The Elevator & Escalator (E&E) business is a life cycle business. Elevator gets installed and then gets maintained by the OEM (for the most part). As it gets old, the equipment gets modernized and eventually replaced. It is a great, recurring revenue (razor and razor blade model), negative operating cycle, asset light, good cash flow generator, high return on capital. The ever-growing installed base is the most attractive nature of the business. In my opinion, Buffet doesn’t own one since no one is ready to sell.

  • Otis is part of United Technology (UTX). It is a cash cow for UTX. I don’t think UTX is interested in
    selling.
  • KONE Oyj (Helsinki: KNEBV) – Family owned business (4 generations). I don’t know why they want to sell it.
  • Schindler – Family owned. There was a rumor that Buffet attempt to buy this during the 2008 crisis.
  • ThyssenKrupp AG – It is part of a Germany-based diversified industrial company. E&E is one of the businesses that produce stable consistent cash flow to fund its other bad businesses. It is going through a restructuring mode, and a there is an activist who is driving the restructuring. Unlike the United States, shareholder activism doesn’t work fast enough in Germany to justify the IRR.

KONE is growing its revenue and profit at a steady rate while gaining market shares. KONE trades 19x PE, 12.5x EV/EBITDA, EV/EBIT 13.4x and 12.4x EV/FCF. KONE’s growth will continue to be driven by urbanization, aging equipment, infrastructure investment, and geographical expansion over the next 5/10 years.

Investment Thesis:

    1. Competitive advantage: KONE is in the highly competitive elevator and escalator industry (KONE with 20% market share). However, over the years it has demonstrated its capability through profitable global expansion and market share gain, gained from other big OEMs and industry consolidation. Through a world class supply chain and logistics management, KONE manages its cost of production and services at a lower level. Steady family ownership and family participating in the managerial decisions adds other benefits, such as longer term thinking, a four generation business, and industry acumen.
    2. Skin in the game: High insider ownership, a family run company (4 generations, 5th generation is on the board) with very honest, candid, and capable management. The Herlin family owns and has overseen the company for the past four generations. It created a strong, supportive, and long term focused environment for managers to make decisions based on longer term value creation. Insiders own more than 26% of the outstanding shares. That includes Herlin Antti’s, Chairman, and ownership interest of ~ 15%. Herlin is one of the billionaires in Finland, and half of his wealth comes from KONE. Family wealth is primarily tied to the long term value creation of the company. It gives extra protection to the minority shareholders.
    3. Capital Allocation: KONE has an unlevered balance sheet. Management has been returning cash to the shareholder, even though it doesn’t have an established dividend policy. The split adjusted divided growth is CAGR: 15% from 1980. KONE uses the FCF to acquire distributors and small maintenance shops to expand its geographical coverage and to increase its maintenance base density.
    4. Recurring Revenue model: KONE generates 47% (based on 2015 data) of its revenue through service business. Services businesses are recurring in nature (90-95% retention rate). Customers pay 3-6 months in advance for the service, so it is a negative operating cycle business. 53% of the revenue comes from new equipment sales, and most of the new equipment eventually get added to the maintenance base, increasing density. Lots of annuity type of service revenue is yet to be realized as the conversion rate in China increases. Service is mandated by government regulation and building insurance companies, as such it can be assumed that this service business revenue will continue to grow at a good level.

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    1. Valuation: KONE is one of the biggest E&E companies in the world with 20% market share. KONE trades at 12.5x EV/EBITDA and 12.4x EV/FCF. Given KONE’s dominant position, management with good capital allocation track records and long term value creation, KONE seems to be fairly priced, if not cheap at this level. However, there are macro headwinds that will have negative impacts on KONE’s short term performance.

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KONE

KONE is in a people flow business as it would like to claim. It is an elevator and escalator (E&E) company that provides solutions and services throughout the life cycle of the equipment. Since exponential technological growth penetrates into the real estate market, building owners want more than just a hoist and car. They all need smart buildings, such as buildings with remote monitoring, predictive analytics to understand the condition of the equipment, AI to enhance the people flow, destination control, and access control, etc. Technology never ends. KONE is the most innovative company among all the OEMs, becoming a trend setter.

KONE has its own operation in around 60 countries, and it has authorized distributors in close to 80 countries. That means KONE has more geographical expansion run way. Traditionally, KONE expanded its operation by acquiring distributors, once the distributors achieved a certain level of business.

Business Segments:

KONE categorizes its business operation through three distinct segments, even though each segment feeds the other ones.

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New Equipment:

The new equipment business market is driven by urbanization, construction market growth and modernization, safety, technological changes, aging population, and changes in millennials’ life styles.

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All the OEMs have experienced high growth in the last decade, primarily a demand driven from China. Although there is still a demand in China, it will be at a lower rate driven by urbanization. Middle-class income is going up as such people will expect more modernized apartments, and the government will spend money on affordable housing schemes.

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APAC-ex China is growing fast according to KONE, Otis, and Schindler. KONE is well established in those markets.

OECD Countries:

A single person household is growing at an exponential rate in the big cities. It indicates that cities will grow
more vertical.

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China:

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Floor space sold growth leads the inventory to a healthy level, but the biggest question that no one is asking is, how these assets are being sold? Of course they are being sold on credit, but how many of them will default? Would the Chinese government force to recapitalize all those banks?

Maintenance:

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It is the highest margin and recurring business (outside of China retention rate is 90-95%). Maintenance business is driven by the growth of the installed base; equipment usage level (very high in China, since low equipment density), government regulation, and acquisition of small maintenance businesses. The Conversion rate in China is about 50% for the all OEMs. However, all of them are expecting a favorable situation in the near future, as people become more concerned about safety , as people adapt themselves to the more service oriented western life style, and when the government regulations get implemented.

Low conversion rate in China:

  • There are more than 8,000 independent mom and pop shops that do the maintenance work, and they are relatively cheap.
  • Chinese customers are price sensitive and OEMs are not able to compete with small shops in terms of price.
  • Many property management companies have their own maintenance business, and they do their own maintenance work.
  • Although there are regulations similar to SNEL, the government is not able to implement them. There were fatal accidents that were caused by equipment malfunction, maintained by small mom and pop stores. China’s Administration of Quality Supervision, Inspection, and Quarantine said that 46 people died in 58 elevator accidents last year, 2015. Regulations will get implemented sooner rather than later.

NOTE: Wage inflation does not affect the margin since all the long term contracts are tied to an index to mitigate the wage inflation risk.

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North America and EU:

KONE has small market share in North America, but the conversion rate is typically high in North America and EU. According to KONE, it has been gaining market share in North America (CAGR- 6%, in the last 10 yrs).

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Modernization:

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Modernization business is driven by the aging installed bases, new regulations, safety, energy (new equipment consumes low energy), or environmental concerns (carbon emission). EMEA experienced high demand between 2006 and 2009 driven by SNEL* regulation. It slows down in the subsequent years, but KONE is expecting to have huge pent up demand in the near future primarily driven by the aging installed bases.

*SNEL –Safety Norm for Existing Lifts

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This is the lowest margin business among all three categories, since it is difficult to have a standardized solution. Although less profitable, KONE sort of standardized a modular based solution to get economic of scale. The main challenge for all the OEMs is that new components should fit together with old components; productivity has to increase by creating efficient people flow, and at the same time solution needs to be implemented with minimum down time. KONE has the largest market share in this market, meaning modernizing competitors equipment as well.

The best part of the modernization business is that it feeds the maintenance business. Modernized equipment becomes a maintenance based, high margin business.

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By modernizing an elevator, the space inside the car can increase by up to 50%, making it easier to access the elevator even with a wheelchair or walker. The reduction of energy consumption is another benefit.

Value Chain analysis:

KONE outsources almost all the components (80%) and system supplies for new equipment to around 100 suppliers (fragmented supplier base). However, it closely work with suppliers to ensure the quality of the product, and it also bears the raw material price increase unless it has an established fixed-price contract. The suppliers are located in the same countries as KONE factories or distribution centers, improving logistic efficiency. Only 9% of KONE’s employees are tasked to be in the assembly line, and it indicates its lean operation and how small its manufacturing facilities are.

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Core products are standardized depending on the vertical it serves. Following the standardized manufacturing process on core products helps KONE to achieve economic of scale. Core products remain the same throughout the world. It also enables KONE to be a low cost producer in the volume business (high capacity to absorb price decline).

NOTE: Otis is planning to execute this strategy, standardizing the products based on verticals, based on recent investor’s presentation.

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From the customer (builder or building owner) perspectives:

KONE makes customers’ lives easier throughout the installation process and during the life cycle of its products, great competitive advantage.

  • Minimal or no support needed from the builder, scaffold-less installation. Significant time saving from the builder and building owner perspectives; I don’t think competitors have fully adopted this yet.
  • KONE invented the MRL (Machine Room Less) elevators. Although it has been copied by competitors, it helped KONE to capture the European and Chinese markets (first mover advantage).
  • JumpLift – It replaces the traditional exterior hoisting system used by developer to move people and things up and down. JumpLift serves as an exterior hoisting system during development. This increases the safety of the construction job, improves efficiency, and speeds up the construction work (can move people up and down during construction 4 times faster than a traditional hoisting system). It is a great competitive advantage for builders when tendering for the project. The building owner can collect the rent sooner than expected. JumpLift will eventually become a permanent elevator. I don’t think any competitor has their own version of JumpLift. Again, first mover advantage. By the time competitors come up with their own version, KONE will be the market leader in the large scale project.“The JumpLift System is a safer way for us to transport our equipment and workers during construction and the fitting-out phases. We can use it in any kind of weather too, which considerably improves the progress of the construction site.” – KONE’s customer, Mr. Herman Knoop, Executive Vice-president, Aannemings Maatschappij J.P. van Eesteren B.V.

Capturing Chinese Market:

Ideally China was Otis’s market place. Otis was there even before KONE entered into Chinese market. There are few things KONE did different from Otis in China:

  • The Chinese market was and is a price sensitive, highly polluted, low energy supply market. KONE introduced MRL products, which consume low energy, emit less carbon, and are competitively priced. It attracted Chinese customers. No other competitors had MRL at this point.
  • Instead of establishing its own distributors, KONE used Toshiba and other established players in the market to distribute its product when it was new to China, but KONE still worked with the end customer. It helped KONE to build a massive network of distributors and agents throughout China. KONE still initiates more than 95% of its sales through distributors and agents. KONE’s conversion rate is low because distributors want to keep some of the aftermarket business for themselves.
    NOTE: Corruption is part of the Chinese economy. Since KONE initiates sales through agents and distributors, I don’t think KONE is directly participating in the scheme even if there is any.
  • Using distributors and agents come with other added value as well. It helped KONE to understand the market at a micro level, and also to establish a massive network within China. KONE sort of created a friendly middle man.

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Middle East – Will it become a huge market for KONE?

Competitors are increasing their investment into the Chinese market, either by acquiring a Chinese company or by increasing their share of JV. However, KONE is slowly moving into the Middle East. KONE is providing a people flow solution (installing elevators and escalators) to the tallest building in Saudi Arabia: Jeddah Tower.

I believe that Saudi and other Middle East countries want to move away from the oil driven economy. Although I don’t know what they are precociously trying to do, it is a regime change moment for Saudi.

  • 31 years old, Mohammad Bin Salman Al Saud is running the country
  • Is low oil price driving Saudi to work on its cost structure that eventually drives infrastructure investment? I assume so.
  • Saudi raised $17.5 billion in sovereign bond sales, $67 billion bid. Did someone know something? Why too much demand for the bond? Must be some other reasons than yield. https://goo.gl/P6fMpO
  • Saudi started to invest in tech, invested in UBER
  • Saudi has recently changed the rules and regulation on FDI to attract western capital.

This might be a good discussion to have with KONE’s management. Why did they buy their Saudi distributors? What do they see in Saudi that the whole world is missing? No one believed in China until the copper price went through the roof.

Value Chain – Maintenance Business:

KONE used predictive analytics to reduce call-outs, which is a big expense for OEMs. KONE’s technicians are equipped with high tech devices that served multiple purposes:

  • Hand held devices have all the manuals and equipment configuration details, so the technicians don’t have to struggle with a hard copy, Increased technician productivity.
  • Technician feeds the KONE’s database by imputing the equipment model, customers, type of malfunctions, etc. That information is being used in multiple ways to help other technicians understand the customer needs, and to predict the next maintenance cycle.
  • KONE’s vehicles are equipped with GPS to reduce the travel time by scheduling multiple site visits at a time, cluster economy. These are very simple things, but I don’t think Otis is doing these. They just started talking about it.

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It helps KONE to produce its services at a lower cost, high margin.

What is new in the value chain?

KONE is experimenting with a new business model in which the customers could lease E&E with a fixed payment plus a fee based on usage. KONE has already built technological infrastructure to do this. This is kind of an extension from its remote monitoring and predictive analytics work.

This business model has been successful in other industries:

  • Customers leased photocopying machines from Xerox for a fixed rate plus a fee per page. Revenue went from ~60 million (1960s) to ~2+ billion in the 1970s.
  • Rolls-Royce has been doing this as well.

What is the benefit? Locking in customers and recurring maintenance revenue since KONE will maintain those elevators. KONE hasn’t disclosed much information about this yet. No other competitor is talking about it, but I am sure it will be copied if it works out.

Financial Summary:

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Working Capital Management:

Although the competition is getting intense in the shrinking market such as China, KONE has still been maintaining its working capital at or near the historical level. This indicates that KONE didn’t use lenient terms to increase revenue. Has KONE been losing sales because of this? Possibly .There are few EU companies that are primarily driven by the Chinese construction market that are having a hard time collecting receivables, and Schindler faces delays in order down-payments. In the meantime, KONE’s advanced payment, advance payment % of sales , account receivables as % of sales, and account payable as % of COGS are improving.

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Quarterly Trend

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E&E Industry and KONE:

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KONE has been growing faster than the market at the same time, and has increased its profitability during the same period as well.

  • Barriers to entry: Although it seems to be low in plain sight, it is hard to break into the industry.
    • It is required to have a certain scale to run a successful operation. It is difficult to get the scale without enough track records and rivalry among existing larger players (Otis, Schindler, Thysenkurp, KONE) are very high.
    • There are a few OEMs that have wound down their operations in China since they couldn’t get the critical mass or they couldn’t adapt to the new elevator era. Customers want more than a car and a rope. They want deep learning technology, AI to improve people flow, predictive analytics to predict potential failure, etc. A small operation will not justify upfront tech investment.
    • The low end of the market is a commodity type of product. To make a real difference, you have to be a low cost producer. It will not be possible if you don’t have leverage over your suppliers or an efficient supply chain.
  • Suppliers Power: Very low. It is fragment supplier based, and different components come from different suppliers. E&E companies can always vertically integrate (backward integration), if the suppliers tend to capture a large portion of the value creation.
  • Customer Power: Customers include developers/builders, architects, and building owners. Although the industry has a fragmented customer base, when it comes to a major project, there is a recurring business pattern based on the previous track record/project delivery. KONE claims that it has granular level customer data and it can predict who needs what and how much business can be done with particular customers. Larger project customers care about reliability and safety of the product and services than they care about the money. OEMs normally have a larger margin on this business, but sales activities get initiated through public bidding so price competition is high. When it comes to volume product, KONE has specific products for specific verticals, such as health care, retail, affordable housing, etc.
  • Rivalry among existing companies: Very high. Unlike corn or wheat, elevator is not a pure commodity product. Purchasing decision is based on many things such how the OEM will support during installation (KONE installs without scaffold), then throughout the life cycle of the project, brand name, and etc.

Capital Allocation:

Almost all the KONE acquisitions are small and complementary in terms of geographical exposure. I believe this is the reason roll-up works in KONE’s maintenance or distributor’s acquisition. KONE buys private companies rather than public companies, offering efficiency in process and economic cluster. Newly acquired maintenance or distributor businesses can readily be plugged into the existing network.

Making significant amount of acquisitions over many decades yields institutional knowledge, and experience adds value. While allocating capital to acquisition can destroy value, KONE demonstrated its ability to not overpay and execute well on integration throughout the years.

KONE is expanded to new regions through acquiring its distributors. As such, I don’t believe management is getting into unknown territory just to gain market shares. Bonuses are not linked to the corporate size.

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Valuation

Public Comp

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Schindler is the only pure play E&E company that can be compared with KONE. Every other company is buried into a big conglomerate or they are very regional in nature. KONE deserves to be traded at premium to Schindler for the following reasons:

  1. KONE has been profitably growing revenue faster than its competitors. With well disciplined management,when the business is not profitable, KONE walks away.
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  2. KONE is not only a high margin business; it continuously improves its margin. It has one of the best supply chains in the industry. Competitors envy its installation operation, which is very lean and cost efficient.
  3. It has a long runway, and it has already established itself in the many growth markets, such as India (#1) and the Middle East (#1)

DCF:

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Otis is expecting the sales to grow between 4 % and 6% throughout 2020. It is reasonable to assume that KONE will grow its revenue around 3.5% for the next five years, implying a 24% margin of safety. I don’t agree with Otis guidance, since they simply extrapolate past growth into the future. I expect to see a period of negative sales growth when the Chinese devalue their currency. I also believe that Chinese will probably need to recapitalize their banks. Something like what happened in America in 2008 will play out in China sooner rather than later. As such, I don’t think that the revenue will grow as Otis guided.

Debt Capacity Value:

What if it were a bond?

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For the sake of conservatism, I am going to assume that sustainable FCF 1,036 million. Since KONE generates very predictable cash flow, KONE could borrow at 3% with 3x coverage ratio. That will be 346.79 million in interest payment, implied maximum debt of 11,559 million or 21.98 per share.

What will move the stock in the near term?
In the short term perspective, stock is priced for perfection. 50% of the new E&E demand comes from China where demand has been declining. The declining demand will automatically trigger a price competition among the existing E&E companies. Otis and Schindler have already started a price war. According to them, price came down as much as 10%, and they are expecting it to go further down, yet their order book went up. They are booking orders at much lower price than they normally do. I have not seen a similar trend in KONE’s book yet.

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There are 400 others OEMs in China. When big OEMs reduce prices, small companies will struggle and may be forced out of business. That void will eventually get filled by the OEMs.

The stock is currently priced – based on consensus:

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Market implied forecast period: 7 years, based on consensus estimate. I don’t expect to have a positive revision since I don’t believe that the shrinking demand from the biggest elevator and escalator market, China or uncertainty of Chinese economy is priced into the market price.

Conclusion:

It is a very simple business with attractive characteristics (net operating cycle; asset light; ever increasing installed base; easy to understand) and trades at a reasonable price. Many confluences of factors, MRL introduction, technological innovation, lack of innovation from competitors, good and efficient supply chain management, and a customer centric value creation approach/culture has led KONE to grow revenue and increase its margin simultaneously. I believe that the margin will continue to expand as the conversion rate and installed base increases and cost-cutting initiatives through technological innovation come into play.

Although there are macro headwinds and uncertainty over China right now, I believe that over time the cash flows will continue to grow and the patient investors will reap the benefit. At least, KONE is deserved to be in the watch list until the panic selling starts. Perhaps the right time to buy is when there is blood in the streets.

KONE – Short (Macro driven and short term)

It is difficult to come up with a reasonable risk to reward ratio to short KONE. KONE is in a life cycle business, and revenue will continue to increase as the installed base keeps on growing even if there is a slowdown in the near term. Although construction goes through the boom and bust cycle, KONE doesn’t really go through the exact same cycle because of its global presence. As such, a low price in itself becomes a catalyst and price will be bid up to a higher level.

  • China is the biggest elevator market in the world. More than 50% of new elevators demand comes from China. The demand side of the economy is getting weaker, and there are 400 OEMs competing for their market share in the shrinking market.
  • Otis and Schindler said that price has come down as much as 10%, and they expect the price to go further down. However, both of their order books went up, implying they are in a price war.
  • KONE claims that it wouldn’t participate in a price war. Order book growth rate has been down in the past two years, but the sales growth rate is only down last year and the working capital management (advance payment) is still at a good rate. This indicates that KONE is running down its order book. If the order book doesn’t grow at the same or a higher rate than the sales growth, particularly in the shrinking market, the sales will decline in the future.33
  • All the E&Es have had a great run since early 2000, primarily demand driven from China. It is difficult to benchmark what will happen to the revenue if the global economy slows down. Maintenance and modernization business will slow down throughout the economic down turn, as it happened in US and EU. The maintenance business is still in recovery mode in Southern Europe. It is reasonable to happen if the Chinese economy goes into a tailspin. Conversion rate will further decline in the near term at least, and it will cost the margin.
  • I don’t think that the slow down in China will be offset by growth from some other regions in the near term.

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EBIT margin will go down because the conversion rate and retention rate will go down in the near term.

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KONE’s working capital management is great, but doubtful account as % of AR keeps going up. If the end customers are in difficult position for a prolonged period, KONE may need to take the impairment charges.

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