Kone – Profit From Urbanization And The Oligopoly Market

Introduction and summary:

This is what makes Kone, a Finnish elevator company,  a potentially good investment:

  • The industry is close to an oligopoly – just four major global players: Otis, Schindler, Kone and ThyssenKrupp (in this rank based on sales). (About 15 years ago all companies were fined for price cooperation.) I believe the four players are unlikely to underbid each other.
  • Tailwind from structural trends like urbanization, population growth and increased living standards.
  • High degree of recurring revenue. Even better, this derives from a continuous increasing elevator base.
  • Capital light business model. Hardly any working capital needed.
  • Family-owned and managed by the Herlin-family.
  • Managed from Finland. The Nordic stock markets have outperformed the US markets, read here for reasons why.
  • Kone has the best quality among the four elevator stocks, in my opinion.

The company:

Kone is a Finnish company and means “machine” in the local language (by the way, Finnish is not related to the Scandinavian languages). Its main listing is in Helsinki and the tickercode is KNEBV.

After WW2 Kone was more or less forced to start making elevators by Finnish authorities, and since then elevator installation has been the main focus of the company. Via organic growth and bolt-on acquisitions Kone has grown into one of the major global players in a very consolidated industry that is dominated by just four players.

Over the last decade Kone Oy has produced these numbers (EUR):

Orders
EPS DPS Sales received
2010 1.04 0.45 4987
2011 1.25 0.7 5225
2012 1.17 0.875 6277
2013 1.37 1 6933 6151
2014 1.47 1.2 7334 6813
2015 2 1.4 8647 7959
2016 1.99 1.55 8784 7621
2017 1.86 1.65 8797 7554
2018 1.63 1.65 9071 7797
2019 1.8 1.7 9982 8400

EPS has grown 6% while sales have grown 8%. Kone has compounded at 20% since 2006, helped by multiple expansion:

Kone Oy share price (blue line – left axis – logarithmic) and three year rolling CAGR (pink line – right axis). Source: Yahoo!finance and my own calculations.

Capital light business model:

Despite operating in the building business, the business doesn’t require  much capital. 12% of the revenue ends up as free cashflow and CAPEX is only 1.3% of revenue. The reason is extensive use of subcontractors which provide most of the parts and components. Furthermore, because customers pay part of both maintenance and installation in advance there is no need for working capital. Likewise, R&D is low at an average of 1.4% of revenue over the last 10 years.

The business is divided into three segments: New equipment (53% of sales), Maintenance (32%) and Modernization (15%). Sales between the regions are 41% in EMEA (Europe, Middle East and Africa), 21% in Americas and 39% in Asia Pacific. Compared to the three other competitors in the “oligopoly”, Kone has the most exposure to Asia, especially China, where we most likely can expect higher future growth.

High returns on capital:

Kone has produced high returns on capital:

  • Return on invested capital (ROIC): 32.7%
  • Return on equity (ROE): 35.8%
  • Return on assets (ROA): 13.5%

The return on capital is a crucial component for estimating future growth and what kind of return to be expected on retained earnings. Over long periods of time (decades) most of the return comes from the marginal rate of return, the retained or reinvested dividends, not from the original investment. The more earnings that can be redeployed, the better (I have explained why here and here).

Balance sheet:

Kone is in a net cash position, ie. they have more cash than debt. Familiy-controlled companies are in general more conservative with debt, and besides the business throws off cash that can supply ongoing projects.

Kone is family-owned:

Kone was founded in 1910, but since 1924 controlled by the Finnish Herlin family. As of today Kone is still controlled by the Herlin family via 62% of the voting rights and 22% of the shares. I consider this a big plus. Family-controlled companies have outperformed the rest of the market, something I have explained in more detail in this article. The Herlin-family is a “guarantee” for a long-term mindset and conservatism. Skin in the game makes prudent investors.

The dividend:

Kone hands back most of the profits via dividends: average payout ratio over the last decade has been 80%. The dividend has grown faster than the earnings, and thus the past dividend growth of 15% is unlikely to continue.

Covid-19:

As with any other company Kone is hit by the Covid-19 virus: The result for 2020 is expected to be in the range of -4% to 0% compared to 2019 with slightly lower EBIT margin. Orders in 1H2020 declined 10.2%, but sales declined only 0.1% while EBIT increased slightly.

Valuation:

Kone’s valuation has expanded over the last decade:

Kone Oy: Blue line is P/E (left axis) and pink line is dividend yield (right axis). Source: annual reports.

The dividend yield has been pretty constant, but this is due to faster dividend growth compared to earnings growth, which of course can’t continue. Today, with interest rates at close to zero, I would say a fair price to pay for Kone is around 25-30 times earnings (considering its stable and predictable business).

Conclusion:

Kone’s business is wonderful and durable, but this is also reflected in the valuation. The multiple expansion can of course continue, but that is something I wouldn’t rely on. We can expect further growth due to urbanization and increased living standards.

What kind of returns can we expect over the next decade? By using the late John Bogle’s very simple formula of calculating future returns, we can play with some numbers:

2.4% (current ordinary dividend yield) + 7% (earnings growth) – 0% (multiple expansion) = 9.4%.

 

Disclosure: I am long KNEBV. I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.  

(This article was published on the 11th of August 2020.)

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