Joy Global (JOY) is a manufacturer and servicer of high productivity mining equipment for the extraction of coal and other minerals and ores. The company operates in two business segments:
- Underground Mining Machinery
- Surface Mining Equipment
In addition to original equipment, Joy Global also manufactures aftermarket parts and provides services for both underground and surface mining and certain industrial applications. Its equipment is used in major mining regions throughout the world to mine coal, copper, iron ore, oil sands, gold and other minerals. Similarly, the company is also a major producer of surface mining equipment for the extraction of ores and minerals and provides extensive operational support for many types of equipment used in surface mining.
Financial Highlights:
For the fiscal year ended October 25, 2013, the diluted earnings per share were $4.99, substantially down from the year 2012 when those were $7.13 per share. To add insult to the injury management's guidance for fully-diluted EPS for fiscal 2014 is in the range of $3 to $3.50 before restructuring cost and other unusual items. The year 2013 was particularly rough for the company where the price of commodities such as coal (the company's main driver for revenues) was down more than 30%. The company took a restructuring charge of about $33.6M and an intangible asset impairment charge of $155M related to some prior acquisitions. Operating performance from its business segments is shown below:
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As you can see, the operating income is down almost 30% from 2012 and net income per diluted share was down by a similar percentage. For the year, cash from operations totaled $639 million and included $166 million of pension contributions. Adjusting for pension contributions, cash from operations for the year was very strong at just over 16% of sales. With the company's pension plans now approaching fully funded status, the go forward discretionary contribution rate is expected to be less than $50 million per year in the next few years. Capital expenditures were $36 million in the fourth quarter, compared to $72 million last year. The year-over-year decline in CapEx is primarily due to lower OE-related growth spending in China. The company had an early start in realizing that it needs to cut costs and started closing down its less productive facilities throughout the world. These actions, which included additional headcount reductions, in combination with the actions taken earlier in the year, are expected to deliver incremental savings of $60 million in fiscal 2014. Below is the comparison of the company's two years performance on various metrics. (Please note that aftermarket revenue was slightly more than original new equipment sales in 2013).
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The good news in all above is that the restructuring has allowed the company to become more efficient by eliminating duplicate processes and redundant job positions in its various divisions. Also combining surface and underground into one business allows focus on the same customers. The company has made cycle time improvements that are enabling it to turn a higher percentage of orders into revenues in the same quarter. The company has improved on-time delivery, while reducing inventories, which increases both customer service and cash flow. While the company is maintaining these cost cutting efforts, it is continuing its important R&D programs that will add long-term value. (R&D spend in 2013 was $49M).
The company's stock price has been hammered in the last two years where it once was about double of what it is now. Since the company derives almost 72% of its revenues from Coal related mining, no wonder its stock seems to move in lockstep with Market Vectors Coal ETF (KOL), see chart below:
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Headwinds:
The company has faced many headwinds recently including a glut of inventory that its customer has accumulated which resulted in delayed servicing and maintenance of equipment. The company stated that many of its customers purposely prolonging scheduled maintenance on their equipment due to sluggish sales. There are many concerns on investors' minds relating to the use of Coal as an energy generating product.
Approximately 62% of the company's revenues comes from its thermal and metallurgical coal-mining customers. Many of these customers supply coal for the generation of electricity and/or steel production. The pursuit of the most cost effective form of electricity generation continues to take place throughout the world and coal-fired electricity generation faces intense price competition from other fuel sources, particularly natural gas. Coal combustion generates significant greenhouse gas emissions and governmental and private sector mandates to reduce greenhouse gas emissions may increasingly affect the mix of electricity generation sources.
Further developments in connection with legislation, regulations or other limits on greenhouse gas emissions and other environmental impacts or costs from coal combustion, both in the United States and in other countries, could diminish demand for coal as a fuel for electricity generation. If lower greenhouse gas emitting forms of electricity generation, such as nuclear, solar, natural gas or wind power, become more prevalent or cost effective, or diminished economic activity reduces demand for Steel, demand for coal will decline. Reduced demand for coal would result in reduced demand for Joy Global's mining equipment and adversely affect its business and financial condition.
Since extraction of oil and gas has been on the rise via "fracking," and natural gas being so cheap recently, there is a lot of hoopla that someday natural gas will completely overtake coal for generation of electricity. Also, there is a lot of concern that coal plants pollute the environment while natural gas is a clean alternative for the environment. So it seems to be a win-win from every respect to switch to natural gas, which is not only cheaper but a cleaner source of energy. The glut of natural gas unleashed by hydraulic fracturing - and the resulting low prices - makes it seem like a no-brainer: Ditch coal-fired electric plants, with all their baggage about air pollution and water consumption, and switch to natural gas. Many states have taken this initiative and this clearly is the reason in the continuous decline of coal prices. The presumption here is that one day, natural gas will completely overtake coal fired plants.
We beg to differ!
Although it's true that many companies have switched to natural gas, there is built-in infrastructure, which would ensure that coal-generated electricity is likely to remain a substantial part of the US grid system for years to come. Joy Global is increasingly servicing its revenue internationally. In fiscal 2013, 2012 and 2011, approximately 61%, 59% and 54%, respectively, of the company's sales were derived from outside the United States. Consider the fact that more than 60% of sales now comes from China and rest of the world where more than 80% infrastructure is coal based and this percentage of international sale is on the rise with burgeoning Indian and other Asian economies. Examining further the production of natural gas by fracking methods, it seems that the life of a particular operation is only 2 to 3 years. Thus, new wells are needed to be dug continuously for maintaining production and keeping a constant supply. With this slight bit of uncertainty about Natural gas production, nobody is going to tear down half a billion coal plant to put in a new natural gas plant just to save a few extra bucks, even if the company happens to be an environment champion.
The below chart is a clear indication of increasing imports of coal in China and India, both of whom are structurally dependent on imports as opposed to the rest of the world.
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Furthermore, in the US , this issue of using coal vs. natural gas has taken a political turn as well as House of Representatives passed "Stop the War on Coal ACT," which was aimed at blocking Federal regulations that could affect coal mining and highlighting differences of conservative Republicans with their more liberal counterparts, the Democrats.
Acquisitions & backlog:
The company is positioning itself well for a turn-around in its business with strategic purchases especially in China. For example with the acquisition of "LeTourneau" for $1.1B in 2011, the company was not only able to gain accretive income from its operations but also sold off the drilling product business of LeTourneau for $375M in cash.
Similarly, Joy Global acquired International Mining Machinery (IMM) in late 2011, which is a leading designer and manufacturer of underground coal mining equipment in China. The results of operations for IMM have been included in the financial statements from Dec 29, 2011 forward as part of the Underground Mining Machinery segment.
As of Oct 25, 2013, the backlog for the company was about $1.5B. Of this total backlog, approximately $346.6 million is expected to be recognized as revenue beyond fiscal 2014.
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Management:
We think that the company's management is fairly seasoned with all senior managers being with the company for more than 10 years on average. CEO Michael Sutherlin assumed his role in 2006 from John Nils Hanson (who remains as chairman), but will retire by February 2014. Edward (Ted) L. Doheny II, has been elected President and Chief Executive Officer of the Company in accordance with the Company's previously announced executive succession process. Sutherlin's compensation for 2013 was about $7M that includes direct compensation as well as stock awards and seems reasonable to us. We also like the fact that CEO and Chairman of the board positions are separately held that avoids conflicts of interest. The compensation of the executive management is tied to various metrics such as return on invested capital and return on working capital, which is a good indication in our opinion. Overall incentive structure is based on long-term performance rather than meeting short-term goals. We like the fact that the firm's recent $1 billion share-repurchase announcement comes at an opportune time, given market prices below our fair value estimates.
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Valuation:
Joy Global is trading around $52.90 as of this writing. The free cash flow analysis shows that Joy Global is cheap on FCF valuation basis alone. In the below analysis, we take actual numbers as reported at the end of fiscal year 2013 and then use greatly reduced forecasts as put forth by the management for the year 2014. So you can see that we use $5.01B of revenues actually achieved in 2013 but use the mid number ($3.7B) per revenue guidance from management, with expected revenues falling anywhere between $3.6B and 3.8B in 2014. Also considering various indications that management has provided during Goldman Sachs Global Industrials Conference in November 2013, we will assume growth of 6% for 1st five years and then growth of 5% for the next five years and finally assume 3% perpetual growth going forward. We think these numbers are reasonable and rather conservative as global economies are going to grow in the long term and Chinese dependence on coal for power generation is not going to diminish anytime soon. So let's see how the numbers look like.
We think that applying 12% discount for such a proven company is a little aggressive but let's use it for our margin of safety. With the below assumptions, the fair value comes out to be $56.06, which points to slight undervaluation at current stock price (about 6%).
- Discount Rate: 12%
- Stage 1 Growth: 6%
- Stage 2 Growth: 5%
- Perpetual Growth: 3%
Based on the above assumptions, FCF is shown below:
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Now if you would like to be a little bullish using a discount rate of 10%, which we still think is reasonable given company's stellar historic performance, the fair value of the company comes out to be $72.41 as shown below. We still think that a lot of people would be comfortable using 10% discount rate for a stable company such as Joy Global. Using these parameters:
- Discount Rate: 10%
- Stage 1 Growth: 6%
- Stage 2 Growth: 5%
- Perpetual Growth: 3%
Based on the above assumptions, FCF is shown below:
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The above fair value of $72.41 means that the company is undervalued by about 36%. So basically, this analysis tells us that Joy Global is a good buy given today's stock price especially considering today's frothy stock market in general.
Shown below is the sensitivity table for various discount rates assuming same stages of growths as shown above.
Risks:
The company's performance remains heavily tied to the commodity prices (Coal in particular). Also, there is a general fear among investors that other sources of energy such as natural gas will someday completely replace coal for power generation purposes. Natural gas offers much environmentally friendly option to coal not to mention that it is also much cheaper. However, this would require large capital expenditures for electricity generating plants to switch their infrastructure to accept Natural gas as input, but this is not impossible given the fact that many relatively older coal plants have already made the shift. The Chinese economy has recently shown signs of weakness where the company sells its bulk of product. If various countries around the globe start to switch to Natural gas as input for electricity generation purposes, this would serve as a severe headwind for the company and dramatically slow down its sales.
The company is not as diversified as it should be building equipment for other types of mining activities such as precious metals - thus any slowdown in coal mining would affect the company in a magnified manner. Another risk is that present CEO of the company is retiring in Feb. 2014 and the new leadership might take the company in a total new direction, which might or might not bode well with shareholders, although we see this as relatively lesser of a concern. Joy's capital allocation has benefited shareholders, although we caution that two recent sizable acquisitions (LeTourneau and IMM) will require continued integration. Furthermore, the company has taken an impairment charge of about $150M on the intangibles, which makes us believe that either the company overpaid or is not cognizant of the real value of the brands it acquired. This is something we will keep an eye on for future acquisitions for the company. Financially, the company's pension liabilities are now fully funded. The company has very reasonable debt on its books with its $1.0B unsecured revolving credit facility maturing in 2017; there is no immediate financial constraints apart from its payments on interest. With a dividend payout ratio of only 14%, dividend payments are not in an imminent danger (current yield 1.30%).
Conclusion:
While we never recommend bottom fishing, there are clues in the light of above stated facts that could point to the fact that Joy Global presents an asymmetric risk/reward scenario for current investors. Now the stock might move lower depending upon short-term whims of Mr. Market, but thinking from the perspective of a long-term investor clearly points that stock price of Joy global is bottoming out. Firstly, all bad news from the last couple of years has been reflected in today's stock price. Secondly, the company has responded well in response to slower demand of its products by slashing costs and improving operations. Would there be more bad news to come? Possibly, but the trend is likely to shift in Joy's favor towards the latter half of 2014. And as soon as there is a slight indication of any positive news, the investors would be ready to pounce on this stock driving its price higher. So the time to buy is now when we know that the company has done all the right things to position itself for a much brighter future going forward. During 2013, we saw the U.S. coal market remain under pressure, but we are now seeing some improvements. Coal consumption is expected to grow over 7% this year, as natural gas prices increased and have averaged $3.70 per million BTU throughout the year.
We expect that the percentage of the firm's sales occurring outside the United States will increase over time largely due to increased activity in China, India and other emerging markets. Ultimately, with growing populations in the world (with a large portion of the company's revenue coming from overseas), the electricity demand would only increase causes a nice tailwind for the company to sell more. With mid-tier miners in china consolidating and top-tier miners only wanting to deploy best in class equipment, Joy global is well positioned to sell more of its products. With increased sales, the company would have more opportunity for aftermarket revenue and the fact that it operates in an oligopolistic market is only going to help this. It is evident that right now is perhaps the most opportune time to make an investment in this company, which would likely bring joy to your way going forward.
Notes & Disclosures:
This is not an investment advice. Please perform your own due diligence before making an investment.
This article was written by "Syed Saqib," a portfolio manager at Netwall Investments LLC. I don't intend to portray that Netwall Investments LLC is either invested in above securities or going to invest in the future. Investing or not investing in any security is solely upon our discretion and it can change without notice. Furthermore, we can get out of a position at any time as we deem fit. This is our foremost fiduciary duty to our clients who have invested their capital with us.
Disclosure: I am long JOY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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