Thursday, August 16, 2012

When Will The Cyclicals Turn?

One of the great imponderables in investing is when to buy a cyclical? The usual advice is to buy when its PE is high or when gross margins have troughed or some other quantitative "rule of thumb" measure. Very rarely is the question asked as to whether the stock is really a cyclical or not. I raise this question in looking at mining equipment supplier Joy Global (NYSE: JOY). The stock is always seen as a classical cyclical, but why should its end demand drivers be necessarily cyclical and why should the cycles be of the same magnitude?

As the reader has probably worked out by now, I think that there is a case against such thinking. Simply put, Joy Global’s principal end market drivers have been the demand for copper and coal. Along with Caterpillar (NYSE: CAT) and Deere & Company (NYSE: DE) it was a darling of the hedge fund industry’s fixation with all things China and commodity related. I recall these stocks notably outperforming the broader markets throughout most of 2008 as commodities surged in the first half of the year, only to then crash as the markets spiraled into chaos in the autumn of 2008. Then as the global economy and the stock market recovered in the spring of 2009, they outperformed again.
However, last year has been a period of marked underperformance.

So is the cyclical about to turn?


Understanding the Commodity Cycle

Markets do have a way of moving prices before earnings movements and they did it again with Joy Global. Although the recent results beat estimates on both the bottom top line, the immediate outlook was not good. Bookings were down a whooping 34% from a year ago and also negative on a sequential basis. New order bookings for surface mining equipment were down 20% and underground mining equipment bookings were down 38%. This led to the legacy backlog being reduced to $2.8bn from $3.3bn in the last quarter.

In addition, the company removed $119m in underground equipment backlog scheduled for the US as it believed that there was a risk of deferral or cancellation. Not good.
Essentially, there are two problems here. The North American coal market and emerging market demand.


US Shale Gas

Shale gas drilling has reduced relative demand for coal as an energy source. This is a structural change in the marketplace and I don’t think that it is going to reverse anytime soon. Indeed, the more applications that are created to take advantage of cheap natural gas prices, the more long term demand there will be for gas.

Furthermore, the US desire for self sufficiency in energy provision is also a key driver, especially when compared with a source like coal, which is perceived as a "dirty" energy source.  Joy Global’s hope is that the export industry will drive US production, but this too is questionable. Not only is China’s electricity usage growth slowing as the economy cools down, but steel demand is likely to slow as well.

It is a similar story with Peabody Energy (NYSE: BTU), which recently lowered US production targets in response to lower demand.  In order to see the effects of this, I’ve pulled out some data from the Association of American Railroads. This is useful because it provides a good barometer of how US coal production is faring.

 

The decline appears to have set in, even before this year’s weaker growth and mild winter.


BRIC Demand Slowing?

Interestingly, Joy Global thinks that the risk to demand for copper, coal and iron ore as being on the upside. I’m not so sure. BHP Billiton (NYSE: BHP) has already talked about demand for iron ore flattening out as China’s growth cools down.

The marginal increase in demand for these commodities has been coming from China and the other BRICs. However, there are clear signs that China’s property market (both residential and commercial) is slowing. Prices are negative on a yearly basis and commercial floor space sold is falling in China.  All of which suggests that, despite steel production back on tap in China, future demand will slow.
The market feels that, given a slowing economy, China will use its huge foreign currency reserves to start launching infrastructural projects in order to stimulate demand and job growth. This may well be true -- why should it be in areas that already have over capacity? After all, the solution to the economic problems in the US was not to build more housing!


Joy Global Not so Cyclical After All?

All of which suggests that investors should not look at Joy Global as just being a cyclical that they can pile into as a contrarian play. All cycles are different and I think there are some challenges here that might cause a longer, flatter pattern of recovery. Also, it is far from clear that we are anywhere near a trough in terms of orders or demand for its particular demand drivers.

There is plenty of time to get into the stock. Joy Global’s cycle will turn again at some point but, right now, there are plenty of unknowns and potential investors might want to see how China’s stimulus spending is going to be allocated before getting too excited.