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Joy Global Inc. (NYSE:JOY)

Q3 2012 Earnings Call

August 29, 2012 11:00 am ET

Executives

Mike Olsen - Executive Vice President and Chief Financial Officer

Mike Sutherlin - President and CEO

Analysts

Andy Kaplowitz - Barclays

Schon Williams - BB&T Capital Markets

Eli Lustgarten - Longbow Securities

Jerry Revich - Goldman Sachs

Ted Grace - Susquehanna

Seth Weber - RBC Capital Markets

Operator

Good day and welcome to the Joy Global, Inc Third Fiscal 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.

Mike Olsen

Thank you, Brian. 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 our results for our third quarter of our 2012 fiscal year. Mike Sutherlin will then provide an overview of our operations and our market. 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 third quarter results. As a reminder, in our 10-Q and 10-K filing, the business segment reporting, the operating results for Surface Mining Equipment segment include a legacy P&H Mining Equipment results plus LeTourneau acquisition results.

While the Underground Mining Equipment segment operating results include the legacy Joy mining machinery results, plus the IMM acquisition results, both acquisitions continue to contribute favorable to the results of the quarter although the general economic slowdown in China impacted IMM's performance.

During the third quarter, we settled the remaining 1% of outstanding IMM shares and our request to delist IMM from the Hong Kong exchange was approved. In the third quarter, IMM recorded bookings of $64.6 million while recognizing $69.1 million of revenue and $10.5 million of operating profit before excess purchase accounting charges.

The excess purchase accounting charges totaled $7.7 million in the current quarter, the result of continued refinement of our acquisition valuation estimates for IMM. We expect the final charge of $2 million for excess purchase accounting in our fourth quarter.

Since the IMM acquisition was completed, IMM results have been unfavorably affected by softness in the Chinese coal markets and increased competition from local Chinese equipment manufacturers.

At the same time during the period since the completion of the acquisition, the work our teams have done with IMM has reconfirmed the strength and potential of their businesses and the significant opportunities which exist for Joy Global to provide product improvements and operational efficiencies. Actions are already in motion to begin to achieve these benefits and to differentiate the IMM products in the Chinese market and to increase market share.

In the third quarter LeTourneau continued to deliver strong operating results. The wheel loader business recorded bookings of $91.7 million in the current quarter by recognizing $110.9 million of revenue and $22.2 million of operating profit before excess purchase accounting charges.

During the third quarter, we amortized the final $2.1 million of excess purchase accounting related to the LeTourneau acquisition while finalizing our acquisition valuation.

Now, moving to the legacy surface and underground mining equipment businesses, strong financial results continue to be tempered by moderation in our bookings for the quarter. Bookings of $928 million in the current quarter were down 35% from a year ago. The decrease in new order bookings compared to the prior year was comprised of a 39% decrease for surface mining equipment and 26% decrease for underground mining equipment.

The 39% decrease in surface equipment bookings in the current quarter primarily made up of 66% decrease in original equipment orders from the record level of OE bookings received in the third quarter, last year.

Aftermarket bookings fared better and were substantially flat with the aftermarket orders received a year ago. Original equipment orders were down in all regions with the exception of Australia. The increase in aftermarket bookings in Eurasia and South America were offset by a decrease in aftermarket bookings in North America, Australia, Asia and Africa.

Current quarter legacy surface orders for original equipment and the aftermarket will reduce by foreign exchange impact of $5 million and $11 million, respectively. The 26% decrease in the third quarter in underground mining equipment bookings, which is attributable to a 55% decrease in original equipment orders or aftermarket bookings were substantially flat with a 2% increase.

The original equipment bookings declined compared to the quarter of last year was due to weak demand for room and pillar equipment in the U.S. coal market and high comparables due to our roof support system ordered in Russia in 2011.

The increase in aftermarket orders was due to increased bookings in South Africa, Australia and China, which were substantially offset by fewer orders in the U.S. Eurasia. Orders for legacy underground original equipment and aftermarket were negatively impacted by foreign exchange by $25 million and $21 million, respectively.

The backlog of the legacy businesses was $2.5 billion at the end of the third quarter, a decrease of 10% from the second quarter. As you may recall, we removed $119 million in underground equipment orders scheduled for the U.S. coal market last quarter as we believe there was a reasonable risk of deferral or cancellation of these orders.

During the third quarter, $64 million of these orders were cancelled while $38 million were completed and shipped under the original terms. Backlog attributable to IMM and LeTourneau business remained stable at $300 million, consistent with the second quarter.

Net sales for the legacy businesses increased by 11% compared to the third quarter last year with surface mining equipment shipments up 22% while underground mining machinery revenue was substantially flat.

OE shipments of surface mining equipment increased 47% while underground mining equipment orders decreased 3% as a result of shallow shipment slipping out of the third quarter. Aftermarket shipments of surface mining equipment increased 8% and shipments of aftermarket underground mining equipment increased 7% compared to a year ago, primarily driven by strong part sales for the surface mining equipment business and favorable machine rebuild shipments for the underground mining equipment business in the current quarter.

Legacy business operating profit of $277 million in the current quarter exceeded last year by $35 million with both, the surface and underground mining equipment units having return on sales percentages just below 24% and incremental profitability of 30%. The increase in operating profit was primarily due to increase in net sales and a decrease in variable compensation expense, partially offset by an increase in period cost.

Income from continuing operations in the current quarter was $1.82 for fully diluted shares, compared to $1.61 per share last year. The table included in the press release and on our website provides a summary of the various items which impacted the current quarter.

The two most significant items besides the after-tax earnings of our acquisitions were $7.5 million, or $0.07 per share decrease in net income due to increased net interest expense related to the financing of the LeTourneau and IMM acquisitions, and through the excess purchase accounting amortization associated with IMM of $5.8 million, or $0.05 per share net of tax.

The effective tax rate was 31.2% quarter compared to 25.3% last year. The effective income tax rate excluding discrete tax adjustments was 31.5% in the current quarter compared to 30.6% in the third quarter of 2011. The full year effective tax rate is expected to be between 31% and 31.5%.

As noted in our press release, we have continued to implement our downsize planning scenarios and expect to incur $20 million of restructuring cost during the fourth quarter. These actions will result in approximately $40 million of annualized savings in the 2013 fiscal year.

Cash provided from operations was $157 million in the current quarter compared to $96 million a year ago. This improvement was due to the increase in net income and a reduction in cash used for accounts receivable and inventories partially offset by less cash received from advanced payments due to the decline in original equipment bookings.

Capital expenditures were $55 million in the current quarter and are on target to reach approximately $203 million for the full year. The revised guidance included in the press release assumes full year fully diluted weighted average outstanding shares of $107 million.

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

Mike Sutherlin

Thanks, Mike, and I just want to add my welcome to the people on the call today. This quarter has been defined by effective execution versus slowing demand in the commodity end markets. Mike has covered our third quarter performance very well and our press release had an extensive analysis of the current status and trends in the commodity markets.

With these as referenced, I would like to take a few minutes to tell you where we see the markets going and how we are going to position Joy Global to derive maximum value. The big two market factors for us of the decline in U.S. coal and continued slow in China.

The U.S. coal market has played out pretty much as we had projected. Everything is correct a little faster than we had expected. Coal exports have continued to be strong and coal has taken back some power generating market share as natural gas prices moved above $2.50. The combination of these factors supported an increase in coal production for the first time in six months during July.

This indicates that U.S. coal has reached bottom. The upside is for natural gas prices that are expected to continue moving up based on the forward strip and the analyst forecast and therefore economics will progressively see coal recover some, but not all of its sheer power generation in the U.S.

We continue to expect older coal-fired units to be retired even with the recent court ruling and eventually they will be replaced as natural gas units are permitted and built, which takes years. Until then most of the excess generating capacity is now in coal-fired units which should provide some additional upside.

Overall, we see the U.S. Power generation market to be structurally limited with longer term upside to the U.S. coal market coming from exports. This has changed in the U.S. market for us. Investments in the west coast port facilities will give PRB coal access to the pacific seaborne market and expansion of Gulf Coast ports and the widening of canal Panama Canal would benefit the Illinois basin.

Conversely, we do not expect lost production from Central Appalachia to come back and this region will increasingly rely on met coal. This is very consistent with the investments that our U.S. customers are making. They are investing heavily in expanding port capacity mainly on the western Gulf Coast and investing in lowering their freight cost by expanding lower cost long-haul operations.

The impact for us will be two-fold. First, we need to size our U.S. underground business for a market that will be structurally smaller going forward. Secondly, we need to prepare for shipping production volumes from Central Appalachia to the Illinois basin and from newer pillar to long-haul equipment.

Trying to held up fairly well in the first half of this year, but this deceleration has the surface in last few months. Although the U.S. coal market moved as expected, we were surprised by how quickly and deeply the China effect has been felt.

Fixed asset investment, industrial production and electricity demand have all slowed through around half their prior year's growth rates. Steel output is up 2% over last year, but all of that occurred in the first half and steel production has since been essentially flat.

Most recently, we have been encouraged by signs of China stabilizing. The domestic coal stockpiles at the Qinhuangdao transfer point have come down 25% since early July, and this has lead to modest recovery in coal prices. Domestic production restriction opposed by Beijing will result in more moderate, but more sustainable production going forward.

The long-term outlook for the emerging markets remains very much intact. With seaborne and commodity markets will continue to benefit strongly from the industrialization of China and India. For example, there is almost 375 gigawatts of power generating capacity under construction worldwide with 90% of that in developing Asia.

90 gigawatts will come online in the next year and add 300 million tons to coal demand. Recent events indicate that China is a high cost producer of iron ore, thermal coal and met coal and this provides the base for long-term growth of the seaborne demand. India has also increased its dependence on seaborne coal, because its production repetitively for sales to make its targets.

Despite the long-term positives, we must first work the near-term softness. Growing China demand has moved all the commodities toward our entry supply surplus, we have supply now chasing demand prices have been pushed down this year up to 30% or more. This has reduced customer cash flow in the resource exporting countries, which are major markets for us.

With cash flows down in supply and surplus, customers are rationalizing their mine expansion projects. Budgets underway are proceeding, but the next projects are being reevaluated. Customers are reporting that the extra round of engineering and planning our improving project economics.

As a result of this process, new projects are being slowed and the pipeline will be getting smaller, but more viable, but to be clear new projects are continuing to move forward. In fact, we are heavily engaged in four projects which we expect will become equipment decisions in the next few months.

Although we believe that commodity demand has reached bottom, finding of the upside of the remains uncertain and as a result we are adjusting our business to be aligned with current conditions. We need to reduce our cost base, simplify our organizational structure and improve our leverage to the upside.

We have already been working on streamlining our organizational structure and its related cost via the One Joy Global initiative and that will take on added importance going forward. We also need to adjust to major shifts in our markets. Although we will get a net cost reduction it will be the result of more significant reductions in some areas offset by increases where we have upside.

We've been doing extension scenario planning and we'll beginning implementing those plans in our fourth quarter. The first stage will be volume based cost reductions with the heaviest exposure in the U.S. We will incur up to $20 million of restructuring cost in the fourth quarter to take $40 million out of our annualized cost in fiscal 2013. The payback on these reductions are expected to average about six months.

The second phase will occur in our fiscal 2013 and is effectively accelerating the implementation of our longer term operation strategy and will involve facility rationalization. We will integrate and consolidate processes across our global factory network and we'll increase concentration and lower cost operations.

These actions will serve us well in a range of market outcomes. They will enhance our leverage to be upside in the best case and they will make us a stronger and more efficient business if current market conditions persist.

Now let's refocus on the near-term. We expect our revenues to be up in our fourth quarter from the third quarter. This incorporates weaker market conditions that are affecting aftermarket order rates which are mostly booked and shipped in the same quarter and we expect aftermarket revenues to be flat in our fourth quarter.

In addition some of our original equipment shipments are behind schedule and may not make the fourth quarter. Some of this is due to subcontractors that are late, and some is due to additional changes that are requested on some new product introductions

As a result, we now expect our fiscal 2012 revenues to be down another $100 million from our previous guidance. We are also narrowing our guidance range for the year.

We now expect fiscal 2012 revenues to be between $5.450 billion and $5.550 [million]. Adjusted for expected decremental margins and rounding we now expect earnings per fully diluted share for our fiscal 2012 to be between $7.05 and $7.20. This does not include the $20 million of restructuring cost, which will reduce reported earnings by another $0.13 per share.

With that overview, I'd like to turn the call back to Brian for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). We will take our first question from Andy Kaplowitz with Barclays.

Andy Kaplowitz - Barclays

Good morning, guys.

Mike Olsen

Hi, Andy.

Andy Kaplowitz - Barclays

Mike, can you talk about your 2013 revenue guidance in a sense that you are guiding flat to down slightly. What kind of order rate does that entail? How much of the revenue next year is already in backlog if there is anything you can give us there, and can you still get book-to-bill close to 1 in this environment?

Mike Sutherlin

Mike is kicking me under the table about 2013 guidance. We don't really have specific guidance for 2013, but there are some implications as you look at our recent order rates and cost reductions and number of things. We are expecting our 2013 to be a more difficult year for us, and we think it will be flat to down slightly, when I say slightly probably single-digit range still at this point.

Our second and third quarters, our bookings have not included any major projects which is very unusual for us. It's not that they are not major projects in the pipeline, but customers are just being more and more methodical and as I said in my comments, we've got four projects that we are actively working on and have been working on, and they are getting closer to decision phase right now.

What we see in the pipeline are some projects that are more viable projects will stay in, but it will be a lower number than we have been looking at historically, so as we look at our recent order rates, second quarter order rates probably was a good reference point. Third quarter order rates are down a little bit from the second quarter.

Some of that is a dip effective particularly in the U.S. as we take production out of the U.S. asking the customers will naturally deplete some parts that they hold at mine site in that depletion of those parts inventory at mine site takes parts down another notch for a quarter or so and then it sort of normalizes a little bit higher level.

If we look at that average and we expand that out to 2013 and we add some projects to that, that's how we get to those within single-digit range of what we are looking at for 2012, and that's the way we are looking at our business today.

Obviously, 2013 will involve some backlog depletion. I don't have the backlog numbers, but I think we're carrying about 60% of 2013 in backlog and expect to be in backlog at the end of year, so a good portion of that and not so much on aftermarket and carry about six weeks of aftermarket, so you can sort of adjust that for the original equipment versus the aftermarket so we have quite a bit of backlog going into 2013.

Right now, we are more worried about the upside. As we look at 2013, the upside is a bigger factor, because of that backlog and the run rates we're seeing right now we feel pretty good that we are going to be within striking distance in 2012, but don't see any catalyst for upside until we see some more strength in the end use commodity demand.

Andy Kaplowitz - Barclays

Okay. That's helpful, Mike, so Mike is going to kick you again probably for this, but I'll try and ask in a way that you can answer it, so when you look at '13 and you looked at you're going to get $40 million from this year's restructuring, how do we think about margins?

It seems like margins should be resilient in that type of atmosphere we have flat to down slightly revenue, but should we think about decrementals under 30%. If you are going to have revenue decline, like, how can we think about margins into next year?

Mike Sutherlin

I'll give you just overview and I'll let Mike give you more specifics, but in 2008, 2009 at that adjusted period from '08 to '09, we held the decremental margins in 32% to 34% range, but we believe that that's the right thing to do and that's our planning range right now.

Some of that requires restructuring cost to keep those decremental margin in that range so that's excluding the restructuring costs associated with that. Part of the reason we have those kind of decremental margins, as we really, really believe we are going to get some good revenue growth not in the next quarter but in the next few years out of some new product development programs we have underway and we really want to maintain those, probably we think it's important for expanding our product line and adding streams to our top line. That somewhat limits the amount on the decremental side and we think that's an investment in the future.

As we look at our margins, we've just done a really, really good job during 2008, 2009 and holding in our margins during that period, we stuck to our guns that we would be very consistent and predictable with our customers, so our plans, our expectations are not to see overall margin degradation in our products.

We think that products delivery great value. They are well priced, we want to hold where we are right now. We may not get a lot of large price realization in 2013 that maybe down to like decimal points of price realization, but we don't plan or foresee giving any margin away either so, Mike, unless you want to give a little background.

Mike Olsen

Yes. I think, Andy, as we look to manage the business, we manage the business very strictly on incremental profitability and decremental profitability. The actions that we are taking in the fourth quarter to take about $40 million worth of fixed cost out and that fixed portion is actually important, because there will be variable costs that will in fact come out if there are some softening in volumes, but $40 million that we've targeted are in fact structural fix cost.

As Mike indicated, we believe that there are programs that are very, very important for the future growth of the business, so as we move into an uncertain market what we want to do is, we want to make sure that we position ourselves in a cost structure perspective to be able to continue to fund those projects for a product development and aftermarket service.

We would anticipate as we go into 2013, that we would continue to manage 25% incremental profitability and about 32% to 34% decremental profitability, and also be in a position to continue to fund the projects that will drive future growth.

Andy Kaplowitz - Barclays

Okay. Thank you, guys.

Mike Sutherlin

Thanks, Andy.

Operator

We'll take our next question from Schon Williams with BB&T Capital Markets.

Schon Williams - BB&T Capital Markets

Hi, good morning.

Mike Sutherlin

Hi, Schon. Good morning.

Schon Williams - BB&T Capital Markets

I wonder if you could just give us some, you gave earnings guidance, could you give us some guidance on may be free cash flow for the full year including the pension contribution? Maybe as a follow-up to that, just to maybe give your thoughts on CapEx spending as well looking at spending $220 million this year. Could you just talk about what your thoughts are on CapEx going forward? Thanks.

Mike Olsen

Yes. If you take a look at where we are on our free cash flow at the end of nine months for the 2012 fiscal year, we now are approximately $100 million worth of free cash flow. Our cash flow historically throughout the year has experienced lumpiness. Some of which is associated with where investments in inventories are going, what's happening with the advance payments and so forth.

We've early on had talked about free cash flow in that $300 million range. Our view currently is that free cash flow will be in the range of $250 million, may be slightly above that for the full year this year. We would expect that our capital expenditures would be about $220 million this year, and that free cash flow would be after a reduction for pension contributions of about $180 million.

Now a significant portion of those pension contributions are voluntary. We have both, our U.S. and U.K. pension plans in very favorable funded position. We have a strategy to get the U.S. pension plan fully funded by about this time next year. Once that takes place, there will be in the order of magnitude of $75 million plus worth of contributions that will no longer be required, so our outlook for this year does in fact include the $220 million of CapEx, plus a $180 million worth of voluntary pension contributions.

Schon Williams - BB&T Capital Markets

Where are we adding just in terms of the CapEx spend? I mean are we in the sixth or seventh inning in terms of some of the build-out? I mean is Tianjin largely as far long as you would like and maybe some of the service center build out. Are we 60% of the way there or 75% of the way there or is there still. I am just trying to get a sense of where we are in terms of the build out plans?

Mike Sutherlin

I think we are past the halfway point. We've got a couple of factors that are playing into this. If we looked at our business, we have about $100 million of CapEx that keeps the business sustainable at a given level and there is some CapEx there for normally priced, but there is also some CapEx to drive things like OpEx programs and things like that but that have improvement impact on the business.

As we get above the $100 million, that additional CapEx is in two categories. One is catch-up for under capitalizing that business historically and that's largely in all service centers that needed to be upgraded or expanded. Then the other part of that is just on growth, so as we look at slower growth environment, we'll naturally begin to pull back our overall CapEx numbers to reflect that.

We had to upgrade service centers in Mesa, Arizona because guys were doing structure welding outside in 110-degree heat. We are putting a new service center in Minnesota Iron Range, because guys were outside doing structural welding in three feet of snow, so we just have had historically some facilities and our guys did a wonderful almost amazing job of making those work despite the pathetic conditions of the facilities we are in.

We have been systematically going there and cleaning those up and upgrading those to first-class facilities in those regions, so some of it is growth, some of it is catch-up. The catch-up, I mean, we are getting probably ending with something on the facility catch-up part of that, and then it will be driven by growth.

As we look forward in our business, we expect CapEx to come down to probably 150 million on an average basis as we get to Tianjin Complex completed and we got a couple more and the service centers finished that we have underway like in Russia and India, and we will see about $150 million is probably more of an average CapEx level.

Schon Williams - BB&T Capital Markets

All right. Thanks, guys.

Mike Sutherlin

Yes. Thank you.

Operator

We'll take our next question from Eli Lustgarten with Longbow Securities.

Eli Lustgarten - Longbow Securities

Good morning, everyone.

Mike Sutherlin

Hi, Eli.

Mike Olsen

Good morning.

Eli Lustgarten - Longbow Securities

Can we talk a little bit about the magnitude of the projects as you keep referring to is as some of your bigger projects and can you talk a bit about the pricing environment of those projects that you got to believe you've kind of commented pricing is getting little bit fine tuned on these programs?

Mike Sutherlin

The projects we are working on and I won't go into too much detail, but we are working on projects right now. A couple of the projects are in Australia. One is actually in the U.S. and one is in South Africa. They are all in coal operation, some thermal, some met coal and these have been on track and moving forward they are core parts of our customers' expansion or upgrade another portfolio.

We as a company have really focused on making our pricing predictable and with our customers we are really pretty transparent with them on pricing and how we arrived with that. We are not a company that tries to keep our prices high and then came in at the last stage of that project, we've given good pricing at the front end and stay with that and that predictability I think has helped our credibility and reliability perception with the customer.

On the projects we are working on, as our customers picked at better projects and look at the projects driven by value enhancement and productivity improvements, they tend to focus much more on the better equipment. The price point goes away, because we are looking at the contribution of equipment gives to their operating cost, and in those environments, we actually really well.

We are moving into an environment where the value proposition is a stronger element of a project economics and it works in our favor, so we are not seeing, nor do we expect us to have to go in a do a deep discounting in breakeven pricing just to get volume into our business. That's not the way we are looking at the market and that not the way we want to run our business either.

Eli Lustgarten - Longbow Securities

You have a rough magnitude of these projects. Is it $0.5 billion worth of projects? I mean, what would be the magnitude of these looking at.

Mike Sutherlin

If we total them up it probably, that or a little bit higher sort of in that range.

Eli Lustgarten - Longbow Securities

Okay. Probably to follow-up, you are taking $20 million of restructuring in the fourth quarter. Can you give us some sense of what kind of magnitude we should expect in restructuring in 2013? Decisions doesn't matter, but are you looking four times, is it $80 million or $50 million, just some magnitude of what kind of programs we should be looking at as you sort of right-size the corporation?

Mike Sutherlin

The 2013 numbers that we are looking at today are $25 million or a little bit higher maybe. A lot of this we've had in our strategic plans, the next step of operational excellence is to get more integration of certain processes in more critical mass around those processes in our factories as we move to standards of technical excellence.

Our ability to do that in some market conditions we've been concerned, because we just pull out of production. We didn't have the breathing room to be able to start to make those moves and these moves require puts and takes that you got to have some little excess capacity to work with.

As we look at 2013, we see a window that allows us to accelerate and move forward on these projects, so part of the spend level in 2013 is staying within that window that gives us that working room.

We obviously don't want to overload the organization with these projects to the point that we don't get the quarters' or the years' numbers made, so we are trying to balance that out, so that's what gets us to that 25-ish kind of number. 25 maybe little bit more kind of number, and we feel that that's doable in 2013.

We think that it can be done without being a distraction to the day-to-day running of our business and making revenues for our investors and making leverage for our customers, so that's the range we are looking at right now.

Eli Lustgarten - Longbow Securities

Okay. Thank you.

Operator

We'll take our next question from Jerry Revich with Goldman Sachs.

Jerry Revich - Goldman Sachs

Good morning.

Mike Olsen

Hi, Jerry. Good morning.

Jerry Revich - Goldman Sachs

Can you gentlemen say more about you expectations for the aftermarket business heading into 2013? I guess within that context it was surprising to see the U.S. underground aftermarket business up this quarter, despite the production cuts. I am wondering if you could just talk about the drivers there as well.

Mike Sutherlin

The U.S. aftermarket was up, but we are now looking at revenues. If we look at bookings, the U.S. aftermarket was down and sort of consistent with the decline in production in the U.S., so, we will see that order rate decline roll into revenue decline in the third quarter and then we got to look for other markets to make up that difference.

Certainly we continue to see strength in a lot of the international markets. We saw overall in our third quarter that the international markets made up most but not all of the decline in the aftermarket bookings from U.S. coal market, so we probably will be sort of around that. We will see the aftermarket flattish maybe a little below, but maybe a little above here for a couple of quarters until the U.S. market begins to normalize and we start to see a little bit more gain back of coal for power generation or a little bit more momentum in the export markets.

Jerry Revich - Goldman Sachs

Mike, can you say more about the major restructuring actions what we should expect for 2013, if you could just give us context for which regions we should be thinking about you right-sizing, obviously, outside of the U.S. and just touch on the level of in-sourcing that you have today versus six months ago and where we should expect that to be 12 months from now?

Mike Sutherlin

The facility issues are probably not something we want to get into a lot of detail. They are delicate issues haven't actually made final decisions on. We are still looking at some of the final decisions certainly haven't been specific with our own people on those issues, but generally thematically, we talked about moving in the directions where we see our market growth coming and you look at seaborne markets and you see so much of a growth coming out of developing Asia and we will continue to move our focus in that direction.

More importantly right now is that we want to get more leverage out of our operational excellence programs and the way to get leverage is to move toward centers of technical excellence and I'll give you a couple of examples.

We make gearing components, transmissions in four, five different factories around the world and we don't get the economy of scale, nor do we get the level of testing, support and building trades like database that we use for our commission monitoring and things like that, so the ability to make those investments and to invest in the processes to improve the cycle time in our processes gets limited because we've got to make those investments in five different facilities. So as we begin to look at centers of technical excellence, we get a concentration of the gear manufacturing processes, we are able to make the investments to speed the processes up, improve the after assembly test and things like that.

That's going to do a lot for our business in the near-term and long-term. Then we can make a couple of other examples like controls, the controls we use on our machines as well, so there is a number things that are in that center of technical excellence category.

It's not automatic, that those centers of technical excellence will be moved to the emerging markets, so there is a balance between concentration where we have critical mass, expertise and conservative, low production cost and also beginning to move our footprint in the direction where we see the longer term market growth, so that's where we are looking at, so that it barge out much granularities you like, but that's as much as we want to go. Then you're going to, Jerry, remind me what the second part of your question was?

Jerry Revich - Goldman Sachs

Yes. Thanks, Mike. The second part was on in-sourcing. Where do you see that going over the next 12 months?

Mike Sutherlin

In 2008 to 2009 we started with about 35% of our production hours. We outsourced and that number came down to below 20%. As we finished the second quarter we were at 30% or 32% outsourcing and that Mike, I'll have to ask you where we are now, but that will come back down as we see production rates fall, that outsourcing will come back down in proportion we expect that to come down into the high-teen's ranges again. Probably it will take a couple of our quarters for that to happen.

Jerry Revich - Goldman Sachs

Thank you very much.

Mike Olsen

That's consistent. What in fact happens with that cycle of that outsourcing is, as the volumes ramp up we use that that outsourcing strategy to insert a variable cost element into our product cost structure, and so as volumes come down and we utilize the reduction in that outsourcing to eliminate and mitigate the adverse impacts of the lost manufacturing overhead absorption.

Operator

We'll take our next question from Ted Grace with Susquehanna.

Ted Grace - Susquehanna

Hi, guys. Just as a point of clarity on Eli's question about restructuring next year. I just want to be sure we understood. There could be an incremental $25 million or plus of restructuring taken again next year and that has a six month payback?

Mike Sutherlin

The next year's numbers, because they are going to involve facility consolidation and things like that, that's probably going to be more of a nine-month pay back. I think, we had that in the comments I think it is nine months on average, so two things you have to look at.

One is, the $20 million that we will work on right now will occur largely in our fourth quarter and may not get all of those, but we'll get most of those in the fourth quarter. We'll get a six-month pay back on the savings and so we expect to see those savings primarily in our first half of 2013.

The 2013 restructuring will be spread over the course of the year, and therefore the savings on a nine-month payback cycle will spread into 2014, and you will see most of the savings in 2014, but again spread mostly over the year rather than concentrated in a quarter or even in the half.

Ted Grace - Susquehanna

Okay.

Mike Olsen

The other thing that's important to realize, as you begin to look at facility actions, there could in fact be some non-cash charges as fixed assets are written down. The $25 million or so that we referred to have are really related to cash costs associated with those actions.

Ted Grace - Susquehanna

Okay. That's very helpful. What I was hoping to jump beyond was the balance sheet, and just looking at kind of the receivables and the inventory lines and trying to adjust for the acquisitions but I was just wondering if you could speak to how working capital levels are tracking versus planned?

Two, any issues that might be driving kind of elevated levels, whether those are kind of a new normal or more transient nature and just kind of tying it back to 2013, and I know you are not giving explicit guidance, but at least thinking about working capital as a source of use of funds. Color on those three issues would be great?

Mike Olsen

Yes. I think what you want to think about is, as you look at our working capital from the legacy businesses, over the last quarter or so we've begun to make some headway in connection with inventories.

As the business ramps up during the second half of 2011, and the first quarter or so of 2012, there were significant increases in inventory in anticipation of those increases in sales. The legacy businesses do a good job of managing accounts receivable and we expect that to in fact continue.

We do in fact begin to see a modest improvement in inventory management, but keep in mind, this is a very inventory-intensive business and customer service levels are significantly important as it relates to keeping that equipment operational 24 hours a day, seven days a week and that actually becomes a fairly significant barrier to entry into our business, so we will improve inventory management, but it will in fact be a gradual process.

Relative to the acquisitions, IMM will present a challenge for us on the accounts receivable side, we have teams established addressing that issue and we anticipate making progress there, but in China in general, receivables are an issue.

In LeTourneau, we expect that their inventory and receivables will in fact be consistent with the management that we see on the surface business. Going forward, if you look back over history, our business from the working capital perspective has in fact been able to generate cash both, during periods of increasing market conditions and also softening of market conditions, and really the big swing factor has been the advanced payment that helped to fund some of the working capital growth when the markets are increasing and then the receivables in inventory cash flow helps to mitigate the softening of advance payments when the market are softening.

We pay a lot of attention to working capital management. In fact, the key element of the variable performance based compensation of every person in the company is driven off of that inventory management, so it gets a lot of management attention.

Mike Sutherlin

Just a point of clarification, we do have long receivable collection times in China, because of the customary way that that market has run for both, IMM in that mid-tier market, so we do not have bad debt exposure. They have had remarkably good track record on not having any bad debt exposure with that.

As we look at our business going into 2013, we will get some natural reduction in inventory as we tapper our production levels of debt and that will naturally happen and we probably believe that we have around $100 million of inventory that needs to come out.

There is stuff that's, we got the some new product stuff that's waiting on some final modifications to go to the dealer or a few things like that that some of that is normal course of activity, some of it is little bit heavier than we would otherwise think, but we do believe that we have inventory that needs to come down over and above the volume effect.

Ted Grace - Susquehanna

That's super helpful. The last thing I just want to ask on related basis is, have you seen any change in bad debt expense that we should be aware of? I know that there have been Patriot's bankruptcy and just to the degree there is anything that's embedded in the margins, it would be helpful for us to pull out that would be great and past dues on a related basis?

Mike Sutherlin

I'll let Mike get there, but we benefit from being a highly critical supplier in these situations, so that's helped us over the years and I think it helps us right now, but Mike can give some detail where we are right now in the marketplace.

Mike Olsen

Yes. Knock on wood. We've been very, very fortunate relative to our bad debt experience really as long as I can in fact remember. We manage our relationships with our customers, we stay close to our customers, we understand when they are getting into situations, where there is increased exposures when they get into situations where they are going through reorganization processes. We worked very closely with them to make sure that they are successful in that reorganization effort.

As Mike indicated, we are typically included in the very top of their critical vendor list, and so we anticipate that bad debt expense will continue to be a very, very minimal impact on our business.

Ted Grace - Susquehanna

Okay. That's very helpful, guys. Best of luck this quarter. We'll talk soon.

Mike Olsen

Thank you.

Operator

We'll take our next question from Seth Weber with RBC Capital Markets.

Seth Weber - RBC Capital Markets

Hey, good morning, guys.

Mike Sutherlin

Hi, Seth. Good morning.

Seth Weber - RBC Capital Markets

I wanted to focus on China for a little bit. The weakness in the IMM revenue and the margins there. How much of that is market? How much of that is competitive pressure? I was interested to hear. It sounds like the Australia bookings were relatively good in the quarter, so I'm just trying to figure out what's going on regionally over there?

Mike Sutherlin

There is an interesting phenomenon going on in China. We have seen and continue to see imports up in China, and industrial production is down, the economy is slowing, fixed assets investment is down, electricity demand actually went down in the second quarter. We saw electricity demand in China down from the first quarter a bit, so on a sequential basis, we saw softness in electricity demand.

That's actually picked up pretty nicely in the month of July, so from the second quarter, the first month of the third quarter they have had a good pickup in electricity demand, but because of all that we saw stockpiles build up at Qinhuangdao, which is the port at which they transfer production from the North and West and barge it down to Shanghai area where the population centers are.

As a result, the imports continued on, we saw as the prices came down below $100, it actually strengthened the imports and then you gave us a pretty good data point on where the domestic price levels are versus imports and the competitive advantage that imports have at lower price levels.

Also, we saw product come offline before it was mandated by Beijing, and it also tells us that some of that production is high cost volume, so we see in the seaborne markets right now because of oversupply Australia has got some production back online, the U.S. has excess production looking for the home in the seaborne markets, because of that and because of slowing electricity demand we ended up with supply surplus in China, and that demand reduction has affected the local domestic market and it affected IMM.

I am not aware of any change in competitive factors as much as just the volumes have come down, and everybody has cut back production in the second quarter as those stockpiles built up. The outlook right now is for that the stockpiles have come down by 25% to sort of back down to normalized levels, price levels have come back up, so we feel pretty good that that things are going to sort of get back to normal, but we also believe that the domestic production in China is probably going to see growth rates in the mid-single digits rather than 9%, 10%, 11% growth rates are probably going to be more like 4%, 5%, 6% year-over-year growth rates in coal production.

Seth Weber - RBC Capital Markets

Then in a more of a normalized environment, do you think that IMM margins can get back to that low-to-mid 20% range?

Mike Sutherlin

There are two things. I think we are working on IMM. One is, yes, we do. I think we can, but those margins require volumes, so as the volume comes back to where it was, we can get those margins back, and obviously there is incremental margin improvement on top of that.

We have a series of programs we are working through with IMM. One of those is a technology transfer to upgrade their products and sort of drive them down the path of higher performance, higher price hike we have with our other products.

That's not normal in that mid-tier market in China, but we think we can make some gains small at first and build momentum, so looking at operational excellence programs to improve the efficiency and lower cost in their factories and we are also working with them on how to build a more direct aftermarket infrastructure which is a big part of our overall profitability in our other global businesses.

We think that there are ways we can improve revenues and improve profitability in IMM despite the market and certainly if the market comes back, we end up with a higher base that we are working with and have lot of programs, but the expectation is reducing their cost and improving their profitability and we want to use that to gain market share and then the volumes we get will be given to us by the market and we think that those will come back in the second half or mostly come back in the second half.

Seth Weber - RBC Capital Markets

Second half of next fiscal year?

Mike Sutherlin

Second half. Calendar year second half.

Seth Weber - RBC Capital Markets

Second calendar? Okay. Then I guess if I could just follow-up, your comment about some of the OE shipments were behind schedule it sounds like my interpreting is stuff got pushed from 3Q to 4Q or stuff is moving forward?

Mike Olsen

Yes. Part of our revenue adjustment that we made in guidance part of that was in 3Q. We had some stuff in 3Q that didn't make the delivery schedules that we had set, so not all of that that $100 million reduction is spread between the third and fourth quarters, again to our own internal plans and expectations.

Seth Weber - RBC Capital Markets

Some of it just goes what goes out of this year then?

Mike Olsen

Some of it we won't catch-up in time. We've had some problems with some subcontract vendors. We've had some problems with some sub contract vendors, we had to do some rework on some of the stuff and as a result of that we are making changes in those vendors and some of that's just going to delay some of the equipment delivery.

Some of it is new product stuff that we have going into some of our customer application as we get those things to mine site, there is always fine-tuning and adjustment that has to do on just because of the new installed equipment and how they fit into the mining operations.

Together those things are creating some delays in the original equipment revenues streams for us right now, and that had bled from the third quarter into the fourth and some of that will bleed from the fourth quarter into next year, but that's all included in that $100 million reduction in revenues that we adjusted guidance for.

Seth Weber - RBC Capital Markets

I got it. Okay. Thank you very much guys.

Mike Sutherlin

Okay. I think we are pretty much on top of that hour with that, but Mike is saying he's got one items he wants to correct and then we will have just a quick closing comment.

Mike Olsen

Yes. I want to make sure that I may have misspoke when I talked about the items that were adjusted from backlog in the second quarter.

Of the $119 million worth of backlog adjustments from the second quarter, there were $38 million of those items that actually were shipped during the third quarter. I may have inadvertently said, $68 million, but there were $38 million worth of those items shipped in the third quarter, and just want to make sure that there is no confusion there, so I apologize for any confusion. Thank you.

Mike Sutherlin

Okay. Well, thanks, Mike. As we close, we are moving through weaker market conditions, but as we do I just want to remind you that at Joy Global we have backlogs in aftermarket that are really pretty significant stabilizing factors for us and we saw that demonstrated in the 2008, 2009 period.

We believe our operational excellence programs have delivered some really good cycle time reductions and it makes us a more responsive and adaptive business and that's very important as we go through market changes. Then we also believe that we've seen markets begin to bottom out or stabilize particularly in the U.S. and China the commodity end markets will begin to shift their focus to the upside.

As a result, we continue to believe Joy Global remains as an attractive investment mechanism, and I will thank you guys for being on the call and look forward to giving you a longer term view of our business at our Analyst Day at MINExpo in September. Hope to see you there. Thank you very much.

Operator

Ladies and gentlemen, that concludes today's conference call. We thank you for your participation.

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