Joy Digs Moat With Aftermarket Business

Over the near term, the company's new-equipment sales will be negatively affected by the construction slowdown in China and the related negative headwinds for its coal, copper, and iron ore customers. Additionally, its strong presence in U.S. Appalachian coal mining equipment has been adversely affected by that coal basin's declining cost competitiveness relative to unconventional natural gas. We think the company's aftermarket parts and service business has become extremely important relative to these near-term headwinds.

Like its primary mining equipment manufacturing peers, Caterpillar CAT and Komatsu KMTUY, Joy's equipment has a long life. These multi-million-dollar pieces of equipment are effectively rebuilt once or twice over their operational life. This intensive use creates a very active repair and service market. Joy differentiates itself from Cat and Komatsu by completely owning its distribution and service network, which creates a robust aftermarket revenue stream. Over the next several years, we expect approximately 70% of Joy's revenue will come from aftermarket services. While this revenue is from traditional parts and repairs, it is also made up of revenue from a lifetime equipment management program. These agreements have a smart-services component where Joy monitors equipment operation, maintenance, and use to provide a targeted cost per ton to extract coal and other minerals. We think this is an attractive product offering especially for independently owned mines in emerging markets that have not gained the benefit of best-in-class mining processes.

Profitability Throughout the Cycle Joy Global's brands and service network endow the firm with a narrow economic moat. We believe its moat is built on the intangible asset of its Joy Mining and P&H brands and quality along with the switching costs associated with leaving the Joy Global repair and service network.

Joy Global competes in the oligopolistic coal equipment manufacturing business. We believe this structure offers attractive margins on new-equipment sales, but more important, the long equipment life offers many opportunities to sell aftermarket services and parts. For example, a dragline's useful life averages 40 years. By owning the dealer and service network for its products, Joy enjoys profitability throughout the mining cycle. While services and parts sales were 68% of Joy's 2014 revenue, we estimate that most peers only get exposure to parts revenue, which makes up just 15%-20% of their sales mix. Dealers typically capitalize on a customer's switching costs, but Joy's distinctive model of owning the dealer and service network means that it can capitalize on this profit stream.

The company has generated 24% and 27% average annual returns on invested capital over the past 5- and 10-year time frames. Over the coming five years, we project a 14% ROIC (18% excluding goodwill). While Joy's ROIC and moat sources are indicative of a strong moat, we still consider the company to have a narrow rather than a wide moat. We think the company is structurally disadvantaged by its lack of a captive finance arm. We also think its more limited product set (Joy does not offer a mining truck and has a limited hard-rock mining product line) is also a competitive disadvantage. We highlight these challenges as part of why Caterpillar has a wide economic moat rating relative to Joy's narrow moat rating. Based on our industry analysis, the ability to get attractive financing from Caterpillar Financial Services and purchase a complementary suite of equipment from one manufacturer is a contributor to why customers are slightly more likely to buy from Caterpillar than Joy.

While we are leery about the Chinese mining competitors, which include Sany, XCMG, XGMA, and Zoomlion, we think they need to improve their technological offerings to challenge Joy. Our China heavy-equipment channel checks show that the domestic mining manufacturers' equipment is of poor quality and unlikely to be worth rebuilding. While the Chinese competitors have been better about getting their construction equipment into non-China markets, they have been slower to gain acceptance of their mining equipment. The primary challenge for entering new markets is finding dealers to sell and service the equipment. While these companies can do a direct-sales strategy, we think they still have to work to gain brand acceptance and improved quality. We also think the mining market requires equipment with better reliability. A nonfunctioning piece of construction equipment can be easily replaced by a rental, but we don't see the same dynamics in the mining market, where much of the equipment is in remote locations or underground, where short-term rentals are not a good option.

Commodity Prices Dictate Sales Joy's business is heavily tied to commodity prices. High market prices for coal, copper, and iron ore encourage mine expansion, which leads to high near-term sales and a longer-term aftermarket sales opportunity. In periods of weak commodity prices, new-equipment sales fall dramatically. The company also faces substantial competition in China, where local manufacturers constitute the vast majority of the marketplace. We think Joy's emphasis on spending several hundred million dollars per year on acquisitions is another risk, as the firm may not realize any of the anticipated synergies that it has targeted. Approximately 55% of sales come from the global coal industry. Both the U.S. and China have identified coal emissions as a prime target for reducing carbon emissions. Increasingly punitive mining and emissions regulation would depress the company's revenue outlook.

Joy's balance sheet is in decent shape. The firm had $1.1 billion in debt on its balance sheet compared with $103 million of cash as of Oct. 30, 2015. At a manageable 2.6 times debt/EBITDA ratio, we believe the firm's strong cash flow generation will prevent any solvency issues. The firm doesn't face any sizable financing maturities until 2016 and enjoys strong EBITDA/interest coverage ratios. In the fourth quarter of 2013, Joy started a $1 billion share-repurchase program. As of January 2015, the company had repurchased 9.8 million shares for $553 million. Overall, we believe Joy is in good financial health, given its strong cash flow generation and EBITDA that covered interest expense a comfortable 10 times in fiscal 2014.