Ignore equipment manufacturers at your peril

Since the last commodity boom 20 years ago, underinvestment in mining equipment in countries such as the United States, Australia and other mature markets is now benefiting companies like Joy Global (JOYG-Q), Bucyrus International (BUCY-N) and Caterpillar (CAT-N), according to a new report from Credit Suisse.

Credit Suisse analysts argue that the most accessible mineral deposits in these markets are near the surface and are being steadily depleted. As a result, more and more miners are having to move underground, where more machines are required to maintain production levels.

At the same time, production is ramping up at existing mines and new mines are being opened in emerging markets like China. Oil production in Canada’s oil sands is also a big market for mining equipment manufacturers.

“These factors should continue to drive the demand for mining equipment for several years,” Credit Suisse analysts argue in a March research report. “The last two mining cycles lasted approximately 15 years each while the current cycle is only about five years old. This cycle has the added benefit of a secular increase in emerging market demand.”

Caterpillar is one company poised to benefit, with an estimated 15% of its sales coming from the mining sector, the analysts at Credit Suisse point out. Joy Global and Bucyrus are also big beneficiaries.

“Equipment manufacturers are benefiting from favorable pricing as the industry has consolidated to two primary manufacturers, Joy Global and Bucyrus,” the report states.

Both companies manufacture surface and underground mining equipment and are adding manufacturing capacity to meet demand, Credit Suisse reports.

Currently Joy Global is trading at about US$74.15 per share; Bucyrus at US$119.97 per share and Caterpillar at US$81.54 per share.

In terms of key revenue drivers, coal is probably the most important commodity for Joy Global and Bucyrus. According to Credit Suisse, the underground side of their business, which represents about 50% of revenues, is almost completely dependant on coal and consequently about 70% of their revenues are directly tied to coal production.

The next largest end-market for Joy Global and Bucyrus is copper, which makes up about 13% of Bucyrus’s revenues and 16% of Joy Global’s. Iron ore and Canada’s oil sands each represent about 5% of their sales.

Emerging markets will help drive future demand for equipment, too. While the U.S. will remain an important market, China and India will certainly need more mining equipment in the future. This is primarily because new coal-fired plants are being built to meet growing energy demand.

The Energy Information Administration (EIA), anticipates coal consumption in non-OECD countries to grow 2.8% a year over the next 25 years and says about 70% of that increase will come from China and India. By contrast, coal consumption in OECD member countries is expected to rise just 0.9% a year.

China is the largest consumer and producer of coal in the world, producing nearly 40% of the world’s coal and it consumes about 35% of global production. Consumption has been going up by about 15% a year due to power generation demand, steel and chemical production and construction. But China has only been able to grow production by about 10% a year and at the end of 2007 it had become a net importer of coal for the first time in its history.

Credit Suisse points out that China makes up about 20% of sales for Joy Global and Bucyrus but argues as China moves to bigger, more mechanized mines, its appetite for mining equipment can only increase.

The report claims that domestic equipment is half the price of imported equipment, but the latter “is generally four times as productive.”(Since 2005, China has been shutting down its smaller unproductive mines and trying to consolidate production at major producers.)

What’s more, both companies are now manufacturing in China. Joy Global has a production facility in the northern city of Tianjin and a network of service centers in the region. Bucyrus has two manufacturing facilities in China and a number of service locations.

Apart from coal, Joy Global and Bucyrus are likely to benefit from rising demand for copper, iron ore and demand for surface mining equipment at the oil sands in western Canada.

In terms of copper, the metal accounts for about 16% of Joy Global’s and 12% of Bucyrus’s end-markets. Demand for copper in China alone has gone up by about 13% annually from 1991 to 2007, while supply has only gone up by about 3% a year. Copper inventories have fallen to their lowest levels since 2002.

So far sales numbers look good. Joy Global’s orders advanced 54% in the first quarter of the year and Credit Suisse forecasts 30% sales growth in fiscal 2008 and 20% in fiscal 2009. Bucyrus’s orders, meanwhile, rose 24% in the fourth quarter of 2007 and Credit Suisse is calling for an increase of 27% in core sales in 2008.

Caterpillar, meanwhile, is forecast to see its sales rise 8% this year as it continues to benefit from “an extended global infrastructure spending cycle.” More than half of the world’s large mining trucks, wheel loaders, motor graders, scrapers and track-type tractors bear the Caterpillar name.

Caterpillar dealers Finning (FTT-T) and Toromont (TIH-T) may also be worth a closer look.

Finning is currently trading at $29.73 per share and has a 52-week range of $23.50-$33.91. Toromont is trading at $29.35 per share and has a 52-week range of $22.45-$32.49.