Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the Consolidated Financial Statements and related notes. References made to years are for fiscal year periods. Dollar amounts are in thousands, except share and per-share data and as indicated. All per share data shown below has been adjusted to reflect our 3-for-2 stock splits completed on January 21, 2005 and December 12, 2005.

         The purpose of this discussion and analysis is to enhance the understanding and evaluation of the results of operations, financial position, cash flows, indebtedness, and other key financial information of Joy Global Inc. and its subsidiaries for Fiscal 2005, Fiscal 2004, and Fiscal 2003. For a more complete understanding of this discussion, please read the Notes to Consolidated Financial Statements included in this report.

Overview

        We are the direct successor to businesses that have been manufacturing mining equipment for over 120 years. We operate in two business segments: Underground Mining Machinery, comprised of our Joy Mining Machinery business (“Joy”), and Surface Mining Equipment, comprised of our P&H Mining Equipment business (“P&H”). Joy is the world’s largest producer of high productivity electric-powered underground mining equipment used primarily for the extraction of coal. P&H is the world’s largest producer of high productivity electric mining shovels and a leading producer of walking draglines and large rotary blasthole drills, used primarily for surface mining copper, coal, iron ore, oil sands and other minerals.

        Over 87% of our sales are to the coal and copper mining industries. In addition to selling new equipment, we provide parts, components, repairs, rebuilds, diagnostic analysis, fabrication, training and other aftermarket services for our installed base of machines. In the case of Surface Mining Equipment, we also provide aftermarket services for equipment manufactured by other companies, including manufacturers with which we have ongoing relationships and which we refer to as “Alliance Partners.” We emphasize our aftermarket products and services as an integral part of lowering our customers’ cost per unit of production and are focused on continuing to grow this part of our business.

        Demand for new equipment is cyclical in nature, being driven by commodity prices and other factors. Our new equipment sales over the last five years have ranged from a high of $716.8 million in Fiscal 2005 to a low of $316.4 million in Fiscal 2001. In contrast, our aftermarket business has shown consistent growth over the past five years despite commodity production restrictions and price volatility, and helps moderate the effects of changes in new equipment demand on our financial performance. Our aftermarket sales over the last five years have grown from $799.8 million in Fiscal 2001 to $1,210.7 million in Fiscal 2005.

        Approximately 83% of our sales in Fiscal 2005 were recorded at the time of shipment of the product or delivery of the service. The remaining 17% of sales was recorded using percentage of completion accounting, a practice we follow in recognizing revenue on the sale of long lead-time equipment such as electric mining shovels, walking draglines and roof supports. Under percentage of completion accounting, revenue is recognized on firm orders from customers as the product is manufactured based on the ratio of actual costs incurred to estimated total costs to be incurred. We generally receive progress payments on long lead-time equipment.

        The major components of our cost of sales are manufacturing overhead, labor and raw materials such as steel. We have taken significant steps to reduce manufacturing overhead. In recent years, we have been adversely affected by increases in the cost of raw materials, especially steel. The mix of original equipment and aftermarket sales affects our operating profit. Our aftermarket products generally carry higher margins than our original equipment and increases in our aftermarket sales have a favorable impact on our profitability. Although steel prices increased, our gross profit margin in Fiscal 2005 increased to 29.2% from 27.0% in Fiscal 2004.

        In Fiscal 2005, approximately 45% of our sales were made to customers from the United States. With the exception of South Africa and Australia, our domestic and international sales are largely denominated in U.S. dollars or pounds sterling. From time to time, we hedge specifically identified committed cash flows using foreign currency sale or purchase contracts.

Results of Operations

2005 Compared with 2004

        Total net sales for Fiscal 2005 increased by $528.1 million, or 37.7%, over Fiscal 2004 net sales. Net sales in the United States increased by $230.4 million, or 36.0%, and international net sales rose by $297.7 million, or 39.2%. Reflecting the cyclical upturn in commodities, original equipment revenues increased by approximately 65% to $716.8 million in Fiscal 2005, accounting for 37.2% of total revenues for the year. Aftermarket sales, which include sales of parts and services, increased approximately 26% to $1,210.7 million for Fiscal 2005.

        The increase in net sales for Underground Mining Machinery in Fiscal 2005 compared to Fiscal 2004 was the result of a $188.5 million increase in shipments of original equipment combined with a $123.7 million increase in aftermarket products and service. The primary increases in original equipment sales were $77.3 million, $67.1 million and $43.3 million in the emerging markets served out of the United Kingdom, the United States and Australia, respectively. The increase in original equipment sales reflects the continuing strong activity levels for new equipment for both replacement of existing equipment and for new mining capacity. Increases in aftermarket net sales were reported in substantially all of our markets. Higher aftermarket sales in the United States accounted for approximately 60% of the overall increase in aftermarket sales. Approximately 40% of the increase in aftermarket sales was due to the increase in repair parts sales, another 40% due to complete machine rebuilds and the remaining increase was due to component repairs. The strong level of aftermarket sales in Fiscal 2005 reflected the continued high level of coal mining activity on a global basis.

        The increase in net sales for Surface Mining Equipment in Fiscal 2005 compared to Fiscal 2004 was the result of a $90.7 million increase in original equipment combined with a $125.2 million increase in aftermarket parts and service. Increases in original equipment sales were reported in Canada, Mexico, the international markets we serve out of the United Kingdom (primarily Russia), Australia, Venezuela and Chile. Approximately 40% of the original equipment sales increase was due to shipments of electric mining shovels to Canada and approximately 20% was due to primarily to shipments of electric mining shovels to the international markets we serve out of the United Kingdom (primarily Russia) with the remainder attributable to the other markets. Increases in aftermarket sales were reported for the United States, Australia, Canada, Chile, Brazil, Russia, Mexico and Southern Africa. Approximately 73% of the aftermarket sales increase was due to the higher repair parts sales, with the remaining increase due to higher aftermarket service sales. The strong level of both original equipment and aftermarket sales in Fiscal 2005 reflects the continued high level of activity in the mining of copper, coal, iron ore, oil sands and gold.

         Operating income as a percentage of net sales for Underground Mining Machinery increased from 11.1% in Fiscal 2004 to 16.5% in Fiscal 2005. The higher volume of sales favorably impacted operating income in Fiscal 2005. Increased production activity allowed for higher levels of manufacturing overhead absorption that exceeded the increase in the variable overhead spending in the United States, United Kingdom and Australia. Product development and selling expenses were essentially flat year over year, and were down significantly as a percent of revenues. These favorable impacts were partially offset by $10.5 million in administrative expenses.

         Operating income as a percentage of net sales for Surface Mining Equipment increased from 9.2% in Fiscal 2004 to 14.4% in Fiscal 2005. This improvement in profitability was due primarily to an $8.7 million improvement in the relationship between manufacturing overhead spending and manufacturing overhead absorption, partially offset by a $15.0 million increase in product development, selling and administrative expenses.

Product Development, Selling and Administrative Expense

         Product development, selling and administrative expense for Fiscal 2005 was $297.9 million as compared to $273.0 million for Fiscal 2004. The increase in product development, selling and administrative expense was due primarily to a $4.2 million increase in compensation expense associated with performance-based incentive programs, approximately $4.4 million for an arbitration award and approximately $2.6 million for the implementation of the SAP enterprise software system, as well as the impact of general cost inflation. Product development, selling and administrative expense as a percentage of sales for Fiscal 2005 decreased to 15.5% as compared to 19.5% in Fiscal 2004.

Interest Expense

        Interest expense for Fiscal 2005 decreased to $15.2 million as compared to $24.3 million for Fiscal 2004. This decrease was principally due to our repurchase of substantially all of our 8.75% Senior Subordinated Notes in June 2005. There were no direct borrowings under our revolving credit agreement at the end of Fiscal 2005. Cash interest paid in Fiscal 2005 and Fiscal 2004 was $16.5 million and $22.0 million, respectively.

Provision for Income Taxes

        Our effective consolidated income tax rates from continuing operations for Fiscal 2005 and Fiscal 2004 were approximately 35.4% and 41.5%, respectively. For Fiscal 2005, the consolidated income tax rate approximated the statutory rate of 35%. Consolidated income tax expense from continuing operations increased to $80.5 million in Fiscal 2005 as compared to $39.3 million in Fiscal 2004. The increase in income tax expense is primarily attributable to the substantial increase in our pre-tax income. Additionally, the consolidated income tax expense and effective income tax rate for Fiscal 2004 were negatively impacted by a $13.4 million increase in our deferred tax valuation reserves relating to Australian corporate income taxes that was not repeated in Fiscal 2005.

2004 Compared with 2003

Sales

        The following table sets forth Fiscal 2004 and Fiscal 2003 net sales as derived from our Consolidated Statement of Income:

        Total net sales for Fiscal 2004 increased by $213.7 million, or 18%, over Fiscal 2003 net sales. Net sales in the United States increased by $87.3 million, or 15.8%, and net sales in the rest of the world rose by $126.3 million, or 19.9%. Reflecting the cyclical upturn in commodities, original equipment revenues increased by approximately 35% to $437.6 million in Fiscal 2004, accounting for 31.3% of total revenues for the year. Aftermarket sales, which include sales of parts, components, rebuilds and services, increased approximately 11% to $961.8 million for Fiscal 2004.

        The increase in Underground Mining Machinery net sales in Fiscal 2004 was the result of an $80.6 million increase in original equipment product shipments and $53.5 million increase in aftermarket sales. New machine sales recorded through the United Kingdom increased by $55.0 primarily due to a large roof support order and an increase in armored face conveyor shipments to both the United Kingdom and China. South Africa increased $18.1 million, recovering from depressed levels of prior year new machine sales with increased shipments of continuous miners in Fiscal 2004. New machine sales increased by $14.3 million in Australia primarily due to an increase in shipments of roof supports, longwall shearers and armored face conveyors, which were partially offset by a decline in sales of continuous miners. United States new machine sales were down slightly due to decreases in shipments of roof supports and armored face conveyors partially offset by increased shipments of continuous miners and shuttle cars. Aftermarket sales showed significant improvement in the United States, growing by $42.6 million, while revenues from South Africa grew by $11.5 million, benefiting from the weakness of the U.S. dollar and the favorable impact of translating South African Rand sales into U.S. dollars. Those increases in aftermarket sales were partially offset by a decrease in complete machine rebuilds of $7.7 million in Australia primarily due to unusually high levels of sales in Fiscal 2003. Throughout the markets we serve both our new machine and aftermarket sales have benefited from the prices our customers receive for their coal. Activity levels in the emerging markets, including China, continued the high level of activity we began to see in Fiscal 2003.

        The increase in Surface Mining Equipment net sales in Fiscal 2004 was a result of a $37.6 increase in new and used equipment shipments, as well as a $41.9 million aftermarket parts and service sales. The increase in new equipment was due to higher sales of electric mining shovels in both Russia and the United States (accounting for $11.7 million and $28.6 million, respectively) and higher U.S. sales of loading equipment manufactured by our Alliance Partners (accounting for $6.2 million). The increase in U.S. new equipment sales was driven by stronger demand in the coal and iron ore markets. The Russian shovel sale, which was the first new electric mining shovel sold in Russia, was attributable to increased activity in the coal market. An increase in sales of used electric mining shovels was attributable to shipments to both Russia and Zambia. In the aftermarket, sales increased primarily in South America and the Southwestern United States (accounting for $26.7 million and $12.8 million, respectively). Service sales were strong in Brazil, Chile, South Africa and the United States, partially offset by lower service sales in Canada.

         Operating income for Underground Mining Machinery increased by approximately $47.8 million in Fiscal 2004 as compared to Fiscal 2003. During Fiscal 2004, charges for the depreciation and amortization of the fresh start accounting items decreased by approximately $3.0 million. Excluding the impact of the charges for fresh start, the increase in operating income for Fiscal 2004 was $44.8 million. The higher volume of sales favorably impacted operating income in Fiscal 2004. Increased sales activity allowed for higher levels of manufacturing overhead absorption that exceeded the increase in the variable overhead spending. These favorable impacts were partially offset by an increase of approximately $9 million in our administrative expenses. Expenses in the United States and United Kingdom in Fiscal 2004 were positively affected by the restructuring activity that took place in Fiscal 2003.

         Operating income for Surface Mining Equipment increased by approximately $25.4 million in Fiscal 2004 as compared to Fiscal 2003. During Fiscal 2004, charges for the depreciation and amortization of the fresh start accounting items decreased by approximately $3.4 million. Excluding the impact of the charges for fresh start, the increase in operating income for Fiscal 2004 was $22.0 million. The increase in operating income for Surface Mining Equipment was the result of an increase in net sales in Fiscal 2004 and a significant increase in manufacturing absorption associated with the higher volume of production of new machines and parts in this segment's manufacturing facilities. These favorable impacts on margins were partially offset by approximately $12.9 million in product development, selling and administrative expenses.

        The increase in the corporate expense was primarily attributable to compensation expense associated with performance-based incentive programs which is due in part to the increase in our stock price.

Product Development, Selling and Administrative Expense

         Product development, selling and administrative expense for Fiscal 2004 was $273.0 million, after fresh start charges of $2.8 million, as compared to $237.0 million, after fresh start charges of $9.0 million, for Fiscal 2003. The increase in product development, selling and administrative expense was due primarily to a $16.3 million increase in compensation expense associated with performance-based incentive programs, a $6.5 million increase in pension expense and a $9.7 million increase for the impact associated with the translation of non-U.S. expenses into U.S. dollars due to exchange rate fluctuations, as well as the impact of general cost inflation. These increases were partially offset by cost reductions associated with the Fiscal 2003 restructuring programs. Product development, selling and administrative expense as a percentage of sales for Fiscal 2004 decreased to 19.5% as compared to 20.0% in Fiscal 2003.

Interest Expense

        Interest expense for Fiscal 2004 decreased to $24.3 million as compared to $27.0 million for Fiscal 2003. This decrease was principally due to our repayment of two industrial revenue bonds in late Fiscal 2003. There were no direct borrowings under our revolving credit agreement in Fiscal 2004. Cash interest paid in Fiscal 2004 and Fiscal 2003 was $22.0 million and $23.1 million, respectively.

Provision for Income Taxes

        Our effective consolidated income tax rates for Fiscal 2004 and Fiscal 2003 were approximately 41.5% and 33.5%, respectively. Consolidated income tax expense increased to $39.3 million in Fiscal 2004 as compared to $9.4 million in Fiscal 2003. The increase in income tax expense is primarily attributable to the substantial increase in our pre-tax income and a $13.4 million increase in our deferred tax valuation reserves relating to Australian corporate income taxes. These factors were partially offset by the fact that a higher proportion of our taxable income earned in Fiscal 2004 was earned in jurisdictions where we are able to utilize net operating loss carryforwards.

        We increased our deferred tax valuation reserves for Australia because such reserves are required under FAS No.109, “Accounting for Income Taxes,” to the extent that we conclude that it is more likely than not that the associated deferred tax assets will not be realized. FAS No.109 states that this determination should be based on a weighing of all available positive and negative evidence. At the end of Fiscal 2003, we had projected that our Australian operations, which were restructured during the course of Fiscal 2003, would be profitable during Fiscal 2004 and begin to utilize the loss carryforwards that existed at the end of Fiscal 2003. As a result, the positive evidence regarding the realizability of the Australian deferred tax assets was considered to outweigh the negative evidence, and no incremental reserve was required under FAS No. 109. However, our Australian operations ultimately recorded a net loss for Fiscal 2004. As a result, at the end of Fiscal 2004, we concluded that the additional allowance of $13.4 million was merited because the negative evidence, namely the cumulative losses of our Australian subsidiary (including the loss in Fiscal 2004), outweighed the positive evidence regarding realizability of the deferred tax asset.

        Because this incremental Australian valuation reserve increased our provision for income taxes without a corresponding increase in our pre-tax income, it had the effect of substantially increasing our effective tax rate for Fiscal 2004. Excluding the impact of this incremental reserve, our consolidated income tax expense would have been $25.8 million and our consolidated effective income tax rate would have been 27.3%. This rate differs from the 33.6% reported for Fiscal 2003 primarily attributable to the reversal of a $6.3 million deferred tax liability related to the projected tax to be due on a distribution of previously untaxed foreign earnings that was recorded in an earlier year but was not needed as the jurisdiction receiving the distribution was able to utilize foreign tax credits to fully offset the tax impacts of the distribution. This reversal was recorded as a discreet item in the third quarter of Fiscal 2004 and was disclosed in the Form 10-Q filed for that period. Excluding the reversal of this reserve and the valuation reserves discussed above, the effective rate for Fiscal 2004 would have been 33.9%.

Restructuring and Other Special Charges

        Costs associated with restructuring activities other than those activities covered by SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” or that involve an entity newly acquired in a business combination, are accounted for in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” Costs associated with such activities are recorded as restructuring costs in the consolidated statement of income when the liability is incurred.

        During Fiscal 2003, we began implementing a manufacturing capacity rationalization at our P&H Mining Equipment Milwaukee location that reduced factory space by 350,000 square feet and resulted in a facility that is more efficient. The rationalization was completed in Fiscal 2004 at a cost of $2.0 million and resulted in approximately $5.5 million in cost savings primarily in cost of sales in Fiscal 2004.

        During Fiscal 2003, Joy Mining Machinery began implementing a manufacturing capacity rationalization plan for North America. Total costs for the Joy North American manufacturing capacity rationalization were $3.7 million. Included in this amount is $1.5 million for one-time termination benefits for 132 employees, $0.8 million for abandoned assets, and $1.4 million for other associated costs. Also during Fiscal 2003, Joy Mining Machinery began implementing a manufacturing capacity rationalization plan for the United Kingdom and Australia. The total costs for the United Kingdom manufacturing capacity rationalization were $1.6 million for one-time termination benefits for 26 employees. The total costs for the Australian manufacturing capacity rationalization were $0.2 million for one-time termination benefits for 27 employees. We realized approximately $5.8 million in cost savings in Fiscal 2004 as a result of the Fiscal 2003 rationalization plan at Joy. These savings consisted of $4.7 million reflected in our cost of sales and $1.1 million reflected in our product development, selling and administrative expenses. These savings are sustainable in future years, but will vary based upon sales.

        During Fiscal 2005, Joy Mining Machinery began implementing a capacity rationalization plan for North America. Total costs incurred in Fiscal 2005 were $0.8 million and consisted of one-time termination benefits for 173 employees. All benefits are expected to be paid by February 2006.

        Below is a summary of the activity related to restructuring costs recorded pursuant to SFAS No. 144 and SFAS No.146.

Critical Accounting Policies

        Our discussion and analysis of financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these Consolidated Financial Statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We continually evaluate our estimates and judgments, including those related to bad debts, excess inventory, warranty, intangible assets, income taxes, performance-based incentive programs and contingencies. We base our estimates on historical experience and assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates.

        We believe the accounting policies described below are the ones that most frequently require us to make estimates and judgments, and therefore are critical to the understanding of our results of operations:

Revenue Recognition

        We generally recognize revenue at the time of shipment and passage of title for sales of products and at the time of performance for sales of services. We recognize revenue on long-term contracts, such as the manufacture of mining shovels, drills, draglines and roof support systems, using either the percentage-of-completion or inventory sales methods. When using the percentage-of-completion method, sales and gross profit are recognized as work is performed based on the relationship between actual costs incurred and total estimated costs at completion. Sales and gross profit are adjusted prospectively for revisions in estimated total contract costs and contract values. Estimated losses are recognized in full when identified.

        We have life cycle management contracts with customers to supply parts and service for terms of 1 to 13 years. These contracts are set up based on the projected costs and revenues of servicing the respective machines over the specified contract terms. Accounting for these contracts requires us to make various estimates, including estimates of the relevant machine’s long-term maintenance requirements. Under these contracts, customers are generally billed monthly and the respective deferred revenues are recorded when billed. Revenue is recognized in the period in which parts are supplied or services provided. These contracts are reviewed periodically and revenue recognition is adjusted appropriately for future estimated costs. If a loss is expected at any time, the full amount of the loss is recognized immediately.

        Revenue recognition involves judgments, assessments of expected returns, the likelihood of nonpayment, and estimates of expected costs and profits on long-term contracts. We analyze various factors, including a review of specific transactions, historical experience, credit-worthiness of customers and current market and economic conditions, in determining when to recognize revenue. Changes in judgments on these factors could impact the timing and amount of revenue recognized with a resulting impact on the timing and amount of associated income.

Inventories

         Inventories are carried at the lower of cost or net realizable value using the first-in, first-out ("FIFO") method for all inventories. We evaluate the need to record adjustments for inventory on a regular basis. Our policy is to evaluate all inventory including raw material, work-in-process, finished goods, and spare parts. Inventory in excess of our estimated usage requirements is written down to its estimated net realizable value. Inherent in the estimates of net realizable value are estimates related to our future manufacturing schedules, customer demand, possible alternative uses and ultimate realization of potentially excess inventory.

Intangible Assets

         Intangible assets include drawings, patents, trademarks, technology and other specifically identifiable assets. Indefinite-lived intangible assets are not being amortized. Finite-lived intangible assets are amortized to reflect the pattern of economic benefits consumed which is principally the straight-line method. Intangible assets are evaluated for impairment annually, or more frequently if events or changes occur that suggest impairment in carrying value.

Accrued Warranties

        We record accruals for potential warranty claims based on prior claim experience. Warranty costs are accrued at the time revenue is recognized. These warranty costs are based upon management’s assessment of past claims and current experience. However, actual claims could be higher or lower than amounts estimated, as the amount and value of warranty claims are subject to variation as a result of many factors that cannot be predicted with certainty.

Pension and Postretirement Benefits and Costs

        We have pension and postretirement benefits and expenses which are developed from actuarial valuations. These valuations are based on assumptions including, among other things, discount rates, expected returns on plan assets, retirement ages, years of service, future salary increases, and future health care cost trend rates. Future changes affecting the assumptions will change the related pension benefit or expense.

Income Taxes

        Deferred taxes are accounted for under the asset and liability method whereby deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using statutory tax rates. Deferred income tax provisions are based on changes in the deferred tax assets and liabilities from period to period, adjusted for certain reclassifications under fresh start accounting. Additionally, we analyze our ability to recognize currently the net deferred tax assets created in each jurisdiction in which we operate to determine if valuation allowances are necessary because realizability of the tax assets is deemed to not be more likely than not.

        As required under the application of fresh start accounting, the release of pre-emergence tax valuation reserves was not recorded in the income statement but instead was treated first as a reduction of excess reorganization value until exhausted, then intangibles until exhausted, and thereafter reported as additional paid in capital. Consequently, a net tax charge will be incurred in future years when these tax assets are utilized. We will continue to monitor the appropriateness of the existing valuation allowances and determine annually the amount of valuation allowances that are required to be maintained.

        Similar to the treatment of pre-emergence deferred tax valuation reserves, amounts reserved pre-emergence relating to future income tax contingencies also require special treatment under fresh start accounting. Reversals of tax contingency reserves that are no longer required due to the resolution of the underlying tax issue and were recorded at the emergence date will first reduce any excess reorganization value until exhausted, then other intangibles until exhausted, and thereafter are reported as an adjustment to income tax expense. Consistent with prior years, we have reviewed the amounts so reserved and adjusted the balances to the amounts deemed appropriate with the corresponding adjustment treated as a reduction to other intangibles.

        We estimate the effective tax rate expected to be applicable for the full fiscal year during the course of the year on an interim basis. The estimated effective tax rate contemplates the expected jurisdiction where income is earned (e.g. United States compared to non-United States) as well as tax planning strategies. If the actual results are different from these estimates, adjustments to the effective tax rate may be required in the period such determination is made. Additionally, discreet items are treated separately from the effective rate analysis and are recorded separately as an income tax provision or benefit at the time they are recognized. To the extent recognized, these items will impact the effective tax rate in aggregate but will not adjust the amount used for future periods within the same fiscal year.