Despite the general slowdown in the world's largest economies, the mining equipment and machinery industry was able to tackle its way out much better than the other sectors. Certain fundamental factors led to the sustained growth in revenues of major equipment and machine manufacturers.
Declining ore grades combined with the increasing or flat demand for coal, copper and other metals meant that a larger quantity of materials had to be mined to meet the demand for these commodities. As a result, an increase in the demand was seen for the new, more advanced machines and equipment in order to enhance the operational efficiency.
Secondly, the rugged and harsh working environment in mining shortens the useful life of mining equipment and machines. This also leads to a constant need for new equipment and machines to replace the old ones. Such poor working conditions also increase the expenditure incurred on servicing and follow up maintenance of the mining equipment and machinery. This is the reason why a substantial proportion of revenues of large equipment and machine manufacturers come from after sales services and maintenance.
The global industry for mining equipment and machines comprises many small privately held manufacturers and a few large publicly held enterprises. One of these large enterprises, Joy Global (JOY) recently announced its fiscal third-quarter 2013 results, which are shown in the table below.
Source: Quarterly Earnings Release
As per the results released, the company saw a decline in its revenue by approximately 5 percent as compared with last year. This effect trickled down to the bottom line and resulted in a decline of 6 percent in Joy's EPS. Operating margins were down by 1 percent due to the one off restructuring charges.
The underground mining machinery segment saw a decline in its sales by 4.2 percent while the surface mining equipment segment experienced a decline of around 5.1 percent in its sales. The company's original equipment sales for underground mining were flat as compared to last year while the aftermarket revenues saw a decline of 8 percent. Within the surface mining equipment segment, original equipment sales declined by 15 percent while aftermarket sales increased by 4 percent.
Source: Company Financial Statements
Over the last 5 years, the company has achieved an average annual rate of 14 percent in its top line. The underground mining machinery segment saw an average annual growth of 12 percent while the surface mining equipment segment increased by an average annual rate of 17 percent, during the last 5 years.
The company has specifically achieved high growth in the last two years primarily due to the acquisition of International Mining Machinery (IMM) and LaTourneau. The higher growth in the sales of surface mining equipment has increased its contribution to the total revenue over time.
Source: Company Financial Statements
The company's consolidated operating margin has gradually improved over the years primarily due to the growth in revenues, better overhead absorption and favorable pricing. The operating margin in 2012 saw a slight decline due to the fall in overall realized prices and non-recurring acquisition costs, which was partially offset by a re-measurement gain realized in relation to the acquisition of IMM.
Increasing sales and improving margins have enabled the company to increase its EPS from $4.41 in 2009 to $7.13 in 2012. This equates to a growth of more than 12.7 percent per year.
Source: Company Financial Statements
Joy Global was able to consistently increase its backlog from 2009 to 2011. However, it saw a sudden decline in 2012. The largest increase in backlog was achieved in 2011 due to the acquisition of companies, as mentioned above. In 2011, the underground mining machinery segment saw an increase of 44 percent in backlog while its surface mining equipment segment witnessed an increase of 145 percent. In 2012, the backlog for both these segments saw a decline of 23 percent and 15 percent, respectively. The decline in backlog was the result of the changing mining industry dynamics, specifically the coal mining industry. The decrease in the prices of commodities coupled with an increase in the operating costs for mine operators has led them to undertake steps to improve their operational efficiency. This has been mainly achieved by cutting down on the capital expenditure incurred on replacing mining equipment. This rising trend led to a decline in the book-to-bill ratio of Joy Global and thus, resulted in a decline in the backlog of the company.
The industry outlook
The demand for commodities, especially the industries served by Joy Global, is largely dependent on the overall economic growth. Thus, the slow economic growth in developed economies and the recent decline in the growth of emerging markets had caused a decline in the demand for such commodities in the global market. In the midst of the U.S. economic recovery, stabilization in China and the EU showing signs of a turnaround, the demand for commodities is expected increase in the future.
The expected increase in the demand for commodities will provide mining companies with enough cash flow to finance the expansion of their operations and invest in new technology in order to enhance their operational efficiency. This will ultimately lead to higher demand for the mining equipment and machinery and thus, improved revenues for manufacturing companies like Joy.
Despite the bright outlook of the industry, I expect slower growth in the near term. There are two reasons for this perception. First, the economic recovery in major commodity consuming regions will take time and thus, the growth in demand will also be slow. Second, the cost cutting measures adopted by mining operators at large tend to suggest that demand growth will take some time. Thus, I believe that the expected growth in the industry will benefit the company in the long run and the outlook will remain stable in the short term.
I also expect the concentration level to increase within the industry. As mentioned above, a large proportion of the industry revenue is generated through aftermarket services and maintenance. Also, it is cost effective for mining operators to do business with a single vendor for the various machines and equipment it needs. Thus, in order to offer more competitive prices and an enhanced product portfolio to their customers, I expect companies within the industry to continue acquiring other businesses to sustain their growth and market position.
Joy Global's share price has fallen by more than 22 percent since the start of the current calendar year. Declining demand and squeezing margins have all contributed to the sharp decline in its price. Despite this decline, the restructuring efforts and its financial health improved over the periods. These improvements have placed the company in a favorable position to benefit from the future trends in the market.
Low forecast prices for commodities and the improving economic outlook suggests that the demand for such commodities is going to improve in the future. According to the Economist Intelligence Unit, the demand for major commodities is expected to improve in upcoming years. Thus, I believe that the mining companies and subsequently, Joy Global will benefit largely from the forecast trends.
Further, the improving cash flow generation of the business coupled with the declining debt level place the company in a stronger position to further expand its market share and product offerings via acquisitions. I believe that the continuous decrease in the stock price is providing investors a suitable entry point. The technical indicators also tend to show a positive sign for the stock and support its current share price. Thus, I give a buy recommendation for Joy Global, accompanied with a stop loss order of 50 pips below the current market price.