Joy Global CEO Discusses F3Q2011 Results - Earnings Call Transcript

Aug.31.11 | About: Joy Global (JOY)

Joy Global Inc. (JOYG) F3Q2011 Earnings Call August 31, 2011 11:00 AM ET

Executives

Michael Olsen - EVP and CFO

Michael Sutherlin - President and CEO

Shawn Major - EVP, General Counsel and Secretary

Analysts

Ingrid Aja - JPMorgan

Henry Kirn - UBS

Seth Weber – RBC Asset Management

Charley Brady - BMO Capital Markets

Jerry Revich – Goldman Sachs

Michael Gallo - C.L. King & Associates

Ted Grace – Susquehanna Financial Group

Operator

Please standby we are about to begin. Good day and welcome to the Joy Global third quarter earnings conference call. Today's conference is being recorded.

At this time, I would like to turn the conference over to Mr. Mike Olsen, Executive Vice President and Chief Financial Officer. Please go ahead, sir.

Michael Olsen

Thank you, Melissa. Good morning and welcome everyone. Thank you for participating in today's conference call, and for your continued interest in our Company. Joining me on the call this morning is Mike Sutherlin, President and Chief Executive Officer; and Shawn Major, Executive Vice President, General Counsel and Secretary.

This morning I will begin with some brief comments which expand upon our press release and which provide some additional background on the results for our third quarter. Mike Sutherlin will then provide an overview of our operations and our outlook. After Mike's comments, we will conduct a question-and-answer session.

During this session, we ask you to limit yourself to one question and one follow-up question before going to the back of the queue. This will allow us to accommodate as many questioners as possible.

During the call today, we will be making forward-looking statements. These statements should be considered along with the various risk factors detailed in our press release and other SEC filings. We encourage you to read and become familiar with these risk factors. We may also be referring to a number of non-GAAP measures, which we believe are important to the understanding of our business. For a reconciliation of non-GAAP metrics to GAAP, as well as for other investor information, we refer you to our website at www.joyglobal.com.

Now, let’s spend a few moments reviewing the results for the third quarter of the 2011 fiscal year. During the third quarter a number of actions were announced which are consistent with the implementation of our strategic plan. In May, we announced the acquisition of LeTourneau Technologies Inc. which consisted of mining equipment and drilling products businesses.

In July, we announced an agreement had been reached with a private equity company to acquire 41% of the outstanding shares of international mining machineries, a public company traded on the Hong Kong Stock Exchange depending regulatory approval and our intention to issue a tender offer for the remaining shares once regulatory approval has been granted.

In July, and August in separate transactions, we acquired approximately 18% of the outstanding shares of IMM in the open markets. Lastly, today we announced an agreement had been reached to sell the drilling products business which was part of the LeTourneau acquisition earlier in the quarter for $375 million. The results of the drilling products business for the six week period from the acquisition closing date to the end of the quarter are reported as discontinued operation.

With all of the moving parts in the current quarter’s results we have included several payables in the third quarter’s earnings press release and have posted similar tables on our website at www.joyglobal.com to enable our shareholders to better understand the operating results for the third quarter.

The tables provide comparative results for the current quarter and for the third quarter last year for Joy Global as it was structured at the beginning of the 2011’s fiscal year and breaks out separately the items associated with unique transactions in the quarter.

Turning to slide two on the website, you take a look at our bookings comparison. Excluding LeTourneau Mining Equipment results, bookings in the current quarter were 46% higher than bookings in the third quarter last year and just slightly less than the record new orders received in the second quarter.

In the current quarter, the amount of new orders received were just about evenly split between the surface and underground mining equipment segments with both businesses exceeding $700 million in bookings in the current quarter. Surface equipment bookings were almost double the amount of orders which were received last year while underground equipment bookings were 17% higher than they were a year ago.

Total original equipment orders were 78% higher than last year led by more than a 200% increase for surface original equipment recorded across all commodities and geographic markets. Aftermarket bookings in total in the third quarter continued their seasonal trend of declining from aftermarket bookings in the second quarter but were 22% higher than they were in the third quarter last year.

Aftermarket bookings were 31% and 13% higher in the current quarter than they were a year ago for surface and underground mining equipment respectively. Mining activity and the increase in the installed base of equipment resulted in higher aftermarket demand across most commodities and geographic markets. The weaker US dollar compared to a year ago caused a $79 million increase in bookings compared to last year.

Turning to slide three on the website, our net sales comparison is provided. Net sales once again excluding LeTourneau Mining Equipment exceeded the prior year by 29% with the underground and surface mining equipment businesses reporting revenue increases of 31% and 24% respectively.

In total, original equipment revenue was 34% higher than last year, while aftermarket net sales increased 25% both businesses reported strong revenue results for both original equipment and aftermarket products and services which is the result of strong original equipment orders over the last several quarters and the level of mine production in the markets we serve.

Aftermarket revenue in the current quarter was 59% of total net sales compared to 61% a year ago and 63% in the second quarter. The weaker US dollar compared to last year benefited this quarter to current by $43 million. On slide four, operating profit is summarized.

Operating profit excluding LeTourneau and the transaction cost associated with acquisition activity in the current quarter was $242 million and 22.1% of net sales in the current quarter, compared to $172 million and 20.3% of net sales in the third quarter last year. The incremental profitability in the current quarter was 28.4% on the $243 million increase in net sales.

Both businesses reported return on sales in excess of 23% and had incremental profitability percentages in excess of the company’s 25% benchmark. The current quarter operating profit benefited from the increase in revenue, price realization offsetting material cost increases, increasing overhead manufacturing overhead absorption, $5 million of contract cancellation fee.

These benefits were partially offset by increased spending for selling engineering and administrative activities. During the third quarter, operating profit was increased compared to last year by $10 million due to the weaker US dollar compared to a year ago.

Income from continuing operations were a $172 million in the current quarter and were $1.61 per fully diluted share compared to a $119 million and $1.13 per fully diluted share last year. As I have described earlier, the current quarter had a number of items which are not comparable with the prior year.

Slide five provides a summary of these items and their impact on earnings per share. For the six weeks period from the acquisition closing the LeTourneau Mining Equipment business added $0.04 per share to the company’s third quarter results. This $0.04 per share is the result of $0.06 per share from operating results reduced by $0.02 per share for the initial estimated depreciation and amortization of purchase accounting charges, over half of which are associated with the amortization of the write-up of inventories which will be amortized over roughly the next fourth quarters.

The quarter also benefited by $0.11 per share to net favorable discreet tax items amounting to $12 million. Quarterly EPS was reduced by $0.08 per share due to a $11.7 million of transaction costs associated with the acquisition activities which took place during the quarter.

Before these items, current quarter earnings were $1.54 per share compared to $1.11 per share last year. The LeTourneau Mining Equipment business which was operated by the company for the last six weeks of the quarter reported $24 million of bookings $43 million of net sales and $6 million of operating profit and almost $10 million of operating profit before the purchase accounting charges.

The effective income tax rate for the quarter was 25.3% compared to 29.6% last year without the discreet items included on page five of the website, the tax rate for both periods was just over 30%. The effective tax rate for the fourth quarter is expected to between 29% and 31%.

Cash generated from operations in the current quarter was $96 million compared to $205 million a year ago. The decrease in cash generation from a year ago is attributable to increases in accounts receivable and inventories both items associated with the increase in the current and projected sales volumes.

During the quarter, the company expended approximately $1.2 billion for investing activities just over $1 billion was used for the LeTourneau acquisition and $141 million was used for the open market purchase of IMM shares. These disbursements were funded with a $500 million, five-year bank term loan and with cash on hand. At the end of the current quarter, debt-to-capitalization was 32.6% compared to 22.9% at the beginning of 2011’s fiscal year.

Now, let me turn the discussion over to Mike Sutherlin.

Michael Sutherlin

Yes, thanks, Mike and just let me add my welcome to those on the call.

This has been a busy and productive quarter for us, both our P&H surface and our Joy Underground businesses continued to execute extremely well as is evidenced by the strong performance in bookings revenues and operating profits.

Mike has already covered this, but I want to reinforce a very positive impact that our operational excellence programs and our Joy Global business system are having on our performance for both our shareholders and our customers. To give this a perspective, we have been able to keep original equipment lead times to less than 12 months even though our bookings continue at a record pace.

Compare this to 2008 when we were booking deliveries over two years out. Not only are these lead times giving us a competitive advantage, but we are also able to respond more rapidly to changing conditions in our markets and changing requirements from our customers.

This quarter we made three very significant strategic moves as Mike has highlighted. The net of these transactions will add significant value to Joy Global. Both businesses have strong revenue growth potential and attractive margins. They will add significantly to our topline and our bottom-line growth and they will make us a better position to more balanced company.

When we acquired LeTourneau Technologies, we were targeting their large wheel loaders for mining. However the deal was offered as all are not been included in drilling products. Although LeTourneau drilling products is a great franchise with substantial upside potential, we soon determine that the capital management resources needed to accelerate its growth potential would put a significant strain on both the drilling and our mining businesses.

I think we did the right thing by making that evaluation and the subsequent decision quickly and by working with a strong buyer who could make this a quick and clean transaction. This is a strategic addition to Cameron’s leading presence in oil and gas equipment industry and I feel good knowing Cameron will provide a good home and solid future for people of LeTourneau drilling products.

This will allow us to concentrate our efforts on accelerating the integration of LeTourneau’s large wheel loader product line into our P&H surface mining equipment business. We expect our customers to continue moving to the larger sized wheel loaders, where LeTourneau has a significant advantage.

We indicated that LeTourneau will be immediately accretive after closing and we are pleased that we delivered on this even in a short reporting period in the third quarter. We received good value in this transaction and we were able to redeploy the proceeds – we will be able to redeploy the proceeds into building our mining business around a 24/7 mission-critical, high value equipment business and services.

Specifically the proceeds will provide additional funding flexibility for completing the pending acquisitions of international mining machinery. International mining machinery will be another key addition to Joy Global. IMM is the leading manufacturer of shearing machines and road headers in the domestic China market. China is a large and rapidly growing market for coal.

Coal production in China has been growing at a 9% compound rate and should reach five billion metric tons per year in the latter part of this decade.

Partly driving this growth is China’s plans to add another 300 gigawatts of coal fuel powered generating capacity by 2015. By comparison the growth of domestic mining machinery has been growing at an even faster rate at over 30% compound rate due to the requirements to improve the mechanization of these mines. It is still very early in the mechanization process and this leveraged growth rate for mining machineries should continue.

We now own or have contractual rights to approximately 60% of the shares of IMM and we will continue to look for opportunities to add to that position while waiting for regulatory approval. Since the Ministry of Commerce was given responsibility for anti-monopoly review, majority of applications have been approved including some with modifications.

As a result, we remain cautiously optimistic for regulatory approval and confident that the subsequent tender will be successful. I would like to provide some observations for the market outlook that we included in our press release. We expect to see continued strong demand for sea borne and thermal coal.

China will be replenishing the stockpile to depleted in the first half of this year as electricity demand continues to grow at a 12% rate. India has significant challenges growing its domestic production and has actually seeing production decline in 2011 year-to-date.

As a result, India continues to grow its imports at high rates. In fact, Indian coal imports are projected to exceed that of China in the next few years. Both countries have very significant infrastructure programs that will support relatively high GDP growth even if the US and Europe continue to slow.

Japan coal imports dropped in the first half due to outages from the earthquake and tsunami, but industrial production and power demand are returning. The return to service of coal fueled power plants that were idled and the prolonged outages of nuclear plants is expected to boost Japan’s coal demand in the second half. Germany has idled over 8 gigawatts of nuclear capacity and this will increase coal burn there by 10 to 11 million metric tons per year.

These demand factors should continue to offset the effect of any slowing in global economic growth. And Indonesia will require a higher allocation of production to be kept in country to fuel domestic demand which will restrict the growth in its exports. As a result, there is a large and extensive pipeline of projects in Australia that have not been slowed even by talks of resources taxes and carbon trading schemes.

While domestic demand for thermal coal in the United States remained stable but stagnant, our customers are seeing opportunities in the seaborne markets. Coal exports in the US are up to levels not seen in over a decade and thermal coal exports are the major factor.

Capital expenditure plans for US based and focused producers recovered to the 2008 levels by 2010 and are up further in 2011. The initially announced 2011 CapEx for these producers was up 8% over a strong 2010 and that is subsequently then revised to up 14%. In addition we are seeing thermal investments in the West Coast that will give Powder River Basin coal access to the seaborne market. And as a result of that, we will continue to see better than expected demand from the US market.

China is effectively the swing factor for global copper demand and China has historically moved between periods of destocking and restocking of copper. They were in destocking mode in the first half but have significantly increased imports in the summer months indicating the move back to restocking. This should support copper demand in the second half.

At the same time, copper production remains challenged due to the continuing factors of declining ore grades adverse weather and labor disruptions. For example, Chile produces a third of the world’s copper and its output dropped 18% on the year in July largely because of labor strikes. As a result, production deficits in copper expected to increase in 2011.

Iron ore supply remains constrained while global steel production has been growing at a 5% to 6% rate this year. Although significant investment in iron ore capacity expansion has been earmarked, those are long-term projects that are not expected to provide relief until mid-decade.

In addition, continued constraints could keep India’s iron ore exports down to their lowest level in eight years adding to the supply constraints. With this outlook, with the industry already operating at high levels of capacity utilization and with longer lead times to bring on new green field mines, our customers continue to drive their capital expenditure programs on schedule.

Despite concerns over economic slowing, commodity prices have remained high and this adds to the incentive to grow production. This is evidenced by our machine prospect list which are machines that are expected to be put on order in the next 12 months. Even though our bookings were strong, this quarter we added more machines to this list that moved inside the 12 month window then we took off the list via bookings. This supports our expectation for continued demand growth.

We continue to see most of strength in seaborne coal, copper and iron ore and geographically in China, Australia, Chile and Southern Africa. Against these strong fundamentals, there are macro signs of economic slowing. We believe this slowing is mostly due to the uncertainty created by unresolved government debt crisis in Europe and the US, that conversely businesses – compared to the government businesses today have stronger balance sheets, the banking system is delivered corporate bond markets have significant liquidity and interest rates remain at historic lows.

In short, industry is much better off today. However we are paying attention because there is historically been a strong correlation between GDP growth and commodity demand. We are not slowing down on our strategic initiatives but are putting routine expenses under the microscope. Extensive scenario finding was a key to our performance during 2008 and 2009, and we are starting that process again.

There is little downside of doing this, since it will resharpen our focus on cost controls in any event. Our outlook for the remainder of the year has improved because of the results year-to-date and that momentum will carry into our fourth quarter. We are also adding the impact of LeTourneau‘s large wheel loader business.

As a result, we are raising our revenue guidance for fiscal 2011 by $200 million from our prior guidance to between $4.3 billion and $4.5 billion. Maintaining our operating leverage at 25% will allow us to deliver earnings per share between $5.70 and $6. This is a $0.40 increase with $0.06 of that coming from LeTourneau after purchase accounting charges.

The discreet tax benefit we booked this quarter is essentially offset by acquisition related cost and therefore the remainder of the earnings increase comes from our core businesses. With that, I will turn the call over to questions. So back to you Melissa.

Question-and-Answer-Session

Operator

Thank you. (Operator Instructions) And our first question will come from Ann Duignan from JPMorgan.

Ingrid Aja - JPMorgan

Good morning. This is Ingrid Aja standing in for Ann.

Michael Olsen

Hi, Ingrid, how are you?

Ingrid Aja - JPMorgan

Good how are you?

Michael Olsen

Fine.

Ingrid Aja - JPMorgan

I wanted to just go back to the comments you made on IMM with your 18% stake. Can you just talk about what you would do if your stake – if the government doesn't approve the deal, where would that leave you? Have you thought about that at all?

Michael Sutherlin

Well, that would be an investment that we would – we care that as an investment if we didn’t get regulatory approval, we would then systematically liquidate that investment over time.

Ingrid Aja - JPMorgan

Okay.

Michael Sutherlin

We don’t have any interest in being that minority shareholder of that company.

Ingrid Aja - JPMorgan

Okay. And then, if you could just talk about what your expectations are for LeTourneau's wheel loaders, I think that the operating profit that they report that you noted this quarter is lower than what historically it has been. So what kind of – do you think you can get back to those higher levels?

Michael Sutherlin

I’ll ask Mike to give you little more details, but this is a six week period after I protracted acquisition process I wouldn’t read a whole lot into the numbers we posted for LeTourneau here in this short period, but Mike can you give a little more granularity on that?

Ingrid Aja - JPMorgan

That would be great.

Michael Olsen

I think, Mike I think you hit right on the head on there. When you are looking at a six week period like that, you won’t have all of the cost that will in fact be associated with that period but at the same time, you’ll have sales that will fall either right inside or right outside at six week period.

So it’s extremely risky to take that six week period of results and try to extrapolated that to an extended period of time. The other issue that adds to the LeTourneau results for that six week period is the estimates that we are putting there for purchase accounting. Once again those are all cost that will be in based on a period of time that is expired or as revenue in fact will take place whenever products get shipped.

So what I would suggest is that we wait and see the results at the end of the fourth quarter and then our forecast for next year to get a better view as to what our expectations are for the LeTourneau business, but our initial impressions of the LeTourneau business are very favorable and we think that it will in fact be a valuable contributor to our surface mining equipment business.

Ingrid Aja - JPMorgan

Okay, that's helpful. I mean, I know that in Q1 they actually reported lower margins because of some one-time issues. Have all of those been resolved?

Michael Olsen

Our sense is that they have in fact been resolved. We went through a significant due diligence process. We are still gaining a more comprehensive understanding of the business as our teams get involved in the operation. But we have not come up with any unexpected surprises up to this point.

Ingrid Aja - JPMorgan

Great. Thank you very much.

Operator

Our next question will come from Henry Kirn from UBS.

Henry Kirn – UBS

Hey, good morning guys.

Michael Sutherlin

How are you doing?

Henry Kirn – UBS

Good, nice quarter.

Michael Sutherlin

Thanks.

Michael Olsen

Thank you.

Henry Kirn – UBS

On the guidance, just a relatively wide range with only two months left in the year, could you talk about some of the considerations that would take you to the high end or the low end of the EPS range?

Michael Sutherlin

I’ll let Mike give you some of that but first I’ll just tell you that when we set the guidance we sort of look at the middle of the range and then things to the high and low tend to be influenced by rounding as much as anything else just to keep from getting down to single pennies here and there. Sometimes it’s up in the low end to look a little unusual and that’s just because of trying to getting to a round number, but I’ll let Mike give you little bit more granularity on this.

Michael Olsen

Yes, I think Henry, there is really a couple of issues. One is the issue of when large original equipment orders are able to begin to be talking on about the surface and underground site you’ll recall that the surface side pocks all of the electric mining shovels on the underground side we pock the roof support orders that pocking process does not begin until the order has been officially received under our strict guidelines.

We are also still feeling our way through the forecast accuracy of the LeTourneau business. We are still getting our arms around the finalization of the what the purchase accounting exercise will result and the lives of the various intangible assets and write-up of inventories and so forth and then the other wild card is what happens with aftermarket revenue which is not as heavily driven by existing backlog.

For the last several quarters we’ve had a very, very strong growth for the aftermarket. Expectations are that that strength of the aftermarket will in fact continue but the range of guidance does allow for potential softness. And so it’s really all of those factors coming together that results in that range.

Henry Kirn – UBS

That's helpful and how did the orders trend through the quarter and was there any discernible change in the trend as we got into August and saw the financial market turbulence?

Michael Sutherlin

No, I mean, things seem to be pretty routine and as we look at the normal as we used to work the prospect list into machine requirements and talk to customers about delivery slots and things like that that’s relatively ordinary course of business.

So as we finish each quarter, we look into the next quarter and we look at the machines that are actively working through that process and that looks pretty much like normal. If I look at the machines that are approaching equipment decisions, here in the fourth quarter it’s doesn’t look substantially different than the list that we saw at the third quarter.

So, original equipment orders can be lumpy but it doesn’t show any evidence of being indifferent right now and that customers are - actually it’s been interesting our customers have called us and initiated the call to us to reinforce to us that they are not backing off or slowing down their plans.

So it’s not always us asking them sometimes they are – we wanted to make sure that we are continuing to drive these production schedules to the promised delivery dates and including keeping production slots available for machines that they have worked in the pipeline.

So, this connect is it seems from the macro environment that is that is the environment we are seeing. Right now, everybody seems to be on schedule we see no evidence of delays, deferrals, slowing down of any other projects that we are working on.

Henry Kirn – UBS

Thank you. That's good color.

Michael Sutherlin

Thanks Henry.

Operator

We’ll now go to Andy Kaplowitz with Barclays Capital.

Michael Sutherlin

Hi, Andy.

Vlad Bystricky - Barclays Capital

Good morning this is Vlad Bystricky on for Andy.

Michael Sutherlin

Okay.

Vlad Bystricky - Barclays Capital

With the sale of the LeTourneau Drilling Products business, would you say that an equity raise is now off the table regarding IMM?

Michael Sutherlin

Well, it certainly gives a lot more flexibility. A lot of that depends on the timing of MOFCOM approval, cash generated between now and then. There are so many variables in there that we can’t predict. We would like to do IMM without issuing equity. We are also very sensitive to not leveraging our balance sheet.

We understand the cyclical nature of the industry’s reserve and having a clean balance sheet is a critical part of our business strategy. So, all those factors way in. We can speculate but there are too many variables and too much time between now and when we expect to get MOFCOM approval to give you any predictability on that.

But I can tell you that that we are not going to overleverage the balance sheet but we prefer not to sell equity. So somewhere in that range is the answer and months go by we generate more cash and that gives us more cushion and more flexibility.

Vlad Bystricky - Barclays Capital

Okay, great, and regarding MOFCOM, has there been any surprises to-date?

Michael Sutherlin

No, it’s a little bit more of a mysterious process than we get with HSR in terms of there is no definitive timeline for responding back to us, where in the HSR process here in the US we have – they have a 30 day window to give us our initial response.

We’ve been asked for some few clarifying list of information just sort of boilerplate kind of information indicating that they are making sure that they have all the documents that they need but, we don’t have any further insight on the process. We have to wait till they come back to us with specific questions and other than clarifying to have all the data they need they haven’t done that yet.

Vlad Bystricky - Barclays Capital

Okay, great.

Michael Sutherlin

When we started the process, we are looking at the expectation of two to four months to go through the MOFCOM review I think the CAT/Bucyrus transaction took something like six or seven months I believe that was the last thing they were waiting on was regulatory approval from China. So, the window then it extends as a result of that data point is wider window than we anticipated when we were into this. So we’re hopeful we’ll get this done by the end of the calendar year, but there is no assurance or certainty that that’s going to be the case.

Vlad Bystricky - Barclays Capital

Okay, great, thank you. Just shifting gears, can you talk about the mix shift towards greater OE and how that will affect incremental going forward. But do you think you can maintain the current level of incremental through your operational excellence initiatives?

Michael Sutherlin

We certainly – our operational excellence are pushing real hard to have that drive real tangible results for our business and it’s been doing that. But as we look at the – as we move further into this growth phase, we will see the increase in original equipment revenues going into our revenue stream.

So the mix will shift away from aftermarket to original equipment. Historically, as we go through the cycle that’s probably a change of somewhere between 600 and 800 basis points of aftermarket percent of sales, so aftermarket percent of sales that starts out at 52% could get down into sort of like the 56% 57% 58% as the cycle progresses.

If you offset that, we are – we invested a lot of SG&A cost here in the first half of this year and we’ve allowed those SG&A cost to increase faster than we ordinarily would to get ahead on some prospects, some R&D projects and some capital projects. We would expect the growth in those SG&A expenses to drop-off and sort of they recover as a percentage of sales based upon the overspending we’ve done in the first half. We’d expect to see some improvement in the second half because we’ve already spent a lot of those resource dollars.

So, there is puts and takes here overhead absorption in our factories continues to show real positive results and as we continue to load up those factories to their capacity we are going to get beneficial overhead absorption.

So, as we look at those list, there is a lot of moving pieces on those list and we see some potential headwinds like product mix in the revenue stream, but we also see some positives that will come into play. So we think we can continue building margins, but we are not going to build them in large steps but over 22% operating margin and if we can continue to tweak it up, quarter-after-quarter we will replace with our results.

Vlad Bystricky - Barclays Capital

Great. Thanks for the color.

Operator

We’ll now go to Seth Weber from RBC Asset Management.

Seth Weber – RBC Asset Management

Hey, thanks. Good morning, everybody.

Michael Olsen

Good morning.

Seth Weber – RBC Asset Management

I guess, now that the dust has settled, can you comment, are you seeing any change in the competitive environment from the combination with CAT and Bucyrus, first question?

Michael Sutherlin

It’s not real. I mean, it’s been I think in the last call we talked about it being pretty quiet I think there is still is pretty quiet. I know that they have plans and they are executing but we don’t see really a whole lot of change in the marketplace right now and we are sort of focused on getting original equipment orders booked and doing some programs that will improve our aftermarket service capabilities. So we are sort of our heads down on our own issues. So we are not necessarily out finding to figure out what they are doing but there is not being obviously, that’s obvious that’s coming across the fence right now.

Seth Weber – RBC Asset Management

Okay, that's helpful.

Michael Sutherlin

Right now, they push this out to their dealers. So that you have a wider number of pieces that have to get their arms around the heavier mine equipment businesses that we operate.

Seth Weber – RBC Asset Management

Right, okay, then for Mike Olsen, I guess, Mike, the balance sheet – the step up in inventory here, I mean, how quickly do you think that that gets drawn down? Do you still think this is a business that generates $400 million to $500 million of free cash flow this year? How should we’d be thinking about the balance sheet right now or the working capital I guess?

Michael Olsen

As you look at the acquisition of LeTourneau, our initial view that is that the two things and one is step-up of inventory is not as large as I initially was expecting and then secondly that step-up of inventory will end up being amortized over a 12 month period and the tax we’ve seen that inventory step-up being amortized over a couple of quarters the LeTourneau mining business and I think it’s a function of maybe less efficient aftermarket infrastructure thinks to have a bit more inventory that’s not turning as rapidly as we expect we can get it to.

As you look at 2012, we are actually not in a position to provide any guidance on 2012 at this point, but we do in fact expect the company will in fact be a positive generator of cash as we’ve been historically and so our expectation for 2012 will be that that will be consistent with our historical trends.

Seth Weber – RBC Asset Management

Okay, thanks. If I could just slip one last one in here the cancellation fee that you mentioned, I think it was $5 million, Mike, was that something that came up in the quarter, is that just sort of a distressed customer? Is there any color around that, has that continued?

Michael Sutherlin

It’s a lingering issue from 2008, but this is when we actually had a contract and we had the deposits associated with the contracting level. So it was in a letter of intent but it was a start-up operation and that operation struggled with getting permitting for that mine and they have some investors steel company investors, steel company investors has just refused to put anymore investment in with their inability to get the mine permits.

So, it’s a metals mine molybdenum mine and so, we got to the point where it seemed unlikely that they were ever going to execute those contracts. We can see their funding levels dropping down. There is no new replenishment of their funding capabilities so they have a finite life the best thing to do is go ahead and take those bookings now.

Seth Weber – RBC Asset Management

Got it. Okay. That's very helpful. Thank you very much guys.

Michael Sutherlin

Yes, thanks Seth. You’re welcome.

Operator

We’ll take our next question from Charley Brady from BMO Capital Markets.

Charley Brady - BMO Capital Markets

Hey, thanks. Good morning guys

Michael Sutherlin

Good morning.

Charley Brady - BMO Capital Markets

With the divestiture of the drilling, LeTourneau Drilling business, and we go back to the initial synergy runrate of $40 million you guys are going to get, is that $40 million is still intact or was some of that baked into the drilling ops?

Michael Sutherlin

I give that to Mike.

Michael Olsen

Yes the $40 million was actually allocated between both of the businesses. We are in the process of separating that analysis and as we look at our fourth quarter earnings release and provide guidance for 2012, we’ll provide an update to the expectation as far as those synergies. But you can’t in fact expect a portion of those synergies will be allocated to both the mining business and the drilling business.

In addition to that, you’ll recall that at the time of the announcement of the LeTourneau acquisition, we talked about the tax step-up that we obtained during that transaction and that tax step-up will have immediate benefit to the company on the sale of the drilling product business and there will be virtually no adverse tax implications associated with that sale and that the proceeds of that sale will fall to the company on a gross basis.

Michael Sutherlin

Yes, Charley, I wouldn’t expect the – when we do the analysis I would expect probably the mining part of the business to have more than half of those synergies, I can’t tell you how much more but, because of the dealer network and few things that we had on the list to consolidate the mining part of business will carry the majority of those synergies not necessarily, but the vast majority it will be somewhere above half.

Charley Brady - BMO Capital Markets

Thanks, that's helpful. And just one more follow-up, on the corporate expense line, that 12.7 run rate, we're at in Q3, and you talk about you were sort of front running some of the SG&A expenses and R&D expenses, would you look for that number to kind of remain at that level or should be stepping down? Obviously, LeTourneau win there for the full quarter is going to maybe bump it up a little bit, but maybe a little guidance on that.

Michael Olsen

Yes I think as you look at those corporate expenses, I think that that there is a couple of things that are associated with that. One as we look to execute our strategy, some of that has included incurring cost to gain a better understanding of those markets where we think there are opportunities for growth both organically and also through acquisitions. So there has in fact been some expenditures put in place to do that.

There in fact has been some additional internal resources added to provide your company with more capabilities to develop the business once again both organically as well as through potential acquisitions. But some of that spending level will in fact continue and some of it will in fact be one-time items that will in fact go away. So my expectation is that we would see a slight moderation of that spending level but not a dramatic reduction of those spending levels as we begin to in essence plan for a larger business.

Charley Brady - BMO Capital Markets

Yes. Thanks very much.

Operator

We’ll now go to Jerry Revich with Goldman Sachs.

Jerry Revich – Goldman Sachs

Good morning and congratulations on the asset sale.

Michael Sutherlin

Yes, thanks.

Jerry Revich – Goldman Sachs

Mike, can you give us an update on how the LeTourneau integration is going? Have you ramped up steel production to full capacity and what are the early returns from your joint purchasing programs? Or should we expect a near term benefit there?

Michael Sutherlin

Yes, we are working through the integration issues with LeTourneau right now and there has been a lot of work on supply chain consolidation. We’re focused a lot on the integration of the field service operations around the world. Some of that includes third-party dealers.

Some of that includes the consolidation of facilities that we have and LeTourneau has in the same locations. The steel mill is a – we haven’t ramped up transferred all of our production – or our requirements over to load that steel mill up yet and we are going through a process of doing a pretty in-depth evaluation of the efficiency of that operation and effectively going to a like a CapEx justification.

Although it adds some real benefits to us we are not typically not a vertically integrated business and we want to make sure that if we didn’t get it with the transaction we would have still been able to justify an investment that gives that same steel capacity. So we are doing some things before we load that with up work.

We want to make sure that their cost justified and we’ll make sure that they are efficient and if we have to do anything to improve the efficiency of that operation we need to know what those plans are before we just load them up with work. So, we are trying to go have a steady program of integration and we expect that to rollout here over the next year.

But, we are not really trying to get quick wins on steel at this point. We are looking at increasing the production rates of the large wheel loaders in LeTourneau at their Longview facility trying to get more production capacity and keep lead times down. But, spiking an integration right now is up on top of the list. Field service integration, service center integration is on the top of our list and we are starting to do some interchange of information around technology sharing and engineering.

Jerry Revich – Goldman Sachs

I appreciate the color. And Mike, can you talk about where gross margins are in equipment you are quoting today versus what you are shipping today? And also you mentioned that the prospect list has grown year-to-date. Can you give us a rough quantification of order of magnitude?

Michael Sutherlin

I’ll give you the process that we use for tracking that and Mike can give you some more information on what the numbers looking like but we monitor that process very carefully, really one of our real strong rules we have in our business is to maintain positive price realization.

So we look at the margins and recent shipments versus the margins we have in backlog versus the margins we have in the separate quoting. And we want to see a progression in those three buckets to make sure that we are maintaining positive price realization. So we do monitor that and when we do business reviews we continue – we look at that information.

We are comfortable that we are doing that. At this point in the cycle and in this point where we are with our pricing and our margins we are not going to get huge gains in those increments as we go from each step to the next but we are getting positive increments going from step-to-step but, Mike, if I can ask you to give a little more detail on the margins what they are looking like?

Michael Olsen

Yes, I think that what we do is really a couple of things. We in fact have long-term customers that we’ve dealt business with for the last 50 years and expect to do business with for the next 50 years and our whole pricing strategy is really based on making sure that that we are able to recover the cost of commodity increases that we see, we want to make sure that we’re in fact capturing the benefit of the actions that we are taking to improve our business.

In other words, we are very careful to say that as we drive our operational excellence initiatives that we’ve talked about here now for several years that we take the profitability that’s associated with those activities and that goes to improve the margin performance of our products.

At the same time we don’t in fact take advantage whenever the markets are extremely strong that just arbitrarily go in and raise prices, because we will be dealing with these same customers wherein the markets won’t be quite as favorable and so we want to make sure that that we in fact have a reasonableness into our pricing.

But the margins that we have in our backlog will be slightly higher than the margins that have been reported in the most recent quarters, the reason being with the operational improvement that we’ve done internally plus our efforts to maintain prices that are sufficient to cover the cost of the commodities that are coming in.

So you’ll see improvement, but once again those will be very slight improvements that unless you know specifically where to look for them and quite honestly that level of detail was rarely made public. But we do in fact see improvements in product margins.

Jerry Revich – Goldman Sachs

And last one if I may. Mike, I understand you prefer to control the IMM business, but can you talk about why you're not given approval for full ownership, why wouldn't a minority position be interesting to you considering how well-positioned the company is in a pretty fast growing long-term market?

Michael Sutherlin

Yes the complication comes around the rules and procedures. We cannot own more than 30% without MOFCOM approval. So we are not talking about 49% ownership, we are talking about a lower level on a ongoing basis. There will be something we will doing – I don’t know, we may look at that and we may decide that that’s the right thing to do, but our interest it not in being a minority owner.

We want to do and we think there is lot of upside in the business but there is also upsides are going to come from technology transfers and lot of things that we can do to add value to that business. As the minority shareholder we would not be able to do those kind of things.

So usually, we could do them but we have to maintain real transaction that gets cumbersome and difficult. So, I wouldn’t rule anything out at this point, but we are not really thinking about that because we don’t really believe that that’s going to be a possible outcome at this point.

Jerry Revich – Goldman Sachs

Thank you very much.

Operator

We’ll now go to Michael Gallo from C.L. King.

Michael Gallo - C.L. King & Associates

Hi, good morning and congratulations on the strong results. My question Mike, as you kind of look at the macro environment, obviously there is a clear softening, you're already running the operations very efficiently and at high levels of margins.

So I was wondering if you can give us a little bit more color on some of the areas you think you might be able to trim. Perhaps, it's too preliminary to put numbers on it. But even if we could talk broadly about, how much you think you could potentially take out and obviously if there is fat and you don't have a slowdown, certainly that can take your margins up to the next level. Thank you.

Michael Sutherlin

Again, I’ll give some overview comment here and then I’ll let Mike walk you through the details but we do run our business on leverage ratios. We look at the operating leverage on the upside. We look at operating leverage on the downside and we went through this looking at the downside in 2008 we were determined to deliver detrimental leverage that was sort of in the low 30% range. I think 32%, 34% range.

And we in fact were able to do that and I think as we look going forward we would continue to maintain those kind of targets on detrimental margins if we did had to begin to reduce the size of the business. Some of that’s going to come out of consolidating the operations.

Some of that’s going to come out reducing the volume of work we get done through outsourcing and outsourcing partners that we have in our network. There is a variety of different places that that comes from, but certainly in the last downturn in 2008 going into 2009, we’re able to get those kind of detrimental margins that we wouldn’t believe that we should target breathing less than that. At this point if we had to reduce the size of our operations.

We don’t think we’re there yet. We’re just trying to trim up cost and lean out the business at current volume levels and based upon your outlook we are continuing to see production schedule increases at this point. But if that turned I really go back to the same plans or the same principles we used before. But Mike can give you a little bit more information on that.

Michael Olsen

Yes, I think that we have some just extraordinarily exciting times ahead of us on a quarterly basis, Mike and I and the rest of the senior management team go through quarterly operation reviews with each of the business is down to a very, very low levels of operations and the areas that I believe that are available to us to improve profitability in the future, one is in the area of serviced energies.

I think that that is beginning to have a lot of grass roots initiatives that are starting to spring up with the two businesses are identifying on their own opportunities where they in fact can work together to provide significantly better service to the customer and to leverage the resources that they have individually to provide that better service at lower cost.

There are opportunities on the supply chain in the organization as we look at establishing supply chain organizations in the emerging markets and we think we are just scratching the surface of things that can take place to there as once again we are bringing the two businesses together into a single supply chain organization.

We’ve talked for several quarters and years now about the operational excellence initiatives, just the other day, Mike and I accompanied one of the covering analysts with one of our major investors, who walked through our P&H National Avenue facility here in Milwaukee and I hadn't been out there for about six months and it was just extraordinarily surprised that the significant progress that it’s been made and those cycle times what it is it from an accounting perspective.

I kind of struggled to see how that shows up on the income statement. But it improves the efficiency and the quality and the amount of capacity that we have. And so I think that it’s all of those areas that we will in fact look to improve the profitability of the business and then also on the spending side we look at on the administrative side, we think that as we look at opportunities to share box back-office opportunities that will end up with better processes at lower cost and those are areas that they were looking at as well.

Michael Gallo - C.L. King & Associates

Okay, that's great, very helpful context. Just one follow-up for Mike Sutherlin. Mike, as we look at some of the new EPA regulations and what some of the potential impacts of that could be on the US domestic coal business, any thoughts on that and kind of how that plays out? Any concerns as to the uncertainty of that or whether that starts to impact some of the CapEx plans on the domestic side of the business?

Michael Sutherlin

The EPA is – the regulations are going to be headwinds for the US domestic thermal coal market. The best – I think consensus estimate we have right now is that, by 2015 we could see something around 38 gigawatts of power generating capacity taken offline.

And at the same time, we don’t expect new coal fired power plants to be usually permitted. So there will probably a limited amount of new coal-fired plants put into the pipeline. Construction will finish on the ones that are in process and that’s definitely why the US customers are beginning to look at the export market.

So, the offset here is that the US market is beginning to look into the seaborne markets for its growth potential rather to domestic power generation. So, I think we’ll see a change in the market where we’ll see modestly declining demand in the US for thermal coal at a modest rate of decline over a longer period of time and that will be offset by more significant upside on the export markets.

But, the EPA regulations unless we get those stopped unless somebody comes to their senses and realizes what the cost impact of those are, they will begin to put some downward pressure on coal demand in the US.

Michael Gallo - C.L. King & Associates

Thank you, very much.

Michael Sutherlin

Yes, Melissa, we are at the top of the hour and so if we can make this as the last question that would probably keep us on schedule.

Operator

Okay, and that question will come from Ted Grace from Susquehanna.

Ted Grace – Susquehanna Financial Group

Hey, guys. Thanks for taking the question. I was just hoping to come back to the prospect list first of all. Mike, if I heard you right, I felt that I heard you say, the areas of strength on the prospect list were seaborne coal, copper, and iron ore. I guess, A, did I hear that right? And B, could you kind of force rank or give us orders of magnitude which were the standouts among the stronger units?

Michael Sutherlin

Yes, it was in those three categories. Probably rank them in that order. Seaborne, coal copper and iron ore we are seeing new things come up unless as we talk about Greenfield projects, iron ore has historically been Western Australia and Brazil, but we are seeing more projects that come on the list in Western Africa for example.

And so, we are seeing some broader strength in iron ore copper obviously is we are seeing the movement out of Chile into Peru as that’s the area that’s got a significant amount of higher grade reserves and so the new mines are beginning to focus little bit toward the north. Just in terms of broad terms, I’d sort of put them in that order, copper coal and iron ore. But, certainly there is a lot of strength and that we continue to see in the near term in a lot of strength in the longer term around major Greenfield projects.

Ted Grace – Susquehanna Financial Group

Okay and you may have anticipated the second part of that question which I was going to ask you was which, if we were to look forward 12 months, where might we look for relative strength to be and it sounds like certainly you mentioned West Africa and Peru for those two commodities?

Michael Sutherlin

That’s right.

Ted Grace – Susquehanna Financial Group

And then I guess, kind of on a similar basis, could you just give us some color on how Greenfield versus Brownfield orders came out in the quarter itself and how that's looking on the prospect list?

Michael Sutherlin

Well, we are in that transition period we are getting to make some – we’d say Brownfield, we are talking about extensions of existing mines. So we talk about a new mine complex goes into virgin territory open up the new mine. Those are longer term projects that we’re starting to see early pieces of those coming in through the pipeline.

But they are longer to plan, they are longer to permit, there was more infrastructure to build that’s got to go around putting those mines in. So we are in a transition so we are getting probably a little bit more Brownfield and Greenfield right now but we are starting to see some of the Greenfield projects trickle into that prospect list.

Ted Grace – Susquehanna Financial Group

Okay and then, in terms of just calling out some of the specific product orders in the quarter was there anything notable, can you just say shovel orders, if there are there any long wall orders, drills, et cetera?

Michael Sutherlin

No, it was a reasonably a balanced quarter. We – nothing is stands out and dominate in the quarter in each one of those categories.

Ted Grace – Susquehanna Financial Group

Okay, and then the last question I'll ask and turn it back to you. In terms of just looking at leading-edge macro indicators, what are the things you guys pay attention to most closely and I recognize that we're all kind of debating where the macro stands relative to the fundamentals on commodities? But in terms of just the two or three metrics that you pay most attention to, whether it's a China PMI or industrial production or spotter or future commodity prices? If you could just kind of give us what you guys are focused on and how you would characterize those at this point or that would be great and leave it there?

Michael Sutherlin

Yes, we look at lot of factors, but we tend to focus a lot on industrial production levels and growth rates in industrial production is been the prime driver. We look at stockpile levels, like steel, stockpile levels and growth and declines in those stockpile levels, we could start to match up the impact of production and whether they are producing ahead of demand or not and we look at the stockpile levels in the mining regions and mine site and poor stockpile levels to see again whether the production is getting ahead or falling behind the demand levels. We did look a lot of those indicators and it’s relatively - a judgment call at the end of the day because you look at lot of data and you have to make some calls over that data. Okay.

Ted Grace – Susquehanna Financial Group

And at this point nothing is kind of flashing yellow to you?

Michael Sutherlin

At this point on the fundamentals, nothing is flashing yellow. Now, the one thing that does begin to flash yellow for us is the PMI numbers. We are seeing slowing of export orders out of China. We are seeing slowing of export orders out of Japan, Germany. So we are seeing the industrial production levels sort of get – be get down to sort of that mutual growth level right now on the PMI index. And so there are some yellow warning signs out there. We haven’t seen that translate into the fundamentals that we track.

Ted Grace – Susquehanna Financial Group

Okay, great. Well, thank you very much and best of luck this quarter guys.

Michael Sutherlin

Thanks. With that, I’d like to probably close out. We’re little bit over our time. Just want to reiterate that we are an operationally and financially efficient business and we are focused on growth strategy and execution. I think you can see both of those in this quarter’s results.

I believe that these factors are going to continue to deliver high value for our shareholders. So we will continue to prioritize on those elements. So, with that I appreciate everybody’s being on the call and listening to our story and we look forward to talking to you in our fourth quarter. Thank you very much.

Operator

That does conclude our conference for today. Thank you for your participation.

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