It’s arguably too early to call a winner in the battles among elevator and escalator manufacturers to establish the top digital platform, but KONE (Kone) (OTCPK:KNYJY) (KNEBV.HE) has made it abundantly clear that is where they intend to be. Not only are digital capabilities increasingly important on the hardware side, they are driving meaningful changes on the service side, and as companies like Kone, Schindler (OTC:SHNDY) and Otis (OTIS) upgrade their integrated digital service offerings, I believe it will be harder and harder for independent service providers to hold their place in the market.
Kone has upgraded its guidance for 2020 on stronger performance in China, but also seemed to make a point of tamping down expectations for 2021 at its recent Capital Markets Day. Given efforts by China to tamp down property development and a shakier global outlook for certain commercial building categories, that seems prudent. Although I continue to be impressed with Kone’s execution, and I like its leverage to both digitalization in this sector and its leading position in China, the valuation remains difficult to reconcile with financial realities.
A Digital Day
Kone’s focus on digital products and services was front and center in the September 29 Capital Markets Day. At the risk of sounding a bit too cynical, the presentations didn’t really offer a lot that was new, so it was really more about trying to drive some sizzle around how increased digitalization in elevators and escalators can impact the business (and the industry) over the next decade-plus.
Management again highlighted its Kone Care and 24/7 Connected Service offerings as part of its digital initiatives. Kone Care is basically a customized (or at least heavily tailored) service plan approach for clients, allowing building operators to choose the level of service they need (and want to pay for), including remote monitoring – a growing offering within elevator/escalator service in general, as it allows for more responsive maintenance and repair ahead of problems.
That dovetails with Connected Services, which allows for intelligent predictive maintenance, constant monitoring, and a more efficient overall maintenance and operational plan. Kone has thus far only achieved about 5% penetration with 24/7 Connected Services (10% in what it calls “forerunner countries” and this remains a significant potential driver).
Overall, Kone estimates that its digital offerings are adding about 1% to its service revenue growth. I believe this can accelerate over time. Independent service providers still have over half of the market for elevator and escalator service, and this is a high-margin business that companies like Kone, Otis, and Schindler cannot afford to ignore. I don’t believe Kone has broken out the margins for its service business, but the overall margins between Otis and Kone are in the same ballpark and Otis reports significantly higher service margins (low 20%s) than equipment margins (high single-digits). As service offerings become increasingly digital/remote and increasingly integrated into the hardware itself, I believe it will be harder and harder for independents to maintain their share in the market.
Product Development Remains A Driver
Kone has established a good track record for innovation, with improving time-to-market, and increasing value-per-unit coming as a result. Kone basically led the “modularization” cycle of the past decade and the move to technology that eliminates the need for machine rooms in the decade before that. Kone also built itself into the leading player in China (which now accounts for 25% of global elevator sales by value and 60% of new units) by creating differentiated offerings that met developers’ needs for applications like affordable housing.
Management was quite bullish on its new DX elevator platform, talking about it as one of the strongest ramps in the company’s history even though it has only been available in Europe. This margin-accretive platform is arguably the first new platform to come out in this new world of digital-based monitoring/service and building automation, and Kone has talked about the value proposition for customers who want to “future-proof” their elevator installations with a product that can be successively updated/improved over time.
Management’s discussion of the financials was interesting. On one hand, we’re only a week or so removed from the company’s announcement of upgraded guidance on stronger demand in China, with revenue now possibly up for the year (a range of -1% to +2%) and some potential for margin improvement as well (versus prior guidance for flat-to-below ’19 margins). On the other hand, management seemed to talk down expectations for that strength in China to persist, or at least at the same pace, into 2021. That’s probably reasonable guidance to give, as the Chinese government is pushing a little harder on deleveraging initiatives for developers.
As far as the rest of the guidance outlook, I basically agree with management’s call for growth in residential and infrastructure markets in 2021, though I think there could be more weakness in some U.S. institutional categories (schools, etc.). I’m also not quite as bullish on the outlook for growth in healthcare facilities, but a lot of companies are starting to talk about this, so I may need to revise my expectations. On the negative side, Kone sees pressure in office and retail, which I very much agree with, and I’d also add that hospitality is likely to be weak as well in the wake of COVID-19’s major negative impact on travel (both leisure and business).
With a slightly better near-term outlook, my numbers go up a bit for Kone, but not enough to really change anything on a meaningful level. I’m still looking for long-term revenue and FCF growth in the mid-single-digits, with the company’s strong margins and returns (ROIC, et al) supporting a healthy mid-teens EBITDA. Management did reiterate a 16% margin target, but I think that will take at least three years (and likely more) to achieve.
The Bottom Line
There are a lot of great things about the Kone story, including a leading market position in the best elevator growth market (China) and an early claim (albeit disputed) to leadership in digitalization. While I appreciate the long-term growth drivers like urbanization and an increased focus on building efficiency, the shares seem richly valued even taking those factors into account. I realize secular growth stories aren’t always (or even often) constrained by valuation, and Kone has a good secular growth story, but I’m not willing to pay up to this degree to participate.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.