Construction and Mining: The China Connection

Nauman is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

When it comes to deciding if construction and mining equipment companies are good plays, the key is to keep an eye on economic conditions in China. Like it or not, China is going to become the hotspot of economic activity in the future as it continues on its path of rapid development. The industry leaders are Caterpillar (NYSE: CAT) and Joy Global (NYSE: JOY). Based on economic data coming out of China, it may be an excellent time to get into one or the other – maybe even both.

Acquisitions are great, except when they aren’t

Both Caterpillar and Joy Global have been absorbing Chinese firms into their operations. For Caterpillar, its most recent acquisition was something of a disaster. Unbeknownst to Caterpillar, Siwei was engaging in ongoing accounting misconduct that it concealed for years. It ended up costing Caterpillar more than $500 million (though they did settle with a cut in purchase price) – the one-time charge did wipe out more than half that quarter’s profit. I can only imagine that Joy Global must have decided to take a much closer look at its own Chinese acquisition – mining company IMM. Luckily for Joy Global, not to mention its investors, everything looks good on that account.

China: Signs that the slumbering giant is awakening

The global economic downturn hurt everyone, China included. There are signs; however, that the Chinese economy is getting back on track, which is very good news for investors in companies like Caterpillar and Joy Global. One bellwether indicator to pay attention to is electricity consumption. Although overall, China saw a decline in the growth of electricity consumption for 2012, a significant jump in the high single-digits took place in the most recent quarter. April’s additional increase of 7% is a good sign that 2013 should see at least the growth of up to 10% in electricity consumption that most analysts are predicting.

Another good indicator is steel output, demand for which comes mainly from the construction and auto industries. February saw China’s steel output surge by almost 10% to an all-time high of 2.2 million metric tons (the previous record was 2.05 million, set the previous month). Other key commodities that are up include aluminum, copper and oil (essential to the machinery manufacturing), construction, and power generation industries.

Demand for those items was so high, in fact, that China had to import more than it normally would, resulting in an actual trade deficit. China doesn’t like running trade deficits, so it is going to be looking to step up mining operations to meet those needs internally.

Perhaps the best news for Joy Global is that China’s coal orders are beginning to ramp up, which means sales for the world’s number two manufacturer of mining equipment. Can you guess who the number one company is? If you guessed Caterpillar, then you guessed correctly.

But, for mining equipment companies to do well, the companies that do the mining must also be doing well – companies like Rio Tinto (NYSE: RIO) and BHP Billiton (NYSE: BHP). Sometimes the mining companies try to increase production by more efficiently exploiting the mines already being used rather than starting new ones (both of which involves buying new equipment to achieve the desired results).

Most analysts believe that both Rio Tinto and BHP Billiton are looking strong for 2013. Also, both mining companies are trimming their costs in billions and are upbeat about the Chinese economy, which in turn should produce solid numbers for both Rio Tinto and BHP Billiton in the future. Backed by a strong economic recovery in the key emerging markets, both companies expect current revenues to increase by mid-teens in the year 2014.

Caterpillar or Joy?

With the Chinese stage set to help both companies do well in 2013, which company will be seizing that opportunity from a better position? Caterpillar had an overall record year in 2012, with a 10% increase in net sales, a 15% increase in profit per share and its 19th consecutive dividends hike that puts the yield at 2.5%. Joy Global, on the other hand, is beating Caterpillar on gross margin and even though its debt situation was better than Caterpillar’s before it took on the IMM acquisition, it is working hard to wipe out as much of the debt from that deal as possible.

Both companies were hit hard in the US by the drop in natural gas prices in 2012, which resulted in many companies switching from coal to natural gas for power generation. With natural gas prices back on the rise, coal production should see a significant bump this year, which would allow both companies to benefit from increased coal demand. Combining those domestic prospects with the rising demand in China, both companies ought to see a significant appreciation in share prices.

The bottom line

With key economic indicators (electricity, commodity orders) pointing towards recovery for the Chinese economy, both Caterpillar and Joy Global are poised to take full advantage of the slumbering giant as it reawakens. With both stocks currently trading near six-month lows, those prices are sure to rise significantly with the Chinese economy. Now would be the time to add both to your portfolio.

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