One key trait that separates developed economies (such as the U.S., Canada, Europe and Japan) from emerging economies is the relative swings in GDP. While developed economies are so mature that they grow or shrink in a glacial fashion, emerging economies are much more dynamic, with booms and busts arriving seemingly every decade.
And for emerging-market economies that focus on commodities, the cyclical swings can be even more profound. Firm commodity prices (as we saw in the middle of the past decade and again just a few years ago) lead to huge spikes in orders for mining equipment. And a huge drop in these economies — and the price of the commodities they produce — can lead to real pain for the companies that serve them.
Many investors got out of JOY long before the cloudy sales picture emerged. Although the company was poised to deliver solid results in 2012, it seems investors concluded that the still-weak global economy would eventually pressure the company’s sales outlook.
When it comes to a deeply cyclical stock like JOY, traders can score solid gains when pessimism is at its peak, as its stock valuation comes down to levels that sharply discount better days ahead.
To understand why farsighted investors should be looking at this stock now, you need to look at the reinvestment rate among miners, which compares capital expenditures (capex) with earnings before interest, taxes, depreciation and amortization (EBITDA).
Mining equipment is used in harsh environments and, as a result, needs to be replaced fairly often. Generally speaking, mining firms tend to spend roughly 50% of EBITDA on capital equipment, according to Goldman Sachs Group, Inc. (NYSE:GS). That’s a 10-year average figure, though it slumped to 40% in 2010 while the global economy struggled to emerge from a deep slowdown that began in 2008.
But the recent sharp slump in commodity prices has led mining firms to become especially cautious as major mining projects get squeezed to generate as much cash flow as possible. As a result, Goldman Sachs looked at Joy Global’s 2014 order book and concluded that the capex-to-EBITDA reinvestment rate for its client base is now down to just 29%, an almost unheard-of level. That explains why revenue for the coming year is expected to decline by more than a billion dollars.
As for the stock, it has lost more than $3 billion in market value since the start of 2011, thanks to that investor exodus.
2009 Redux?
JOY has seen this scenario play out before. In 2008, customers began canceling orders, and orders (and sales) didn’t pick up much in 2009 or 2010. But farsighted investors knew that the company would eventually see its clients play catch-up by placing new orders. For the more nearsighted, by the time that trend was fully in evidence, they had missed the major move in this stock.
But what if the market for JOY’s mining equipment doesn’t hit bottom in coming quarters, as the replacement cycle would suggest? Well, this stock already holds solid value in the context of depressed current sales trends. Thanks to massive cost cuts, analysts at Goldman Sachs think the company will generate at least $4 a share in free cash flow (FCF) in fiscal 2013, and more than $5 a share in FCF in fiscal 2014.
To seize on the FCF/valuation disconnect, the company is now in the midst of a $1 billion share buyback that could reduce the current share count by 15% to 20% if completed at prices around $50.
To be sure, Goldman’s analysts aren’t yet penciling in a big demand snapback in fiscal 2015. Then again, in the depth of the financial crisis in 2008 and 2009, few analysts were willing to pencil in a more robust mining spending environment a few years down the road.
Here’s a chance to think like a fund manager and not a Wall Street analyst. Joy Global is a must-sell stock when business conditions are great and shares reflect a robust outlook. That’s when Wall Street analysts are at their most enthusiastic.
In contrast, fund managers, many of whom aren’t really concerned about how the next few quarters will play out, look for great companies stuck at the wrong end of the economic cycle. That’s the reason to be thinking about a company like Joy Global right now.
Action to Take –>
— Buy JOY up to $58
— Set stop-loss at $48
— Set initial price target at $70 for a potential 21% gain in eight months
This article originally appeared at ProfitableTrading.com
This Stock May Look Like a Screaming ‘Sell,’ but I Say It’s a ‘Buy’
P.S. I’m not a market technician, but I’ve seen enough charts in my day to know when a pattern is shaping up to be … interesting. I encourage you to check out my colleague Amber Hestla’s presentation to learn more about what the dreaded “triple top” could mean for your portfolio in the coming weeks.
