Winter Still Coming For Joy Global

By Stephen D. Simpson, CFA | August 28, 2013 AAA

Cyclical industries have a habit of answering the question “How much worse/better can things get?” in pretty dramatic fashion. With mining companies slashing capex budgets left and right, winter is definitely coming for leading mining equipment company Joy Global (NYSE:JOY). While management's success in streamlining operations, improving manufacturing yield, and reducing fixed costs should keep the company's head attached firmly to its body, there's a risk to shareholders that the market hasn't fully digested what weak orders today will mean for tomorrow's revenue. So although I believe Joy Global is undervalued on a long-term basis, investors buying or holding today have to be able to tolerate the thought that the shares could have further to fall before stabilizing.

Strong Relative Performance As Conditions Erode
Credit where due – this is a tough market for any company with significant exposure to mining capex spending, but Joy Global did better than expected on multiple fronts.

Revenue fell 5% from last year, but that was still good for a nearly 12% beat relative to the average Wall Street guess. Underground revenue fell 4% and surface equipment dropped 5%, but both were stronger than expected by analysts. While original equipment sales were down 8%, aftermarket sales were down only 2% as mining companies continue to need parts to maintain the equipment they have in operation.

Continuing a trend, Joy once again surprised to the good on margins. Gross margin fell only one point from last year and improved slightly on a sequential basis. Likewise, while the year-on-year decline in operating outpaced the sales decline (down 8%), the company's operating margin was over a point better than the sell-side projected. Curiously, while underground and surface segments showed similar revenue trends, the segment profits split noticeably, as underground profits fell 17% and surface profits actually rose 2%.

Orders Continue To Weaken
Joy Global continues to see significant weakness in equipment demand. Bookings fell another 36% and came in almost a third lower than some of the estimates I saw. OEM bookings were particularly weak, falling 76% to less than $100 million and for a book-to-bill of just 0.16.

To a certain extent, this isn't a huge surprise. Caterpillar (NYSE:CAT) and Komatsu (Nasdaq:KMTUY) have both signaled weak mining equipment demand, as have other players in mining capex including Colfax (NYSE:CFX) and Atlas Copco (Nasdaq:ATLKY). What's worse, what demand there is in the mining sector tends to be going more in the direction of automation products like material handling systems – good for FLSmidth (Nasdaq:FLIDY), but not good for Joy Global.

Management's own comments tell the tale. Most mined commodities are at or near net surplus positions, pricing has moved to marginal costs, and miners have cut their capex budgets in half. Even with signs of recovering coal demand in the U.S., Joy Global may have a tough time meeting 2014 revenue expectations ($4.6 billion going into earnings) without a big turnaround in orders.

The Bottom Line
As I pointed out recently in a piece on Deere (NYSE:DE), one of the challenges in dealing with a cyclical company like Joy Global is trying to figure out just what exactly the Street expects and how it will react to incremental negative data. I don't have much doubt that Joy Global will ultimately return to growth at some point, but I don't know how bad it will get in the interim, nor how the Street will react once the double-digit revenue declines start arriving. So while I do think Joy Global is cheap on a long-term basis, it could very well get even cheaper over the next six months.

The commodity supercycle may be over, but I continue to believe that Joy Global can grow both revenue and free cash flow over the long term. Likewise, I think the shares are well below fair value, but investors looking to buy today have to be prepared for the possibility of double-digit paper losses before seeing the turnaround.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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