Caterpillar Has a Huge Problem on Its Hands

Joy Global and Caterpillar have a huge problem on their hands: The rising quality of the equipment being manufactured within China. This is something Rio Tinto is seeking to capitalize on.

Jan 12, 2014 at 2:37PM

Caterpillar (NYSE:CAT) and Joy Global (NYSE:JOY) have a problem: China. No, I'm not talking about the Chinese economy here, I am in fact talking about the quality of mining equipment being manufactured within China, which has drastically improved in recent years.

It used to be the case that mining companies, such as Rio Tinto (NYSE:RIO), would stay away from native mining equipment manufacturers within China as the kit was usually of an inferior quality, although the equipment was cheaper. However, now the Chinese companies are catching up. Indeed, according to comments from Rio Tinto CEO Sam Walsh given in an interview with the Wall Street Journal:

The Chinese manufacturers are really improving in this field and can now be compared to the major US manufacturers... funnily enough [on the rail cars] the quality actually was much higher [compared to the miner's traditional supplier]...Instead of spot welds, for example, on the sheet metal they were actually continuous welds.

Spot welds are usually weaker than a continuous weld. As a result, Walsh revealed that Rio had actually been increasing its purchases of heavy equipment from Chinese and Indian companies. Now, I don't want to speculate but I would say that the Chinese are able to put more effort into the production of their equipment due to lower labor and construction costs, while Western companies are skimping on quality to save costs.

Unfortunately, it would appear that the quality of Chinese mining equipment is only going to improve from here on out while costs continue to fall.

I say this because according to a study entitled China Mining Equipment Industry 2013-2017 published back in June 2013, China's domestic mining and quarrying equipment manufacturing industry is expected to expand by about 22% by 2017 increasing economies of scale. The study also highlights the fact that China's producers will emerge as industry favorites due to their low cost.

All in all, this means that miners like Rio will be able to buy better heavy equipment for a lower cost. In addition, it is likely that as the quality of the equipment continues to improve, maintenance costs will fall. This is really bad news for companies like Joy and Caterpillar, which are already struggling to grapple with rapidly decline resource sector capital spending.

Getting worse
Actually, mining capex is declining faster than originally thought. Specifically, during 2012 JPMorgan analysts predicted that global mining capex would decline 14% from a high of $136 billion during 2012, to $117 million annually by 2014. However, global mining capex is estimated to be around $100 billion this year, a 26% decline already.

Unfortunately, Joy and Caterpillar are already suffering from this downturn, and it looks as if things will only get worse for these companies, even before we consider the effect of an increase of Chinese equipment in the market.

Joy's fiscal fourth quarter results reveal how serious this slowdown already is. In particular, the company reported that quarterly earnings per share declined 47% year on year. Additionally, sales collapsed 26% year on year, and bookings for new equipment declined by 20% year on year.

In comparison, Caterpillar reported a similar 43% year-on-year decline in earnings for the fiscal third quarter. Caterpillar also, within its fiscal third quarter earnings announcement, issued a primary 2014 outlook stating: "We're not seeing bright spots in mining yet, but the turnaround will happen at some point, and when it does, we'll be ready to respond."

So all in all, with the world's largest mining equipment producer taking such a pessimistic view on the future it's hard for individual investors to remain positive.

Foolish summary
So overall, it is not secret that capex in the mining industry is falling, and this is bound to hurt the industry's largest capital equipment manufacturers, Joy and Caterpillar. Nonetheless, the speed of the decline in capex has surprised many, and further bad news continues to hit the market in the form of improved competition from China. All in all, the outlook for Joy and Caterpillar is bleak, and it could get worse.

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Fool contributor Rupert Hargreaves owns shares of Joy Global. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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