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KONE Corporation – Rising on demographics

KONE is one of four global players, which dominate the worldwide market for elevators & escalators (E&E).
The company is set to benefit from demographic and technological changes in the long-run. With an oligopolistic market structure and high barriers to entry, profitability will remain on a high level. Altogether with a strong financial performance and shareholder friendly dividend policy, I believe that KONE is a sustainable long-term investment.

The E&E industry and why it is interesting?

The global market for elevators and escalators is appealing, since it is based on fundamental and basic demographic and economic developments.
As you can see in the graph below (taken from KONE), the market structure is clearly defined.

Market Structure

A big cake – cut in a few pieces

With an estimated global market value of more than € 70 bn (Credit Suisse estimation, 2016) the E&E market is controlled mainly by four players:

  • KONE
  • Otis Elevators
  • Schindler Aufzüge
  • ThyssenKrupp Aufzüge

Global market Share

Significant capital outlays protect established OEM´s from outside competition. To enter the market, new entrants would have to invest a lot in R&D and production facilities.
Despite huge capital needs by competitors, most E&E OEM´s have emerged in the early 20th century (or even earlier, like Schindler). More than hundred years of customer relationship are hard to copy. Most importantly, customers are used to take the same elevators for 20 years. Custom and perceived product safety are strongly associated with large brands. These „soft factors“ pose strong barriers to new market entrants.
Smaller E&E providers specialize on niche markets or are acquired by the top 4 OEM´s. Therefore, the current E&E market has – to a large extent – emerged into a sellers market, where large OEM´s capitalize on their global infrastructure, their brand recognition and safety promise.

Growth Drivers and Competition – in detail

The following section focus on existing growth drivers and the competitive landscape from KONE´s perspective.
Aforementioned growth drivers (urbanization, GDP growth etc.) are a global phenomenon, but there exist key markets where opportunities are most compelling:
– New equipment powerhouse: China
– Huge need for Modernization: North America
Additionally I will mention a third growth driver, which I believe will unfold its potential in the long-run.

New Equipment – China as the world´s largest E&E market

China has already taken over the top position for annual new equipment orders. Since 2009 China accounted for more than half of the worlds orders.

New Equipment orders ww

I believe that Chinese growth in new equipment orders is sustainable for the decades to come. We can identify at least two major reasons for this development:

  1. Chinas enormous growth in household income. Middle income consumers are rapidly increasing their share in Chinas overall population, which is expected to reach almost 45% by 2025.
    Middle Income China
    Higher income results in new requirements for urban living and working, directly affecting sales of new E&E equipment and services.
    Compared to western developed countries, China still has a relatively small share of middle income population (currently at 19%). In both United States and Germany, the share of middle income households accounted for more than 60% until the early 2000´s.
  2. Increasing household income is accompanied by urbanization. In China – as in the rest of the world – higher income possibilities are limited in rural areas. Therefore, Tier-1 and larger Tier-2 cities are emerging as hubs, supporting growth in wider regions around them. Around 600 M people are living within the 6 most active Chinese city-hubs – with 20 more hubs expected to emerge in the coming years. Chinese government is actively encouraging rural residents to urbanise. The country aims to have 60% of its people living in cities by 2020, up from 56.1% currently. The World Bank estimates a billion people – or 70% of the country’s population – will be living in cities by 2030.
    Hubs ChinaHubs China 2
    Emerging city-hubs result directly in higher population-density. Altogether with increasing average income, housing/office space in China adapts quickly to modern standards in infrastructure, increasing the need for E&E solutions.

Key Finding: China´s growth in new equipment is supported by sustainable, long-term demographic changes!

On the other side, China´s economic development has resulted in an increased consolidation within the real estate developers landscape. Since 2011 the country´s top 100 developers have increased their combined market share by 16% (from 24% to 40%).

Developers Share China

This development puts global OEM´s (like KONE) in an advantageous position. Large country-wide real estate developers prefer global OEM´s as contractors. Coordination of country-wide projects requires contractors with according infrastructure and operating capacities. This leaves capital-constrained local E&E contractors to serve niche markets, while big projects will (most often) be assigned to global players. Therefore, OEM´s with existing networks in China will mostly profit from this development. With currently 500 sales and service points around China (2014), KONE is outpacing their direct competitors by a huge margin:

PoS China

With two R&D and production sites, KONE´s strong engagement in China has paid-off in the past. Since 2006, KONE has managed to lead the market with new equipment sales. Despite a current decline in new orders, KONE defended its leading position with 20% market share (KONE estimate; 2016).

NE orders China

Key Finding: KONE is significantly gaining from Chinas overal economic development. Its strong local presence is a key differentiator and will be the basis for future growth!

Modernization – large potential in North America

North American E&E equipment is outdated to a large extent. Growth in new equipment has been very low since more than a decade, leaving half of current inventory being used for more than 20 years. Based on KONE´s estimates, North America accounts for 25% of global modernization potential (in value).

KONE USA

Modernization and replacement of old equipment has been targeted by KONE since the mid 90´s. With the machine-room-less (MRL) technology, KONE invented a new type of elevator, reducing energy costs by 80% while making transportation faster and eliminating space utilized by machine rooms. Since 2009, the market responded and demand began to shift from hydraulic (conventional) to MRL equipment.

Machine-Room-Less

With US electricity prices rising constantly with 3% p.a. since 1990 (Statista), demand for energy efficient buildings has grown ever since.
As a first-mover, KONE has established itself as the market leader in MRL equipment in North America (and globally).
Supporting factors of the MRL technology are a rising population density in larger cities and increasing efforts of developers to minimize running costs within buildings.

Capitalizing on its leading position in MRL will be a key advantage of KONE since similar opportunities exist in Europe and other western markets. Main difference is here the average age of  E&E equipment. With significantly „younger“ equipment in Europe, modernization needs will emerge in the mid- to long-term.
With expanding R&D facilities (last one opened in 2016, USA), KONE is growing its capabilities and will – most likely – benefit from rising needs in energy and floor efficiency.

Innovation – the potential of data

KONE has redefined its strategy („people flow“) to focus on the interaction between E&E´s, buildings and people by utilizing data.
With over 1 bn people using KONE´s products daily (company estimates), vast amounts of data are generated.
Recently, KONE has partnered with IBM´s Watson (https://www.ibm.com/watson/) to collect and store equipment data. Over the coming years, KONE will connect its global equipment base of more than one million E&E´s to cloud-based services in order to:

  1. anticipate equipment downtime and carry out services more quickly
  2. make buildings smarter and create a personalized customer experience

While (1) will increase operational efficiency and minimize costs, (2) can be a key competitive advantage in the future. An example given is KONE´s „Destination Solution“. This application enables elevators to minimize the number of passengers per cabin and stops per ride based on the number of people waiting and their desired destination.

Only a few OEM´s (Schindler is actively engaged) have yet decided to invest in data analytics. Similar to its first-mover advantage in MRL technology, I believe that KONE will again benefit from their early engagement – to a larger extent than most of its competition.

Financial Performance

Now let´s take a look at KONE´s financial performance during the last 10 years. As we will see, the company has been able to meet key financial accomplishments.

Constantly improved EBIT margin

As mentioned in its investor relations, KONE is targeting a stabilized EBIT margin of 16%.

KONE EBIT

KONE´s margin improvement is associated with limited growth in wages and SG&A´s – in relation to revenues.
Since 2007, compounded average growth in revenues was almost 9%, whereas wages grew by 7% and administrative costs by only 2%. Material costs (mostly) evolve in line with revenue growth. This is very often the case with manufacturers dependant on resources like steel, aluminium and other basic materials (used to build E&E´s). Therefore wages and administration expenses are the main adjustable factors in KONE´s cost management.

Question remains, to what extent both expenses can growth below revenues. I believe that once a stabilized operating margin of 16% is achieved, management will post new guidelines for future performance.

Keeping Debt low!

Compared to many large- and mid cap companies, KONE has been reluctant to load „cheap“ debt on its balance sheets.

Debt to Equity

Despite decreasing costs of borrowed funds, KONE has managed to reduce its debt ratio significantly. From a personal point of view, I like this development. Debt can push sales and asset growth in „good“ times but can be a business-threatening burden in „bad“ times.

Strong equity compounding

By purchasing a stock I buy into the equity position. Therefore I want to know what is in there and how it has evolved in detail!
Additionally, use of earnings/equity can give you a hint on the direction the company is heading (more on this topic later).

Use of earnings I_II

As we can see, nominal return on equity has averaged 30-40% since 2007. Given the company´s financial structure, this figure supports our initial assessment of a strong and sustainable financial performance.
Since the company distributes equity (for dividends and share buy-backs), it is important to assess by how much a company is able to compound equity from operations. Therefore we will derive growth of non-diluted shareholder equity. Adjusted by option rights and share-based payments we can see „real“ retained earnings growth in the graph above (grey bars). On average, KONE was able to compound its equity from operations with more than 13% annually.

Since KONE is not hoarding cash, its „real“ retained earnings went into PPE, acquisitions, other intangible assets and debt reduction.

KONE Assets

Key Finding: KONE´s expanding assets and sales,combined with a high nominal return on equity are strong indications for the ability to grow business with sustainable profitability – KONE is growing within its franchise!

Attractive dividend policy

The company has been steadily growing its dividend payments since the 1980´s. KONE is planning to continue distribution „determined on the basis of the overall business outlook, business opportunities, as well as the present capital structure and the anticipated changes in it“ (KONE, Dividend Policy).

KONE FCFE

We can see that from available FCFE (Free Cash Flow to Equity), 55% on average are used to pay out shareholders. Because KONE is generating high margins (on sales, assets and equity), the company is able to compound equity AND distribute significant amounts directly to shareholders.
I believe that the company´s positive business outlook combined with a disciplined capital policy set the basis for future shareholder value growth (both in dividends and compounding equity).

Attention: There is one red flag, resulting from KONE´s recent use of earnings. Until 2011, KONE´s ratio between distribution and compounding was relatively stable. Since 2012, distribution has increased compared to equity compounding.

Use of earnings II_II

This development raises the question whether KONE will shift its focus regarding shareholder value. Retaining earnings should be preferred if funds can be invested with constant/ growing returns on equity and assets.
If management is not convinced to remain its earnings power, it should distribute earnings. Reason is that in such case, shareholders have the opportunity to invest their funds in more profitable assets.

Personal opinion: I believe that KONE´s strong past performance speaks for itself. In 2012 we saw a decrease in profitability, which has not recovered until 2015 (based on net income margin). I believe that KONE increased dividends despite short-term difficulties. With management still being convinced of future growth within the franchise, periods of higher levels of distribution may be periodically existent. Nevertheless, positive long-term outlook is still intact.

Supporting „soft facts“ !

I believe that strong financial performance is (mostly) the result of „soft factors“ hidden in the corporate culture and „the way, business is done“. Within KONE, I can find a business philosophy, which appears to be prudent and long-term oriented.
Other investors may not agree on the importance of these factors. Nevertheless I see strong evidence that shareholder structure and business culture are key differentiators between mediocre and great businesses.

A major shareholder for the long-term

The majority of KONE´s voting rights (> 60%) are controlled by Antti Herlin. He is the heir to the Herlin familiy which controlled KONE since the mid 1920´s.
Herlin currently serves as Chairman of the Board of Directors. He served the company as CEO from 1996 to 2006. Herlin began KONE´s expansion into emerging markets, especially China. Additionally he paved the way to innovation, building high-rise elevator testing facilities in Finland and entering into strategic alliances with Japanese manufacturer Toshiba to establish the machine-room-less technology.

Standing in line with KONE´s family tradition, the company has appointed Herlin´s son (Jussi Herlin) and daughter (Liris Herlin) to the board of directors.
Appointing both Liris and Jussi Herlin at a young age (currently they are 28 and 33) the company is undertaking the right steps to keep ownerhsip with managers closely tied to its values and tradition.

Personal opinion: I strongly favour businesses run/controlled by a single family for generations. I believe such structures support longevity of a business through prudent decision making. Family members often see their business not just as a step on their career path but rather as an asset which has to be grown and preserved for the next generation. Seeing interests aligned between management and long-term investors is crucial for long-term success!

Transparent corporate policy

Taking a look at KONE´s investor relation section has surprised me a lot – in a positive way. Without going much into detail I would like to provide a short list of facts provided by KONE´s IR you won´t find with a lot of other companies:

  • Presenting its key financial target: KONE states that it targets a long term EBIT margin of 16%. More specifically it is stated that „the aim is not to maxi­mize the EBIT margin in the short term, but rather to grow the absolute EBIT in an optimal way over the long term and as a result maintain a strong return on capi­tal employed“ (No window-dressing here!)
  • Yearly revenue and EBIT outlook, dated back to 2008. This section enables investors to check on KONE´s ability to meet the targets which it has laid out for the following year. Providing this „easy check-up“ indicates, that the company is confident in meeting its targets and not afraid to step into open discussions when targets are not met
  • Detailed list of 50 largest shareholders including number of shares, percentage share, voting rights and market value. Additionally, all board members, executives and auditors are listed regarding their share ownership and voting rights
  • Corporate Governance reports dated back to 2008. These reports include benefits, compensations and option plans for board members and executives. Usually you have to sift through every annual report at once to find these information
  • List of KONE´s top 4 business growth drivers. Easy to understand description of what drives KONE´s business
  • Complete archive of presentations of by department heads, dated back until 2007

This short list is far from being complete. My goal is to emphasize on KONE´s principle of transparency. The company makes it easy for investors to dive into critical facts and to check if the company is able to meet its targets.

Conclusion – buy & hold!

My final evaluation is that KONE is a company I feel comfortable in buying and holding for the very long-term.
Taking into account company characteristics, we have:

  • a strong equity compounder
  • a very attractive dividend policy, yielding currently almost 3,8% per share
  • a sustainable capital and cost structure
  • management/owners in place to lead the company for future generations
  • a focus on innovation and product quality

Addtionally the E&E industry has:

  • an oligopolistic structure, where sellers have significant pricing power
  • strong and long-term demographic changes, supporting both new equipment and services

In terms of valuation, I focus on cash flow available for equity holders – Free Cash Flow to Equity.
FCFE is cash left from operations after all debt obligations and capital expenditures are paid. These funds are free to use for distribution or reinvesting into the business, therefore directly affecting shareholder value.

With market capitalization at € 21,5 bn, KONE´s current FCFE (€ 1,05 bn) yields almost 5%.

KONE

FCFE is growing 15% annualy since 2007. As we have seen before, KONE represents a relatively stable business. Sustainable earnings power exists – proved by past results and future business outlook.

Just by extrapolating past FCFE growth in to the future, we see that yields (based on current market cap) rise exponentially. However, this simple price-value analysis should be considered with caution since past results are no guarantee for future performance. Nevertheless, it gives us a feeling by how much business growth affects valuation.

Along with our preceding due diligence, I feel comfortable buying into KONE, since high probability exists that FCFE will grow substantially. Based on current pricing, these results will pose significant returns on investment.

 

I hope you enjoyed my analysis on KONE. Please feel free to contact me for questions and remarks or to leave a comment.

Yours sincerely,

Aktien Analyse

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