The market turned bullish about Joy Global (NYSE:JOY) in recent weeks, but Longbow isn't impressed. The research firm downgraded the stock to "underperform" last week, planting a price target of $50 a share. That represents nearly a 20% downside from the stock's current price.
While I usually take analyst estimates with a grain of salt, investors may have a reason to worry here, especially after Caterpillar (NYSE:CAT) recently reported dismal mining-equipment sales numbers. Is it time to short Joy Global?
Is the optimism justified?
Longbow believes the current demand for mining equipment doesn't justify the high consensus estimates for Joy Global. In other words, the optimism that Joy's Street-beating second-quarter numbers fueled may have already been baked into its share price.
At first blush, Joy Global's Q2 numbers were nothing to write home about. Its bookings fell 7%, net sales dropped 32%, and net income slumped a staggering 59% year over year. Nevertheless, the company gave the market sufficient reasons to turn hopeful, one of them being the confirmation of its full-year revenue guidance. In contrast, during its last quarterly earnings, Caterpillar lowered its forecast for mining-equipment sales, expecting them to drop twice as much as earlier projected at 20% for the full year.
But then, Joy's outlook suggests that it had perhaps already factored in the worst, leaving little room for revision – Joy expects to end this financial year with revenue between $3.6 billion and $3.8 billion, which represents at least 24% downside versus 2013.
Pay attention to the indicators
Joy Global really caught the market unawares when it raised the lower end of its projected adjusted earnings range for the full year by $0.10 to $3.10 and $3.50 per share. But if the small improvement in guidance has encouraged investors to believe that the worst is over for Joy Global, they may be jumping the gun.
The weakness in end markets has compelled Joy Global to resort to aggressive cost cutting. But that can help maintain margins only to a certain extent. Moreover, even at the higher end, the EPS outlook represents a substantial 30% downside versus last year. Here's a graph that gives you the full picture.
Simply put, Joy Global cannot stage a comeback until sales pick up. And considering that it relies heavily on coal-mining companies for revenue, Longbow's concerns are justified. For evidence about the dire situation that the mining industry is still in, look no further than Caterpillar's three-month rolling sales data through May. Worldwide retail machinery sales from Caterpillar's resource industries, or mining division slumped 46% year over year during the period, with the Asia-Pacific and Latin American regions reporting more than 60% drop in sales each. The numbers for the quarter ended April were equally dismal.
Can't rely on services alone
Bulls maybe betting on Joy Global's service side of business (earlier referred to as aftermarket business) to pull it out of the mess, but it's too early to rejoice. Aside from equipment, Joy makes parts and rebuilds, and provides repairs and maintenance services to mining companies. The business made up 55% of the company's total sales last year. Small wonder, then, that the market was excited when Joy reported an 8% year-over-year increase in service orders versus 27% lower orders for original equipment in its last quarter.
Nevertheless, it's important to note that service sales from Joy's largest market, the U.S. continue to remain weak, primarily because of depressed commodities prices that are hurting mining companies' margins. Joy Global is still "cautious" about its service business given the persisting challenges, which also explains why it has such a muted outlook for the year despite two consecutive quarters of strong service orders. Long story short, the company needs much more than higher repair and parts orders to sustain its business.
Ready to plunge?
It'll not be an easy road to recovery for Joy Global. Caterpillar believes that order rates in the mining industry are still only "a fraction of where they were" in 2011-2012. Given the present situation, it could take years for these companies to see those levels again. Against this backdrop, the recent run-up in Joy Global shares -- they have gained nearly 8% over the past month -- appear to be overdone, and I believe Longbow is right to be on the sidelines.
Neha Chamaria has no position in any stocks mentioned. The Motley Fool recommends BMW and Nike and owns shares of Nike. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.