2013 jun-14 2014 2015 2016 short capitalization valuation ... · cagr outpaced even china’s...

Kone Oyj (HLSE:KNEBV) – SHORT Price €31.69; target €20; 40% upside

Pavel Kaganas [email protected]

1

Investment Thesis

Kone is a short. Asia was 85% of Kone’s growth in the last 5 years and now represents 40% of the business.

However China experienced a 13% decline in starts so far in 2014 (and 8% decline in footage sold), and will

continue to decline on excess housing inventory and more wealth moving abroad.

China is also getting more competitive, with 8 large global and local elevator players compared to 4 major comps in

the RoW. Limited China capacity has supported pricing and margins in recent years, but every competitor has now

over-built capacity (~700k units vs. ~500k of sustainable demand). This is pressuring prices, squeezing margins, and

will only get worse with China’s wage escalation. The leading competitor with best execution (Otis) is also winning

back China share, as it was un-blackballed following a deadly accident several years ago.

Much of the street believes Kone’s guidance that Chinese volumes will continue to grow from 2012/13’s excessive

base. This is reflected in the consensus target of €1.82 EPS in 2016 compared to a more likely estimate of ~€1.28.

The shares are also priced to perfection at 21x trailing and 20x 2014 PE, requiring uninterrupted growth for share

appreciation. The weak European business, rich valuation and cheap carry limit near-term risk for a short, while

Chinese lead times catching up into order declines offer an attractive ~40% upside potential at a €20 target. Risks

are timing (orders/backlog still growing) and potential China stimulus.

Kone Oyj - Summary Financials Consensus

(€mm) 2008 2009 2010 2011 2012 2013 Jun-14 2014E 2015E 2016E

Total Revenue 4,603 4,744 4,987 5,225 6,277 6,933 7,063 7,389 7,895 8,348

Growth 12.8% 3.1% 5.1% 4.8% 20.1% 10.4% 6.2% 4.6% 6.8% 5.7%

EBITDA 623 665 762 791 906 1,023 1,065 1,124 1,217 1,303

Margin % 13.5% 14.0% 15.3% 15.1% 14.4% 14.8% 15.1% 15.2% 15.4% 15.6%

Backlog 3,577 3,309 3,597 4,348 5,050 5,588 6,537

YoY Growth 9.0% (7.5%) 8.7% 20.9% 16.1% 10.7% 11.3%

Diluted EPS 0.83 0.92 1.05 1.26 1.29 1.44 1.51 1.55 1.69 1.82

Growth na 10.9% 14.2% 20.1% 2.6% 12.1% na 7.5% 9.1% 7.5%

Capitalization Valuation Multiples Consensus

2013 Jun-14 2014 2015 2016

Share Price € 31.69 TEV/Rev. 2.2x 2.2x 2.1x 2.0x 1.9x

Shares Out. 513 TEV/EBITDA 15.1x 14.5x 13.8x 12.7x 11.9x

Market Cap. € 16,271 P/Dil. EPS 22.0x 20.9x 20.4x 18.7x 17.4x

- Cash 926

+ Total Debt 133

TEV € 15,478

5-yr trading history:



2

Key Investment Points

Priced for growth; all growth tied to softening China construction market:

Kone’s revenue CAGR’d at 9% from ’08-’13, but Asia accounted for 85% of that growth. Kone’s 30% APAC

CAGR outpaced even China’s booming Elevator & Escalator (E&E) market CAGR of 20%, to become the #1

E&E producer. APAC now accounts for 40% of revenue, compared to 15% in 2008, and makes Kone the

most China-leveraged of any major E&E player. They are also the most leveraged to China’s residential market

(60% of revenue), half of which is gov’t-supported affordable housing; a market the company admits will not

grow this year. Even China’s manipulated “official” property starts were down 13% YTD July, with

tough comps ahead from China’s excessive construction spike in mid-late 2013 (real declines in starts may be

even worse). Inventories are at two-year highs (exhibits in appendix), especially in the lower-tier cities which

had the fastest growth in recent years. The continued shift of Chinese investments abroad further pressures

property markets.

Intense/ifying competition and over-capacity will pressure margins:

Kone’s (and most of the E&E industry) revenue and profit growth were not impeded by the recession of

‘08/09 thanks to China. They continued to perform well enough through 2013, but with tougher pricing,

pressured margins and slowing markets. Maintenance margins and market share have been resilient longer-term

but swing more through downturns, as happened in the US and Europe through ’09-10 and even now in

Southern Europe. China pricing is also pressured (not outpacing ~10% wage escalation.)

The industry’s assembly-focused operations (outsourced components) create a mostly variable cost structure,

giving little operating leverage through growth, and eliminating any lasting benefits of winning market-share at

the cost of near-term margins. That margin is gone and market share will flip right back once the low-end prices

back up (best operators like Otis don’t price down much). Kone also admits that most supply chain

globalization benefits have already been realized. There is no margin upside here.

China’s relatively nascent E&E market (90+% new equipment vs. 20-40% RoW) combines more lower-end

units with minimal maintenance work (~65% of global units but only 30-40% of global revenue; 30+% lower

ASPs.) This provides no downside cushion, so revenue is completely reliant on volatile construction volumes.

Further, New Equipment (NE) margins in China have been higher than the RoW and 2013 was a record year

for China construction. This means any flattening or declining equipment orders will soon hit Kone’s top-line,

and even harder on earnings (12-month order-to-deliver lead times).

Hard Comp; Slow Start



3

The “Big 4” of Otis, Kone, Schindler and Thyssen dominate the EMEA and US markets, and have selectively

increased capacity in those markets. But they have expanded much more in China, where the large Japanese and

smaller Chinese competitors are also adding tremendous capacity. While limited capacity in China supported

prices and margins in recent years, intensifying competition and margin contractions has already started, and

will only intensify. The increased capacity signals strategic intentions and will shape the looming war for market

share.

Legacy

businesses

slowing/shrinking

The ex-Asia market relies more on recurring maintenance work, which accounts for 60-80% of EMEA and

Americas revenue, over 60% of Kone’s EBIT, and carries double the margin of NE. The China slowdown and

aggressive capacity expansions, will force increasing competition into these legacy markets and squeeze margins.

Kone has cited price declines in Europe for over a year and its ex-Asia business was flat so far in 2014.

The biggest factor to be felt across all segments is the slowed backlog growth. There is little reason to envision

much backlog improvement, as orders catch up to China starts declines (lag in residential from “start” to E&E

order), as does Europe. The Americas are too small to offset the balance.

(2%)

(1%)

0%

1%

2%

3%

€ 2,700

€ 2,800

€ 2,900

€ 3,000

€ 3,100

€ 3,200

Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14

EMEA - LTM Revenue and Growth

(5.0%)

(2.5%)

0%

2.5%

5.0%

7.5%

10.0%

€ 850

€ 900

€ 950

€ 1,000

€ 1,050

€ 1,100

€ 1,150


Americas - LTM Revenue and Growth

0%

3%

6%

9%

12%

15%

18%

€ 0

€ 500

€ 1,000

€ 1,500

€ 2,000

€ 2,500

€ 3,000


APAC - LTM Revenue and Growth

(15%)

0%

15%

30%

45%

€ 3,000

€ 4,000

€ 5,000

€ 6,000

€ 7,000


Total Kone - Backlog and Growth



4

Company Overview

Based in Finland, Kone OYJ is one of the largest global elevator manufacturers, holding #1/#2 positions in EMEA

and Asia. 45% of revenue comes from higher-margin recurring Service revenue and 55% from NE. This flipped

from 53/47 several years ago, as Kone was an early mover (following Otis) in China’s NE construction boom

(APAC is 40% of revenue, compared to 15% a few years ago). Kone is heavily leveraged to China’s residential

market, generating ~60% of its revenue. The Company has also been aggressively acquiring maintenance operators

outside of China, completing up to 30 small acquisitions per year; €650mm of M&A over the past 7 years. The rest

of FCF is paid out through dividends.

Industry and Competition

The E&E industry is very mature, generating healthy margins and excellent returns on capital. Except for a minor

ex-Asia pullback during the financial crisis, and largely driven by Asia growth, it has outgrown most global macro

and construction trends. Though Europe dominates the installed base for maintenance (and ~50% of the industry’s

value), China accounts for 2/3 of global new installations. Americas and Europe, where half the installed base is

over 20 years old, are more driven by Service volumes (maintenance and modernization), accounting for 60-80% of

value.

The

non-Asia NE market is 80-90% dominated by the “big 4” of Otis, Kone, Schindler and Thyssen, though they only

hold 45-50% of the China NE market. Otis is the market leader, with Kone a close second.

Otis (US-based, owned by UTC) is the largest E&E firm in the world; with the biggest installed base and biggest

mix of maintenance. Industry leading execution (and thus 10% higher margins) has made Otis the industry

innovator, being the first to globalize its supply base and pushed first into China. Otis lost market share in recent

years (which Kone gained) following a deadly accident in China, but has been recovering share in 2012-14 (VAR



5

calls indicate it is no longer black-listed for gov’t work). Otis just completed a large restructuring program that

combined E&E with their other building services/materials (e.g. HVAC, security) into one selling and ops group.

Schindler (Swiss-based; public) is the largest player in escalators; has been pushing aggressively for global growth

and capacity increases (especially catching up to Otis and Kone in China.) Operational hiccups, expensive expansion

and delayed restructuring program have hurt margins. Schindler is most tied to Chinese infrastructure but is pushing

aggressively into residential. Essentially family run. Most likely to price down.

Thyssen (German-based; owned by ThyssenKrupp) is the most Americas-exposed, but has been pushing hard to

grow its small Asia base. It is also at the tail end of a large restructuring program.

Risks

China soft or artificial landing – China has been supporting its property and construction markets

extensively in recent years. It has more direct funding control over infrastructure and affordable housing,

but less over commercial residential markets (where Kone is most leveraged). Artificial support would

require large nationwide policy changes like loosening lending requirements, lowering down payment

requirements (30% on 1st mortgage, 60% on 2nd mortgages, 3rd homes are prohibited), or tightening rules

for moving capital outside of China. We have seen some of these desperation moves in 2Q14. However the

official China stance has been that even if it supports, it will try to avoid doing so for the housing market

for fear of oversupply and bubble development.

o The YTD decline in housing starts could also be the repeat of similar patterns in recent years

where a weak 1H was followed by a strong 2H; this is mitigated by more Chinese investments

moving abroad than in prior years.

Accretive Acquisitions – Kone admits to looking at large M&A opportunities (Europe & Asia competitors,

LatAm new entry), but not finding willing/reasonable sellers (conversation with IR). Considering the scale,

market share, and large European anti-trust settlement several years ago (~$1bn fines), a consolidation

seems unlikely. The Japanese OEMS are rarely sellers (and Kone is partnered with Hitachi.) Kone’s

relationships with real estate developers (and Otis’s recent operational consolidation of its E&E, security



6

and HVAC services) might also guide Kone to make a large acquisition. Kone’s unlevered balance sheet

and cash flow would provide cheap borrowing cost and accretive terms.

Management

Kone has been well run (though usually chasing Otis’s strategy), first by the grandson of the founder (and still

Chairman) Antti Herlin from 1996-2006, then by Matti Alahuhta (previously at Nokia; still on Kone’s board), and

starting in 2014 by prior CFO Henrik Ehrnrooth (CFO 2009-13; previously Goldman Sachs investment banker).

The split-share structure retains the majority of the voting control with Chairman Antti Herlin, the head of one of

Finland’s wealthiest families. The Board announced a one-year repurchase program in early-2014 for up to 10% of

outstanding shares, but none have been repurchased YTD.

Valuation and Projections

Kone and other OEMs continue to guide for flat EMEA, slightly up Americas and ~10% China growth in 2014.

Though China’s 2012-13 construction starts (especially in housing) are unsustainable, the street still has an

overblown perception of Kone’s growth trajectory. This has been supported by results from its comps, all of whom

continue to report order growth in China. The street thus generally aligns with company lines, seen in consensus

EPS CAGR of 8%, from topline growth of 6% though 2014-15. 7 analysts have buy ratings, 9 holds and 8 sells

(mostly larger banks.)

The question of timing comes down to lead times: Chinese developers can delay Resi. E&E orders by 9 months

after a “start” (or longer by some analyst estimates), so orders may keep increasing through 2014, while starts and

sold footage continue to decline. This risk is offset by a weak European business, rich valuation and cheap carry.

The longer term upside of Chinese lead times

catching up into order declines will come from

the inevitable playing out of China’s over-built

housing inventory, E&E pricing pressure,

excess industry capacity, and over-earning

equipment margins. This construction

correction presents a more likely scenario of

declining revenue and margins, leading to 5%

EPS declines next two years.

The projections herein assume flattish EMEA

(though service margins continue to decline);

slightly up Americas; 0/15/10% down China

units and 1/2/4% China margin declines in

2014/5/6 (price pressure and cost absorption).

The declining earnings will alter the street’s

projections and re-value the shares that trade at

20x 2014 and 19x 2015 Consensus PE by

several turns. This will drop the shares to

~€20, giving ~40+% upside for a short at

current ~€32 levels. Kone shares are held

~10% short, pay a 3% yield, and trade

~€30mm daily volume on the Helsinki

exchange. Borrow is available.

(€mm) 2011 2012 2013 2014 2015 2016

EMEA 2,894 3,094 3,157 3,157 3,189 3,243

Americas 947 999 1,119 1,137 1,157 1,180

Asia-Pacific 1,384 2,184 2,657 2,803 2,456 2,274

NE Revenue 2,396 3,155 3,737 3,860 3,497 3,301

Service Revenue 2,829 3,122 3,196 3,237 3,304 3,396

Total Revenue 5,225 6,277 6,933 7,098 6,801 6,697

Total growth 5% 20% 10% 2% -4% -2%

NE EBIT 247 337 402 391 308 271

Services EBIT 478 486 552 550 548 554

Adjusted EBIT € 725 € 823 € 954 € 942 € 857 € 825

NE margin 10.3% 10.7% 10.7% 10.1% 8.8% 8.2%

Services margin 16.9% 15.6% 17.3% 17.0% 16.6% 16.3%

Total EBIT% 13.9% 13.1% 13.8% 13.3% 12.6% 12.3%

EBITDA € 791 € 909 € 1,033 € 1,020 € 935 € 903

margin 15.1% 14.5% 14.9% 14.4% 13.8% 13.5%

Net Income € 576 € 663 € 744 € 749 € 683 € 659

margin 11.0% 10.6% 10.7% 10.6% 10.0% 9.8%

EPS € 1.12 € 1.29 € 1.44 € 1.45 € 1.33 € 1.28

growth 15% 12% 1% -9% -4%

2012 2013 2014 2015 2016

Est. EBITDA 2 2 € 909 € 1,033 € 1,020 € 935 € 903

Consensus € 1,124 € 1,217 € 1,303

Est. EPS 2 2 € 1.29 € 1.44 € 1.45 € 1.33 € 1.28

Consensus € 1.55 € 1.69 € 1.82



7

Appendix: Select China stats from construction, housing, and E&E markets

Inventories rising; Yields shrinking Excess construction and thus E&E orders

Supply outpacing demand

Kone won artificial share; Otis is recovering China E&E market

2013 jun-14 2014 2015 2016 short capitalization valuation ... · cagr outpaced even china’s...

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