Value Investor: KONE is one to watch

Scandinavian-based KONE Corporation is an international leader in the manufacture, installation and maintenance of escalators and elevators. We think KONE has a high-quality business, with a squeaky clean balance sheet and a bright long-term outlook.

However, with 30 per cent of sales emanating from China, we are cautious on the outlook for new installations in the near term given the oversupply in Chinese high rise residential buildings. We recently adjusted our valuation to take into account a more challenging sales environment in KONE’s biggest market. While not cheap today, we suggest KONE is a worthwhile inclusion to your watch list in anticipation of further price weakness.

History

KONE Corporation was founded in 1910, drawing inspiration for the company name from the Finnish word for machine or device. Headquartered in Helsinki, Finland, KONE originally operated with a license to import elevators, but by 1917 the license was terminated to allow the company to focus on manufacturing in house.

KONE was subsequently purchased by Harald Herlin, beginning the Herlin family’s long association with the company which continues to this day under current Chairman Antti Herlin.

World War two was an important period for the company, as large scale orders for elevators, electric hoists and cranes from the Finnish government allowed the company to reach critical mass. KONE listed on the Helsinki exchange in 1966, commencing an acquisitive period for the company which saw its first expansion outside its domestic market.

KONE entered the US in 1981. In 2014, KONE was ranked the 42nd most innovative company in the world by Forbes. This was the fourth consecutive year KONE was recognised, ranking sixth among European companies and the only elevator and escalator company featured on the Forbes' list.

KONE today operates in 60 countries with over 47,000 employees working to generate annual sales exceeding €7.3 billion. KONE has a market cap of €16bn with its dual share classes listed on the Helsinki exchange.

The business

KONE commands a leading position in the manufacture and installation of escalators and elevators with a sales precense throughout most of the worlds important markets. KONE services its customers through a decentralised manufacturing capability, providing faster lead times and natural hedging thoughout the key centers of Scandinavia, Europe, the US, India and China.

Due to trends such as rising urbanisation and increasing high-density living, it appears, albeit anecdotally, that the world is likely to continue consuming ever increasing numbers of escalators and elevators per capita.

Modern living environments, transportation systems and entertainment facilities are all using greater levels of aided transportation systems to move more people more efficiently. The escalator industry in general, and KONE in particular, are well positioned for this, evident in the steadily rising sales from new installations over the long term.

Further, with over 100 years of operation, KONE has established a base of over 1 million installed units. This is important due to the recurring maintenance required to keep the equipment operating efficiently and in compliance with safety standards, creating a revenue opportunity for KONE through its in house maintenance division.

A large contribution from maintenance is encouraging as it builds a level of consistent demand, which is often relatively insulated from economic cycles, into the revenue profile boding well for more consistent and higher quality earnings.

The vast majority of the global industry is concentrated into the hands of KONE Corporation and its competitors ThyssenKrupp, Schindler Group and Zardoya Otis.

Assessing the profit margins of the players gives an informative clue about how they operate. On first glance, Zardoya Otis, the smallest player controlled by 50.1 per cent shareholder United Technologies, appears to be the clear leader with profit margins well north of peers.

However, on closer inspection, it seems Zardoya Otis has tapered its manufacturing and new sales division considerably due to the weak economic environment throughout its home market of Spain and wider Europe.

In 2014, new sales contributed just 24 per cent of sales, suggesting they are now predominantly a maintenance operation which contributes over 76 per cent of total sales. This suggests to us that industry players price new sales on very slim margins, almost as a loss leader to place them in good stead to secure the capital light, more recurring maintenance contracts, which have considerably higher margins.

As Zardoya Otis generates the majority of its revenue from maintenance, it has higher margins than its peers. However, its potential to grow is severely capped, placing its earnings at risk if it lost market share in maintenance. KONE and Schindler have similar margins in the 10 per cent range as they both derive between 30-40 per cent of sales from maintenance.

KONE has established itself as a global leader through a series of targeted acquisitions. In particular, KONE’s precence throughout the Asia Pacific has grown considerably to become the most important region alongside Europe, the Middle East and Africa. In 2014, KONE derived 30 per cent of sales from China.

Given the unprecedented amount of elevator intensive residential and commercial construction which has occurred in China over the last 10 years (ghost cities anyone?), China appears likely to have a significant amount of excess supply which some predict will take the better part of a decade to absorb. Its possible that Chinese demand for high rise construction tapers in the future, taking demand for elevators with it as the market finds equilibrium.

Another possibility is that the Chinese authorities ‘kick the can down the road’ by embarking on an additional period of stimulus, which could boost demand for elevators in the near term but likely delay and intensify the problems over the long term. In any event, if you don’t have a high degree of conviction in the future, it does not make sense to invest, which is where we find ourselves with KONE.

Financials

We recently reduced our valuation to $31.64 by reducing our adopted NROE to 40 per cent. As you can see on the right below, KONE would only be interesting at current prices under the most bullish of assumptions. It is for this reason that we are happy to watch from the sidelines, in anticipation of a better entry point if our fears over its Chinese sales outlook improve, or if the price is materially lower.

KONE has provided FY15 guidance of net sales growth of 6-8 per cent translating to EBIT of 1,190-1250m euros, representing a 16-22 per cent growth assuming constant currency.

Alex Hughes, International Analyst, StocksInValue. StocksInValue provides model portfolios, stock valuations and research covering Australian and international markets.