On Nov. 15, 2010, Caterpillar (NYSE: CAT) announced that it will acquire The Energy Strategist Portfolio holding Bucyrus International (NSDQ: BUCY) in a cash transaction that amounts to $92 per share. The deal represents a 32 percent premium to the stock’s closing price before the announcement. Readers enjoyed a return of about 150 percent in a little over a year.

The transaction is the latest in a string of mergers and acquisitions (M&A) in the energy patch. With nearly $200 billion worth of deals in 2010, energy is the top sector for M&A activity and this year likely will mark a new record for annual deal flow. This trend should continue well into 2011; oil prices are soaring, major companies are flush with cash, and debt capital remains inexpensive. The graph below tells the story thus far.

Source: Bloomberg

Investors have already made their money on Bucyrus, but that’s no reason to miss out on the next multibillion dollar deal. Wall Street investment bankers are salivating over the prospect of more M&A activity and using Bucyrus and other recent buyouts as a template for new deals. Individual investors should follow their lead.

The Bucyrus Story

Caterpillar is an icon of US manufacturing. Investors are likely familiar with the behemoth’s eponymous product line of trucks, tractors, backhoes and large-scale industrial machinery.

Bucyrus might lack the high profile of its acquirer, but the mining industry is in the early stages of a multiyear uptrend that will make related equipment the fastest-growing and most profitable sub-segment in the machinery business. Caterpillar’s management recognizes this potential and paid a significant premium to pick up one of the leading players in this market.

Founded 130 years ago, Bucyrus cut its teeth as a producer of the massive steam-powered shovels used to dig, level and prepare ground for railroad tracks, the backbone of US freight and passenger transportation of the era.

In the early 20th century, the Milwaukee-based firm also gained prominence for manufacturing three 95-ton shovels ordered by the US government to perform excavation work on the Panama Canal. One photo displayed at the company’s museum depicts President Theodore Roosevelt sitting on a Bucyrus made shovel during a tour of Panama Canal Zone in 1908.

Today, the mining industry accounts for almost 100 percent of the Bucyrus’ revenue, with the coal market generating more than three-quarters of overall sales. The company also provides equipment to operators in the Canadian oil sands, a rapidly growing business that made up 7 percent of its revenue in 2009. Caterpillar also services this end market, so the combined firm should have ample opportunity to grow this business. 

To this day, Bucyrus is a leading manufacturer of shovels and excavation tools for the mining industry. Here’s a quick look at some of its key products.

Mining outfits use draglines to pull a large bucket or scoop that contains overburden, or the rock, dirt and debris that cover coal and other mined deposits located near the surface. Draglines can weigh as much as 8,000 tons–the equivalent of 700 large school buses–and can cost up to $200 million. This heft is important: The bucket or scoop attached to a dragline can contain as much as 152 cubic yards of detritus, almost half the volume of an Olympic-size swimming pool. At this time, Bucyrus only has one legitimate competitor in the market for draglines, ensuring that the firm enjoys a substantial competitive moat.

A pioneering manufacturer of electric mining shovels, Bucyrus has maintained its leadership in this business line. Don’t make the mistake of assuming that industrial manufacturing involves building low-tech goods as inexpensively as possible. Bucyrus’ shovels may perform much the same task as the equipment used to dig the Panama Canal, but the addition of advanced electronics maximizes the efficiency of each scoop. In the mining industry, shovels are used primarily to pick up coal and load it into trucks for transport.

Hydraulic excavators are smaller machines that use scoops or backhoes to move overburden and other materials.

Mining outfits use drills to produce blast holes. Explosives are lowered into these holes to break up rock and expose the targeted minerals. Bucyrus’ current product line allows users to automatically change out drill bits, a capability that minimizes downtime and maximizes efficiency.

In addition to these key surface mining products, Bucyrus produces a range of underground mining equipment that accounts for roughly half of its overall sales. For example, the company manufactures complete long-wall mining systems, a process that involves cutting coal from the wall of an underground mine. Beside hydraulic shears, Bucyrus also makes electric trucks and conveyor belt systems that transport coal to the surface as well as hydraulic roof supports that prevent cave-ins.

The after-market parts and service business is an even more contributor to Bucyrus’ sales mix than new equipment; in any given year, after-market sales can account for from one-half to two-thirds of overall business.

Consider that a dragline has an operating life of at least 40 years. Meanwhile, most of Bucyrus’ underground mining equipment has a useful life of 5 to 15 years. That means that when Bucyrus sells a new piece of equipment, it’s also likely locking in a stream of revenue from service and parts contracts that can last for decades.

Better still, the after-market business is insulated from economic downturns and earns higher profit margins. When commodity prices dropped in late 2008 and early 2009, mining firms cut back orders for new equipment, especially big-ticket items such as draglines and long-wall mining systems. But producers must ensure that their existing equipment runs, which requires regular servicing and replacement parts.

Roughly $30 billion worth of Bucyrus’ equipment operates around the world today, equivalent to a decade’s worth of sales. With the largest installed base of mining equipment of any manufacturer, Bucyrus enjoys a built-in lead in the after-market business.

Mining the Super Cycle

Bucyrus’ growth story is simple: Its major customers have committed to a significant multiyear increase in capital spending, primarily to open new mines and expand existing facilities.

Australia is the world’s leading exporter of coal. In recent years Indonesia and Australia had alternated as the leading exporter of thermal coal, but thanks to new mines and export terminals, Australia is set to pull ahead in coming years and should remain in the lead for at least two decades.

When it comes to metallurgical (met) coal–a higher-grade variety used to make steel–there’s simply no contest: Australia exports more than four times the quantity shipped by its two closest competitors, the US and Canada. Although both of its rivals are expected to grow exports of met coal significantly in coming decades, neither will be able to overtake Australia.

Australia’s dominance in the export market makes it a key market to watch for new mine developments. The table below lists new coal mines under construction in Australia.

Source: Australian Bureau of Agriculture and Resource Economics

This table comprises only mines that are already under construction and are due to be completed within the next five years. These mines involve a total capital expenditure (CAPEX) of more than USD5.1 billion. In addition to these deals, the Australian Bureau of Agriculture and Resource Economics is tracking about 50 additional projects that are at an earlier stage of planning and permitting.

Although Australia is the world’s largest exporter of coal, it isn’t the world’s largest producer; both China and the US both extract more coal than Australia. And companies in these nations are spending billions of dollars to open new mines and take advantage of attractive prices for seaborne coal.

There are also a number of smaller, fast-growing coal producers. For example, the US Export-Import Bank recently approved $900 million worth of loan guarantees for India’s Reliance Power (India: 532939). The deal involves about $400 million worth of orders for mining equipment manufactured by Bucyrus that will be used to mine coal to feed Reliance’s massive Sasan power plant.

And that’s one of many deals to come. India is expected to be the world’s fastest-growing importer of thermal coal over the next five years as it brings new capacity online to meet the economy’s growing power needs.

Mongolia is another market to watch; the nation is expected to become an important supplier of coal to energy-hungry China in coming years. Several global mining giants, including Peabody Energy Corp (NYSE: BTU), have invested in Mongolian coal projects. During the conference call to discuss the Caterpillar deal, Bucyrus’ CEO Timothy Sullivan noted that both companies supply this emerging market.

All of these new mine developments should increase demand for Bucyrus’ equipment. Some of this growth is already visible in Bucyrus’ backlog of unfilled orders. In the third quarter Bucyrus reported a total backlog of $2.5 billion, up nearly a third from the end of 2009. 

The Hungry Caterpillar

Caterpillar has made no secret of its interest in expanding mining-related product offerings. In August the company outlined mining as one of its “Big 8 Imperatives,” and management noted that it expects rising consumption of basic commodities in emerging markets to drive an up-cycle in demand for mining equipment.

In fact, the company had planned to spend about $700 million over the next few years to expand its mining product line organically. This deal will give Caterpillar an immediate presence in key markets and accelerate  its organic-growth projects by as much as 3 to 4 years. Caterpillar also would have struggled to compete with Bucyrus in draglines and other well-established and specialized equipment lines.

Besides secular growth opportunities in mining equipment, the management teams cited the following advantages when discussing the tie-up:

• The ability to use some of Caterpillar’s components in Bucyrus’ products should cut costs and make it easier to change and replace parts;

• The two companies have very little business overlap, so the transaction amounts to a bolt-on deal that directly expands Caterpillar’s product offerings;

• About half of Bucyrus’ sales come from the big five mining companies–BHP Billiton (ASX: BHP, NYSE: BHP), Rio Tinto (LSE: RIO, NYSE: RTP), Anglo American (LSE AAL, OTC: AAUKY), Vale (NYSE: VALE) and Xstrata (LSE: XTA; OTC: XSRAY). These mining giants prefer to form strategic relationships with a small number of large suppliers instead of ordering equipment from multiple firms; and

• Caterpillar has an unparalleled network of dealers, some of which already distribute Bucyrus’ products. The combined firm will be able to leverage its dealer network to market and distribute new equipment more effectively. But the real opportunity resides in the after-market business where a larger and more established network of dealers will help the combined firms win more lucrative long-term parts and service deals.

All told, Caterpillar expects the deal to be accretive to earnings in the first full year of operation and produce annual synergies of $400 million beginning in 2015.

Every major acquisition elicits its fair share of naysayers, especially when the deal involves the acquirer paying a considerable premium. But the market welcomed the tie-up; Caterpillar’s shares rallied last week after the company announced the acquisition.

My view: Caterpillar realized that Bucyrus was going to be a much more expensive stock as the mining CAPEX cycle took hold and Bucyrus’ backlog continued to expand. Given the industry’s growth, I don’t regard paying less than 18 times forward earnings as excessive.

Who’s Next?

Who’s the next acquisition target? Among producers of coal mining equipment, the obvious answer is Joy Global (NSDQ: JOYG). If we value Joy Global at a similar 18 times forward earnings, it would fetch around $90 in a buy-out. But that valuation is conservative.   

Joy is the only remaining independent pure-play on mining equipment. Investors looking to play the theme could buy shares of Caterpillar, but the firm’s business lines serve a host of other end markets, including residential and nonresidential construction. Investors looking for a pure-play on mining equipment will allocate more money to Joy Global.

Meanwhile, Caterpillar is the 800-pound gorilla of the earth-moving and heavy equipment; this deal will make other companies in the industry to sit up and take notice. And because there aren’t any real alternatives to Joy Global, the stock could earn a significant scarcity premium and fetch north of $110 per share in a deal.

Together, Joy and Bucyrus control more than three-quarters of the global market for specialty mining equipment, enjoying a duopoly in key market segments. Joy also has benefited as major mining outfits ramp up CAPEX; the company’s order backlog stood at $1.8 billion at the end of its fiscal third quarter, compared to less than $1.5 billion at the end of 2009. Meanwhile, orders for equipment have soared more than 50 percent from the year-ago quarter

Joy conducts business through three units: Joy Mining Machinery for underground mining equipment, P&H Mining for surface equipment and Continental Crushing and Conveying (CCC).

Joy Mining and Machinery is the company’s largest segment and accounts for a little more than half of total sales and backlog. A subtle difference between Bucyrus and Joy is that former focuses a bit more on surface mining equipment. The basic underground mining equipment Joy produces is more or less identical to that built by Bucyrus and includes conveyors and shuttle cars for transporting coal, continuous and long-wall miners for shearing coal and hydraulic roof supports. Joy is generally perceived as having a slight edge in the underground mining business.

Joy’s surface mining business accounts for a bit more than one-third of sales. The company operates in the same basic product categories as Bucyrus, though it lags the latter when it comes to draglines and other bigger pieces of equipment.

The Continental Crushing and Conveying business consists of equipment used to break coal and other mined materials into smaller pieces for ease of sorting, transport and storage.  This business, Joy’s smallest, chips in a little more than 10 percent of revenue.

Like Bucyrus, a sizeable chunk of Joy’s revenue comes from more stable and profitable after-market service and parts contracts.

Although big mining firms prefer to negotiate with a handful of smaller suppliers, the market is tight enough to accommodate more than one competitor. And the miners won’t allow Bucyrus-Caterpillar to enjoy a monopoly; the industry needs a thriving major competitor.

Joy Global has invested directly in Chinese manufacturers and is enhancing its already significant presence in the country. Although Joy and Bucyrus are global market leaders, a number of smaller Chinese and Russian players manufacture lower-end equipment for surface and underground mining. Joy may seek to expand by acquiring or forming joint ventures with these firms. With surging demand for domestic thermal and met coal, China is expected to be one of the fastest-growing markets for coal mining equipment. Such a deal would make Joy a leading player in this key emerging market.

Alternatively, Komatsu (Japan: 6301, OTC: KMTUY) and Hitachi (Japan: 6501, NYSE: HIT) both compete with Caterpillar in multiple business lines, and the former has long been considered Caterpillar’s arch rival. With a market capitalization of less than $8 billion, Joy Global is much smaller than both Hitachi and Komatsu and would be a potential target if either firm is looking to boost their mining exposure.

Joy might form a strategic joint venture with one of these manufacturers or a European firm such as privately held Liebherr of Switzerland or Volvo (Sweden: VOLV B, OTC: VOLVY), two names firms with exposure to mining-related machinery.

Regardless of whether Joy goes it alone, forms joint ventures or is acquired by a larger rival, I see significant upside for the stock. Buy Joy Global, the latest addition to the Gushers Portfolio, under 85. 

And Bucyrus is only the latest in a series of acquisitions this year. In early 2010 Schlumberger (NYSE: SLB) agreed to acquire Smith International in an $11 billion all-stock deal, handing Smith investors an overnight gain of around 40 percent. Smith was one company I highlighted at the end of 2009 as a likely target for a major oil services firm.

And two coal mining names I’ve highlighted in The Energy Strategist have been acquisition targets. Chinese firm Yanzhou Coal Mining (Hong Kong: 1171, NYSE: YZC) paid a significant premium to acquire then Portfolio holding Felix Resources, while Peabody Energy abandoned a deal to acquire Macarthur Coal (ASX: MCC) earlier this year.

My top 10 takeover picks for 2011 include two smaller oil equipment firms with leverage to the boom in deepwater drilling, a handful of high-yield master limited partnerships that are poised to take advantage of a record-low cost of capital, and two agricultural names leveraged to high grain prices and biofuels mandates. 

I will reveal these 10 takeover plays in the Dec. 1 installment of The Energy Strategist. Readers will have the opportunity to discuss these takeover picks–and any of the names in the model Portfolios–during an online chat session slated for Dec. 2 at 3:00 pm EST. You can click here to to sign up for an email reminder about this event. I look forward to hearing from you.

Winter’s Coming, Let’s Fly South

For me, winter hasn’t truly arrived until I set a fire in the fireplace. I guess there’s just something about that smell of burning wood that reminds me of wintertime, or perhaps it’s the taste of the traditional cognac I pour while enjoying the first fire of the season. Winter finally came this week with just enough of a chill in the air to justify buying a small bundle of wood from my local grocery store for the exorbitant price of $10.

The first few months of winter are always a welcome change of pace, and I always enjoy that first fire. But winter gets old quickly. By early January I’m usually yearning for spring.

But this year I won’t have to wait long–I’m headed to sunny Orlando, Florida for the World MoneyShow, which will take place Feb. 9-12. Better yet, immediately thereafter I’m sailing to even warmer climes on the Money Answers Investment cruise. 

I’d like to extend a special invitation to all subscribers to join me in Orlando in February. I also hope you’ll all decide to make a longer trip of it and follow me south for the cruise. To sign up for the World MoneyShow as my guest (it’s free of charge), click here. And for more information about the Money Answers Investment cruise, including a detailed itinerary, www.MoneyAnswersCruise.com or call 1-800-707-1634.