Why I'm Not so Bullish on Joy Global

Joy Global (JOYG) along with Bucyrus (BUCY) are the 2 main public companies in the US for pure plays on "mining equipment". While I expect demand to be strong, which will help both these companies' revenues, I have turned cautious on these names due to rising input costs - essentially the same thesis I have for the agriculture equipment makers i.e. Deere (DE) [May 14: Deere Earnings - Why I'm Avoiding Equipment Stocks].

Simply put, just as the automotive companies are being destroyed by change in style to small cars AND steel prices (Ford announced yesterday it is cutting more white collar jobs as steel prices ramp, GM doing yet another round of restructuring announced today), the impact of higher input costs is beginning to be felt across the globe by producers. [May 17: WSJ - Fast Rising Steel Prices Set Back Big Projects]

Now in some industries, such as automotive, there are other issues, so revenue is flat lining, but even in "great industries" like agriculture or mining equipment that are seeing stellar growth, it is coming at a cost. Lower profit margins. So while the folks on Wall Street ignore this issue because all they rely on are "government figures" on inflation - we are talking about it, and have been talking about for a long while. This will put a serious crimp on profit margins, and thus when the market faces reality - create lower stock prices.

How is it effecting even the most stellar groups? We saw a few weeks ago the story in Deere - as to Joy Global while revenue is surging look at their gross margins - a year ago this quarter they were 33.2%; this quarter? 26.4%. That is a massive reduction in 1 year. So in plain English it takes more revenue just to derive the same income if your margins are dying on the vine.

Now again, the demand is SO strong in this industry since mining equipment is at a premium that much of this gross margin destruction is offset by a huge ramp in revenue, but for 95% of the world's industries, demand is nothing like mining equipment.

Again, I've said this many times - inflation is a tax on all things; producers and consumers. Someone has to pay the piper; either in the form of crimped profit margins (producers) or large price increases (consumer). Or both. Wall Street is missing this story because they are relying on the fantasy story of 3% government inflation. 2nd half 2008 and 1st half 2009 profit margins will suffer.

The only "saving grace" for corporate America continues to be that MUCH of their cost structure is human beings. Human beings that they are either laying off (if you read the company news, and ignore the government reports) or only allowing minor wage increases for those that remain. But for industries that consume large quantities of raw materials - a major headwind is now here.

Those who do NOT have large ramps in revenues to offset this will see profit reduction. And for those who are currently enjoying these large ramps in revenue, if China and other developing nations begin to slow materially, their large revenue growth will stall, and they to will join the vortex downward. So risk increases; and this is reducing our pool of investing avenues by the minute.

• Joy Global Inc. said Thursday its fiscal second-quarter profit fell 7 percent as higher expenses offset increased sales, but the surface mining equipment maker still beat analyst estimates.
• Net income for the three months ended May 2 fell to $72.1 million, or 66 cents per share, from $77.6 million, or 70 cents per share, in the year-earlier period. Excluding one-time charges of 13 cents per share for a contract termination and 7 cents per share related to an acquisition in February, Joy Global had adjusted earnings per share of 86 cents.
• Revenue climbed 34 percent to $843.1 million from $629.2 million. Analysts expected $798.3 million.
• The company's cost of sales rose to $620.9 million from $420 million, and its product development, selling and administrative expenses rose to $108 million from $89 million.
• Orders reached a record $1.2 billion -- up 69 percent from the prior-year period on strengthened conditions in the U.S. coal market and continued growing international demand. Original equipment orders grew 102 percent, and aftermarket orders increased 22 percent.

Again let me emphasize that the demand for the products for the mining equipment makers is off the charts - I am not implying that anything will change tomorrow or in a few weeks. In fact I expect revenue to continue to ramp smartly, BUT profit margins will be squeezed. So I'd rather play this trend (rising tide) with other companies (boats). (even those boats have cost pressures, but it's all relative). The guidance in the Joy Global report has some interesting tidbits, worth posting - we can glean information on many related themes by reading earnings reports of ancillary companies.

• The Company continues to benefit from unprecedented demand for its underground and surface mining equipment in response to the strong demand for coal, copper, iron ore and oil sands. All of these major commodity markets that the Company serves have extremely thin supply surpluses, or most often, significant supply deficits, as commodity supply increases to date have been unable to match commodity demand growth.
• In thermal coal markets, stockpiles at power generators remain at extremely low levels, and the rebuilding of inventories will add to the supply deficit. The Company believes the gap between coal demand and supply could reach 60 to 100 million tons this year.
• Industry forecasters expect steel demand to continue growing at 5% - 6%, led by growth of 10% in China demand. Both metallurgical coal and iron ore remain in significant deficit, and some projections indicate that steel supply could be 20 - 30 million tons less than demand this year due to shortages of raw materials.
• The U.S has become the swing supplier to the international thermal and metallurgical coal markets, and export demand and prices are redefining the domestic market.
• Based on the status of existing expansion projects and industry projections, the Company expects that the commodity markets will generally remain in supply deficit for the next three to five years or longer.

Disclosure: No positions

Comments

[pachanguero:]

They will raise prices as they are now. They will offset any costs by passing them upstream.

You are wrong amigo. simple business 101

2008 May 31 08:02 AM

[pachanguero:]

I should have said downstream. In todays market they can make higher earnings for years.

Sold out through 2011. You have to wait in line to buy. They are not DE. BUCY is the only other game in town. I suspect they will raise price next.

You are so right on Coal, but IMHO you missed this one.

Inflation is like a cancer

2008 May 31 10:43 AM

[garlicbulb:]

If they are sold out through 2011, can they raise the price on those orders? I suspect that either they can't or the buyers have the option of backing out of the order. Too much price increase and too much slowdown could cause a lot of those orders to evaporate

2008 May 31 08:28 PM

[TraderMark:]

Pachanguero,

So far it appears any price increases are not keeping up with the rising costs of inputs. They lost 7% of gross margin in 12 months; that should make one take notice.

Again, I did not say bad companies, bad sector or anything of that nature. But if you ramp sales, and costs ramp over and above your price increases you lose margin. That seems to be happening increasingly across equipment makers, whether mining, agriculture or just about anything.

2008 Jun 01 03:19 PM

[Think-About-It:]

I perfer to invest in sectors experiencing (A) shrinking gross margins on expanding sales rather than one experiencing (B) increasing margins on flat/contracting sales. An often over-looked benefit of senario (A) is that the smaller margins act as a barrier to entry for companies in related industries thinking about getting in on the hot sector's growth.

It's hard to find companies with (C) expanding margins and fast growing sales that don't have huge P/E multiples making them vulnerable to short-term bad news. I'll take the trade-offs that (A) sectors offer.

2008 Jun 02 03:23 PM

[read more t...:]

The GM decline was partially caused by the mutually agreed upon maintenance contract termination of a dragline put in service in 1996. The $20 Million charge was taken straight out of Gross Margins. Adjusting for this the GM still declined but was more like a 29% GM not the 26% referenced. Purchase accounting rules also impacted operating margins. Overall JOYG buys steel about 9-12 months ahead of time and builds escalators into the contracts. I think this article makes the margins a bigger deal than it really is once you get past the headline numbers.

2008 Jun 03 12:36 PM