, the U.S. coal market is expected to see gains in 2013 as higher natural gas prices and improving economic activity lead to an increase in coal burn."
U.S. Export Coal - "One of the strongest drivers of U.S. coal in 2012 was the export market, as U.S. coal producers found demand for excess thermal coal from increased coal burn in Europe and the record level of imports by China and India. The U.S. exported 124 million tons of coal in 2012, a 15 percent increase from 2011. Exports are expected to come off their record pace, but remain at historically high levels in 2013."
All three of these quotes indicate to me that coal demand has not only stabilized, but is continuing to make a comeback. This trend is expected to continue throughout this year, and should make existing mines more and more profitable. In the context of the new capital expenditure regime, I would view this to be very positive. Management also discusses the fact that part of the slowdown it experienced was due to eir customers stretching out the time between maintenance of their machines and reducing their inventory of replacement parts. This is fundamentally a temporary capital conservation activity by miners and as a result, demand should increase above normal levels to compensate.
Primary Risks Review
The overhanging concern that JOY investors should expect a potential write-down related to their IMM acquisition similar to the one Caterpillar (NYSE:CAT) blundered into has been completely eliminated at this point. In fact, we didn't even have to wait until the earnings call for this as the company assuaged concerns during the Barclays industry conference. I would further highlight this as confirmation of the superior management of JOY compared with major competitor, CAT.
Based on the discussion from management I included above, investors should have their concerns related to unexpectedly low demand and margin pressures significantly reduced. All signs point to a bottoming in demand and a steady (not blazing) recovery. Additionally, the ability of management to actually increase operating margins in the face of economic headwinds and industry consolidation remove my mid-term concerns of margin erosion as a result of industry consolidation.
But What About Book to Bill?
If you spend much time reading analyst reports from the street, you'll notice they place a lot of faith in the book to bill statistic. If you're curious as to why, the chart below shows the relationship between book to bill and share price over the last 33 quarters.
As you can see, there appears to be a strong relationship between the two. The error that the analysts make on the street however, is that they place their emphasis on the outright level of the ratio (must be above 1) rather than the change or trend in the ratio. Simple linear regression confirmed that the level of Book to Bill has absolutely no predictive power of share price performance over the following quarter. However, increases or decreases in Book to Bill regressed against share price showed a significantly stronger relationship (R^2 of 67% vs 5%) indicating that investors should be concerned more about the rate of change of future orders rather than requiring future bookings to be higher than revenue (BtoB >1) before being satisfied in the business from a fundamental point of view.
I view almost all of the new information to be of a positive nature. The primary exception is the facts that despite beating expectations, overall new bookings and revenue were down sharply from last quarter. If this continues into Q2 and Q3, we will need to revisit our investment thesis again. However, overall economic trends seem to have clearly bottomed, and the company has improved its positioning to capture future upside when the market fully turns. With the elimination or significant reductions in the primary risks and uncertainties surrounding the stock, I reiterate my recommendation to BUY shares.