Joy Global: Good Things Expected from Machinery Industry

Our Zacks senior analyst covering the machinery industry, Mario Ricchio, has some encouraging words to say about this group’s upcoming earnings season. We got his take on why this is, and found out his top recommendation in the space.

Ahead of first quarter earnings, what are your expectations for machinery companies in your coverage?

Our expectations are very high for the first quarter. We anticipate the median first quarter EPS growth rate to increase 21% compared to same period a year ago. Strong international sales volumes, increased pricing power, and a weak U.S. dollar should fuel the profit gains.

The difference this time around, as opposed to other machinery cycles, is weak U.S. machine orders have failed to lead to a series of downward earnings revisions. And it’s really a story of the booming global economy carrying the day. Since the companies we cover, in some cases, have more than 50% of earnings from international operations, they are expected to weather the storm called U.S housing.

Unfortunately, the good news on earnings appears priced into the sector. The machinery stocks are treated as cyclical stocks, so they are selling off on worries of a future U.S. economic slowdown. We believe the market is looking beyond the first quarter and paying much more attention to the outlook for second half of 2008 and the full year 2009. We think the days of double-digit earnings growth end at the end of 2008. Our 2009 median EPS forecast calls for growth in the range of 5-7%.

What effect, if any, do you expect the global economy to have on the machinery group as a whole?

There is nothing bullish about the domestic economy. The residential real estate market is in a severe downturn and the commercial construction market is right behind it. It looks like Sam Zell nailed the top of the cycle by selling Equity Office Properties to private equity. We expect U.S. commercial construction activity to slow dramatically amid a weaker labor market and tightening credit conditions.

With a severe U.S. slowdown upon us, it is very important the global decoupling remains intact. The strength in the global economy is the only reason we believe there will be positive earnings growth for the group. International machine orders are expected to increase at a double-digit rate for mining and energy-related equipment.

Foreign companies and governments alike are flush with cash from the multi-year surge in commodity prices. They are reinvesting the flow of funds back into infrastructure and mining projects that pull more resources out of the ground. By region, the growth stories in the Middle East (oil), Latin America (agriculture), and Asia (exports) remain on track. The pockets of weakness are in Europe, where the construction boom in Spain and the U.K. are likely to slow from a fast pace.

If you had to pick one or two Buys in machinery, what would they be, and why?

We still like shares of Joy Global (JOYG). The U.S. coal market remains positioned for an intermediate-term rebound. U.S. power generation is returning to normal levels and coal-fueled plants are under construction. Producers have lower output to reduce the excess inventory levels. So in essence, we have demand conditions improving at the same time supply comes down. This is a recipe for higher pricing.

Against this positive domestic backdrop, we have a supply deficit brewing among the international economies. Investors should know that China is now a net exporter of coal. The countries that typically export coal to China—Australia and South Africa—are running into a few supply constraints. U.S. coal producers are filling in for the supply shortfall with their own metallurgical grade coal, which will help keep U.S. coal supplies tight for the foreseeable future.

Consequently, we see the fundamentals maintaining coal prices at a level necessary to support an upturn in coal-related equipment spending. On the surface mining side, the business continues to be supported by higher commodity prices for iron ore and copper. So really, Joy Global is hitting on all cylinders right now. We like to think of it as a great way to play the commodity boom. Our target price is $75.00.

How would you advise investors interested in diversifying into machinery stocks?

We would look at the industry players on a company-by-company basis. Growth rates will depend on the respective end markets served and the level of international exposure. We suggest underweighting companies that are heavily exposed to the U.S. residential construction market or companies beating earnings solely off of share buybacks. Instead, we would look at companies with strong overseas exposure to infrastructure build-out and domestically in road building and mining-machinery.

Mario Ricchio is a senior analyst covering the machinery and homebuilding industries for Zacks Equity Research.