You can paint the picture either way to prove your bullish or bearish stance on Joy Global (JOY), the mining equipment manufacturer. It all boils down to one single question - Is the current trough in JOY's stock secular or cyclical? If it is cyclical, then the stock is a buy as the stock price will go up as macro conditions become more favorable for businesses.
However, the problem comes when a large part of the market thinks of the current downfall as secular. This belief is widely held as 60% of JOY's revenues come from coal mining. With the shale gas boom and the rising divergence between prices of natural gas and conventional sources of fuel, and regulators tightening the noose around the necks of coal-fired plant owners and forcing them to switch to environmentally friendly sources of fuel, the usage of coal is expected to fall in the coming future; thus, clearly making a bearish case for the stock until it reorganizes according to the need of the hour.
Also, unusually warm winters have led to a direct decline in electricity demand, and hence, power generation. Declining iron ore prices highlight the slack in demand due to a weak Chinese economy, which forms up to 65% of the global iron ore demand. Both these points strengthen the bearish case at least until the next earnings announcement to be held on August 29, as the chances that JOY will not be able to meet analyst expectations increase.
On a positive note, JOY can strike an attractive deal with General Electric (GE), the giant conglomerate, which has decided to go big on the $61 billion global mining industry. Also, Chinese electricity production from coal rose by 7% YoY in the first quarter, thus giving a cushion to the company against the damages from the U.S. coal market.
Earnings Preview and Q1 Earnings Call Highlights
The table shows analyst expectations for the next quarter and the YoY growth that will be achieved in case the company meets the expectations. Last quarter, the company's performance exceeded expectations, as the announced EPS of $2.04 were greater than the expected $1.95. However, given the soft global demand, the revenue forecast for the financial year was brought down from $5.59 billion to $5.56 billion.
The chart shows JOY's exposure to its two different segments. The historical data shows that the proportions shared between both segments have remained almost same over the years. However, it is predicted that the declining growth in demand of coal will lead to a gradual shift of revenues from underground mining to surface mining, which deals lesser in coal mining.
Coal, Annual Energy Outlook till 2035 and Reaction of Other Companies
Future coal consumption, by far, will be the most important factor to determine the demand for JOY's machinery in the future, which will ultimately drive the stock's price.
U.S. coal consumption alone drives 30% of the company's revenues. 25% of it is accounted to underground mining equipment. Three factors have hampered or will hamper the demand for JOY's products in future:
- Shale gas boom and falling natural gas prices.
- Increased regulations to curb carbon dioxide emissions from coal-fired plants.
- Unusual warm winters in the U.S.
In the U.S., the power sector is responsible for 90% of the total coal consumption, as coal is used to produce electricity. The U.S. has around 1,400 coal-fired electricity generating units, which produce 40% of the total electricity consumed in the country. This production eats up 900 million short tons of coal per year. Following shows the sources of electricity generation in the U.S.:
However, given the shale gas boom and falling natural gas prices, this division is going to change as the energy landscape of the U.S. revolutionizes. Important to see will be for how long natural gas prices stay down. Another important factor can be the amount of liquefied natural gas that is exported by the U.S. in future, which will eventually lead to a decrease in the supply of natural gas and a rise in its prices.
Even now, the industry is slowly adopting natural gas for electricity generation purposes. The decision has been influenced by regulators who want manufacturers to help reduce overall carbon emissions. A majority of the new additions in capacity are using natural gas and renewables.
Currently, coal consumption accounts for 20% of the overall U.S. energy consumption. However, it contributes 34% of the overall carbon dioxide emissions. Therefore, regulators are justified in controlling coal usage. Following shows U.S. coal consumption and the gradual shift of energy usage sources to produce electricity.
The graph shows that coal consumption has shown a mean-reverting pattern. Also, recently, lesser coal has been used to produce electricity.
The market has already realized the future reduction in coal consumption. This has been exemplified by a huge drop in CAPEX by coal companies like Alpha Natural Resources (ANR) and Arch Coal (ACI), which are sailing through troubled waters nowadays and are saving cash reserves to help formulate and implement a survival strategy.
On the same lines, BHP Billiton (BHP), the largest mining company in the world, delayed its Australian coal extraction project known as the Olympic Dam Expansion, to keep coal supplies down. Also, BHP does not plan to carry out a mega project in 2013.
When talking of competitors' outlook, one can argue that CAT recently announced its all time record earnings, which shows an overall positive outlook for the market. However, this cannot be extended to gauge the performance of JOY for this quarter, as the company depends heavily on coal consumption, which has a dark future ahead.
Retirement of coal-fired plants is estimated to be in a range of 34 gigawatts-70 gigawatts, which makes it 11% and 22% of the current fleet respectively.
*EUR is Economic and Regulatory factors.
However, coal mining in the U.S. is also dependent on U.S. coal exports and Chinese coal consumption, which forms a large part of the overall global coal consumption. From 2000-2010, the U.S. exported 5% of its coal production. Coal exports are of two forms; metallurgical coal, which is used to make steel, and steam coal, which is used for electricity production. The biggest market for U.S. steam coal exports is China. Chinese electricity production increased by 7% YoY for the first quarter, which sends a positive signal to the U.S. coal demand, and hence, to JOY. However, China is undergoing some serious slow growth in demand, as the GDP growth rate has plunged for six straight quarters. Therefore, the overall situation displays a confusing picture.
JOY strategically acquired International Mining Machinery Limited, a leading Chinese manufacturer of underground mining equipment, in 2011 to penetrate the Chinese coal market. However, according to JPMorgan analysts, the weak Chinese economy will be a challenge for the company in the near future.
Iron Ore And China
Iron ore prices are falling relentlessly. Following shows the graph of iron ore prices:
This highlights the soft demand for iron ore on a global scale. China, alone, uses 65% of total seaborne iron ore. Iron ore inventories have reached their record levels in China. Therefore, a rise in demand is not expected in the near future. However, the positive aspect to this is that after such a decline in prices, suppliers in China have cut down their production levels. This can force Chinese steel mills to import from the U.S., thus leading to a rise in mining activity of iron ore, which will help increase the demand for JOY's machinery.
- Firstly, most of the negative news is already priced in the stock.
- The company has a massive backlog that it can work on till the economy recovers. Total backlog amounts to $3.14 billion, which is 19% up YoY.
- GE, the monster conglomerate, has decided to have a mighty share in the big global mining industry. JOY can be a suitable option for the company due to a couple of reasons; JOY is already well settled in the mining equipment business and GE will find an easy way into the market. Secondly, JOY is a leader in electric shovels and GE makes electric motors. The industry has already consolidated and GE can easily become the market leader after acquiring JOY.
- Through its One Joy Global program, the company is cutting costs by aligning its two businesses wherever possible. The cost cutting details in the earnings call will be an important catalyst for the stock.
The company is enjoying higher margins as compared to its competitors.
The book to bill ratio is 0.8x, down from 1.3x in F1Q'12 and 1.4x in F2Q'11. Apparently, the company does not have a debt problem. JOY is trading on a forward P/E of 7x. Analysts expect its earnings to grow at an annual rate of 4% for the next five years. The stock gives a dividend yield of 1.3%. The current ROE is 36%, which is well above the industry's ROE of 3%.
The stock is currently 58% below its 52-week high. Cramer thinks that the stock is overly punished for the decline in coal consumption. Coal will still be used for the coming ages if not for electricity generation purposes. He believes that the company is a classical example of a cyclical stock. However, he believes that the stock will not rise until it finds catalysts in the form of a rebound of the Chinese economy or a deal with GE. We suggest a hold position until the earnings call, which will make things a lot clearer.