No Joy for Joy Global

Because the coal market is tanking, it’s an interesting place to look for investments.

I must admit, I’m not very interested in the coal producers themselves because I see no sustainable competitive advantages. The businesses that serve the coal market, however, do interest me, because I can find companies that possess such advantages. I believe Joy Global (JOY) might be one of them (neither my clients nor I own any shares of Joy Global at present, although this could change at any time).

Joy Global makes some of the huge equipment used for mining. This includes both surface and underground mining equipment, like conveyors, breakers, long wall shearers, roof supports, drills, shovels, draglines, loaders, etc. Joy’s website gives all the fascinating details.

Joy’s equipment is highly specialized, and that means it is highly integrated into mining production companies. Joy’s equipment is also highly productive, which means that mining businesses focused on costs and long run efficiency can benefit from owning Joy’s products.

Most importantly, Joy’s mining equipment is difficult to optimally operate and maintain over the long run without support from Joy, which means that one of Joy’s most important businesses is parts and service. To keep this type of equipment is good working condition, it is beneficial to engage the services of Joy Global.

Joy gets almost 55% of its business from coal miners. That is because Joy has specialized in the type of equipment used for mining coal, both underground and surface. Everyone knows that the coal industry is severely depressed right now with low coal prices due to too much supply and low demand. Coal suffers, too, from competition from alternatives like natural gas at very low prices, as well as oil, nuclear, wind and solar. Significantly, coal is also facing severe political pressure because it is considered such a dirty energy source. Many of the governments of the world, particularly in the U.S. and Europe, are working hard to eliminate coal as a source of energy.

What may not be as well understood is how fundamental coal is both as an energy source (thermal coal) and as an input to making steel (met-coal). Even if everyone agreed that coal is a terrible energy source, it would take decades to completely switch from coal to other energy sources (even here in the U.S.). Coal is also a major energy source in places like China, India and Indonesia (the 1st, 2nd and 4th most populous countries). In China, switching from coal will take a very long time, even assuming the Chinese government agrees to curtail its use. India and Indonesia, in contrast, are trying to figure out how to produce more coal to meet their growing energy needs. Coal may be hated, but it’s not going away any time soon, and perhaps not ever.

In addition to coal, Joy does business with mining companies focused mostly on iron ore and copper, but also gold, oil sands, and potash/salt. None of these businesses are doing that well now, either, because of too much supply and not enough demand. In other words, it is not just the coal market that has Joy down.

Although down, I don’t think Joy is out. Even in it’s depressed state, it is still generating over $3 billion a year in revenue, 75% of which is the more consistent service business I referred to above. And, Joy is still quite profitable. Profit margins are down from a high of over 14% (trailing twelve months) in 2011 to 8% now, but that is still quite respectable. Over the last 4 quarters, Joy still earned $2.69 per share. Not bad.

As investors know, it is the future, not the past that determines a security’s price. For Joy, the short to intermediate term looks pretty unclear. I think it is prudent to assume that the commodities boom of the last 15 years is over. That means looking at Joy’s past 15 years of financials doesn’t necessarily help a lot in figuring out the nearer term future.

I do believe that Joy’s service business is a good place to start in assessing value, though. Joy’s service business has generated an average of $565 million in revenue a quarter over the last three quarters. As a base, that is a bit over $2.2 billion a year in revenue. Unfortunately for Joy, that service business has been declining, too, as miners have been putting off maintenance and overhauls to try to make ends meet.

Assuming Joy’s service business continues to decline, I still think that Joy will remain profitable and able to pay interest payments and dividends. I think Joy’s service business, even without any original equipment sales, could see a further decline of around 25% and still be able to pay interest and dividends. The service business could decline 25% from here, or more, but maintaining a level that low seems unlikely. I believe creditors and bankruptcy judges will agree that maintaining equipment in good working order at the mining companies is in everyone’s long term interests.

As a base case, I’m assuming Joy can do $500 million in revenue a quarter just from service (down 11.5% from the last 3 quarters). Using a 6.5% net margin (lower due to continued fixed costs) on that gives you around $1.28 in earnings per share.  Hang an 8x multiple (which assumes 0% growth), and you get a $10.24 price. I think that is a pretty negative scenario: assuming service declines 11.5%, and no original equipment sales.

Could things be worse? Of course. Assuming services declines 25% and gets only a 5% net margin (even bigger hit from fixed costs), you end up with $0.74 in e.p.s., which would be below Joy’s dividend rate of $0.80 per year. Hang my no-growth multiple of 8x on that and you get a $5.90 price. I think that is an extremely negative scenario, but one that must be considered.

Assuming the coal market eventually stabilizes and Joy gets back to its current level and mix of services and original equipment (75%/25%), then you get back up to $3 billion of sales, an 8% net margin, so $2.37 in e.p.s., and an 11.5x multiple (3% growth), and Joy would be back up to $25 to $30 in price. That would be a nice return from here.

If I assume a 25% chance of my worse case price, $5.90, 50% chance of my base case, $10.24, and 25% chance of my stabilization case, $27.28, I come up with an assessed value of $13.42. With that, you can see why I haven’t bought, yet, but I am getting close to doing so.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

No Joy for Joy Global