Ben Graham Fellowship Finalist: – KONE Short ThesisVW Staff
Pavel Kaganas’ write-up of KONE Corporation (HEL:KNEBV) won him a Benjamin Graham Fellowship.
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KONE Corporation: Investment Thesis
KONE Corporation (HEL:KNEBV) 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 Corporation (HEL:KNEBV)’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 Corporation: Key Investment Points
Priced for growth; all growth tied to softening China construction market:
- KONE Corporation (HEL:KNEBV)’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 Corporation (HEL:KNEBV)’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 Corporation (HEL:KNEBV) 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).
See full presentation on Value Investing Congress – KONE: Elevators Going Down? in PDF Format here.