Description

Bull Thesis: Joy Global (JOY) is a very good business with a razor/razor blade model operating in a sector at a cyclical bottom. 

Variant Perception:  Mining capex should decrease dramatically through 2016, as the industry adjusts to a secular change from a decreasing Chinese economic growth rate. The company’s pricing and high margins should come under pressure as miners start to look to suppliers for help in cutting costs.  JOY’s razor/razor blade model could be undermined as miners work around the company using third party suppliers. 

Falling Industry Capex:

While estimates vary, there is no question that mining capex soared over the last 20 years.  After already growing at a roughly 8% CAGR from 1990-2001, capex, driven by China’s stimulus, spiked close to 5x from 2006 to the peak in 2012 (see exhibit 1 below).

The capex boom was driven by China’s property boom and its effect on commodity demand and prices.  That boom is just now starting to unwind and we are likely in the early innings of that reversal.  With commodity prices surging, virtually all mining projects were forecasted to have very high IRRs, which lead to a race to get rocks out of the ground as quickly but not necessarily as efficiently as possible.  Mining capex is also heavily front end loaded, with equipment at new mines having a disproportionate effect on overall capex.  Mining projects usually take 3- 5 years to develop, so the pipeline of new mines is clear to see and drying up through 2016. 

Industry Pain Shifts to Suppliers:

Coal accounts for roughly 70% of JOY’s revenue.  The 2Q met coal benchmark price is $120/MT down from $330/MT in 2Q 2011. We looked at a sample of very efficient producers from across the globe and found that even these top tier operations are largely unprofitable at current prices (see exhibit 2).  We would also note that thermal coal is producing similar margins. 

Despite the financial distress of the industry it serves, JOY is having a relatively prosperous time.  From 1992-2008, the company produced an average EBITDA margin of 8.5% vs. consensus estimates of 17.5% for FY2014.  But the good times might not last.  Production costs skyrocketed in the boom but miners have been able to get much more efficient in the last two years.  At first miners reacted to falling prices by ceasing to initiate new growth projects.  Producers then refocused on operations removed costly third party contractors, figured out ways to cut overhead and benefitted greatly from decreased employee turnover. 

The U.S. coal industry has been hit far worse than global peers due to tighter seams (costlier to mine) and a geographic disadvantage.  Thus, it has been forced to make cuts sooner.  This has led to decreases in maintenance capex, which appear to be sustainable for multiple years.  The U.S. companies also started to look outside for help.  One C-level executive at a major domestic producer recently told us that, his company was embarking on its third round of negotiations with vendors and that the first two were successful in cutting prices and was confident this would produce similar results. We now believe that the rest of the world will follow the same path as the U.S. Peabody Energy laid out similar plans on its recent 1Q earnings call, CEO Greg Boyce stated “Our portfolio of met operations, we look at their competitiveness and then we go down through a process which says okay, structurally can we move these operations lower on the cost curve so they can remain competitive as the market moves? You've seen us do a lot of that. The whole owner/operator conversion strategy was a strategy to drive us down the cost curves.  Then we look at efficiencies, we move into a next phase, which is what we're actively moving into now where we aggressively talk to all of our suppliers, we look at all our efficiency activities, we look at our mine plans and we make those adjustments. I will just say that at the end of the day we have a view that our operations have to make money and they have to be sustainable.” It is highly likely that other miners are making similar plans.  When asked about the effectiveness of these negotiations on the call Boyce responded “It's not only consumables but it's also services as well…. Well suffice it to say it has been bearing fruit.”

Razor/Razor Blade Model under Pressure:

The domestic mining executive also disclosed some very interesting points on potential weaknesses in Joy’s business.  When asked particular about negotiations with Caterpillar (CAT) and JOY, he stated that he knew CAT was discounting but was unaware on JOY since they had not ordered a new continuous miner in a couple of years.  He then went on to say that you could “work around JOY in services”.  He clarified that instead of using Joy Global for services, third party contractors undercut the company on price.  While JOY makes money on both new equipment and after-market parts and services, the new equipment is the least profitable of the group.  Joy Global’s bullish statements on the services business on the company’s 1Q call, have driven the stock higher since, despite an earnings miss and lowering of expectations. 

The proof of JOY’s strong business is the razor/razor blade model and the ability to maintain pricing.  Despite the industry’s troubles, JOY only started giving slight discounts last year.  The executive while not certain also believed that JOY is likely discounting more than the company admits to publicly.  Using volume discounts is a way to publicly state that prices are being maintained.

Datapoints Portend Further Weakness:

While the coming fall in capex is well known, it still is not showing up fully in analyst estimates. Goldman Sachs, (note dated 1/2/14) sees global mining capex falling 13% YoY in 2014.  Consensus estimates expect a 25% YoY decrease in FY2014 revenue for JOY.  Then in 2015 GS expects a 12% YoY decrease in global capex and analysts somehow expect a 3.5% increase in sales for JOY, leading to a nearly 20% increase in EPS.   Even within GS bearish estimates, capex is still higher than individual company guidance.  In the boom companies repeatedly spent above forecasts but now are spending well below, leading to continued cuts.  We would point out that the analysts who follow Joy Global cover industrial companies not mining, which could be driving the disconnect between perception and reality.  Analysts have clearly been behind the curve and have cut 2014 EPS estimates nearly 50% in the last year, we would note that the stock has risen over that time period.

Caterpillar recently lowered guidance (1Q earnings release April 24) for Resource Industries to about a -20% YoY decline in 2014 from about a -10% decrease.   The company then released an 8-K showing the decline in mining is accelerating, with YoY retail sales falling 49% YoY in April (see exhibit 3 below).  Resource Industries is essentially Bucyrus, which CAT acquired in 2011 and is the closest comp to JOY.

While a relatively small business, oil sands mining equipment is repeatedly mentioned by the company as a growth area.  However, cheap natural gas has made SAGD cheaper than mining.  Thus growth is unlikely to materialize. Additionally, we would put a low multiple on a supplier to the highest cost oil in North America with prices expected to decrease over the next eight years.

Valuation:

JOY is valued at roughly18x FY2014 consensus EPS, a multiple more in line with that of a growth company, when it appears that the commodity cycle could be heading for an extended downturn.  Investors used to believe that JOY could generate $4.00 - $5.00 in EPS with just the after-market business, that is clearly not the case.  Conservatively, on a normalized basis we estimate $4 bln in revenue for JOY, assuming 13% EBITDA margins and a 8x multiple, would yield approximately a $40.00 stock price.  However, we believe the depressed nature of the business could lead to lower valuations as estimates come down. Our best guess is that JOY produces $2.75 or less in EPS in FY2014, earnings should then decline through 2016 with decreasing industry capex.  We believe 14x in-line with historical multiples or $38.50 per share is a more than fair price. 

Catalyst