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Manning & Napier Advisors’ Pick from the Heavy Machinery Industry
Posted by: Vanina Egea (IP Logged)
Date: November 15, 2013 04:38PM

Mined commodities continue in a stark decline. Since 2011, copper, silver and gold have lost more than 20% of their face value. The situation placed a great question mark upon mining companies and suppliers. Among those suppliers, heavy machinery manufacturers have suffered especially as new orders and inventory declined steadily. Today, I look at Komatsu (KMTUY) and Joy Global (JOY) as prices seem to enter a stable ground.

Original Equipment Sales Is Not All

Through the Joy and P&H brands, Joy Global offers mining equipment for surface and underground mining for extraction of coal, copper, iron ore, oil sands, gold and other mineral resources. Most importantly, and a key characteristic to offset poor performance during adverse economic environments, is the firm's aftermarket services. Management has been very savvy when taking the initiative to balance portfolio offerings, and has spread sales and services facilities to more than 20 countries.

During the last quarter, Joy Global reported a small decline in overall performance while doubling cash flow when compared year over year. Due to market conditions, management announced that difficulties will continue throughout 2014 as customers continue to be cautious. Hence, both the original equipment and aftermarket segments are expected to confront headwinds in the coming year. For the same reason, and the cyclicality of the industry, cost policies will remain in place.

Structure optimization and capacity realignment are two policies that Joy Global gives great importance to curb slow growth. During the first phase, $47 billion has been saved, and an additional $65 billion is expected through the second phase. At the same time, manufacturing facilities will be relocated to low-cost operational countries like China, Poland and South Africa. On the downside, the firm has concentrated 38% of total sales in 10 customers, and the absence of technological advancements is an important obstacle to a greater market share.

Financially, Joy Global is very strong, even with rising debt. Currently the stock trades at 8.4 times its trailing earnings, packing a 31% discount to the industry average. The guru holding the largest stake in the firm, Manning & Napier Advisors, increased its stake in the company during the last year, while Tweedy Browne and Brian Rogers followed suit. I share their optimism due to the balanced portfolio that has helped to curb the troubled economic environment.

Free Falling

Komatsu is world´s second largest construction and mining equipment company with presence in every continent. The company also has a forestry segment, and manufactures industrial machines, engines, and temporary structures. The regions contributing the greatest sales-share are Latin America, North America, and Asia, with a combined total of 49%. Most importantly, and reflecting the troubled environment the company faces, is the reduction of yearly projections by an average of 10%.

Looking forward, Komatsu expects sales of mining and utility equipment in Japan to continue rising, while the Chinese market slowly begins to recover from the experienced downturn. On the other hand, sales for mining equipment in Latin America, Oceania and Asia will continue to linger, offsetting any upswings in Japan and China. In the end, management expects profits to continue dropping through 2014 as backlog continues to decline and new orders fail to materialize. In this case, end-market diversification has not been accompanied with an aftermarket operation, offering no strong option to slower sales.

With respect to international expansion, Komatsu lacks meaningful opportunities. Also, this is not the time to enter into direct competition with industry giant Caterpillar. Another downside to the firm is the rise of strong domestic competitors, and tighter competition among foreign industry peers. On the efficiency side of the business, returns on capital investments continue to decline in great part due to an important inventory that is yet to be depleted. Last, currency exchanges have favored the business model, but rising costs continue to eat away that advantage.

The balance sheet for Komatsu is strong, thanks to wide operating margins and recovering cash flow. Trading at 13.6 times its trailing earnings, the stock carries a 10% premium to the industry average. Throughout 2013 no guru has acquired or increased its position in the company. And the only transaction registered for the current year is Ken Fisher´s option out. I share his pessimism due to the lack of growth catalysts and declining overall performance.

Easy Option

Both Komatsu and Joy Global are operating under weak market conditions. However, Joy Global has developed a strong aftermarket segment. This characteristic has helped the firm to curb environmental headwinds. And, even though performance indicators show a decline, this is very small when compared to most industry peers. Hence, I prefer Joy Global for a long-term investment.

Disclosure: Vanina Egea holds no position in any of the mentioned stocks.

Guru Discussed: Manning & Napier: Current Portfolio, Stock Picks
Stocks Discussed: KMTUY, JOY,
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