Kone

This Finnish elevator manufacturer has been in our portfolio since we incepted our global equity portfolio in September 2008. We remain patient and satisfied co-owners, and we are in this for the long run even if

the company’s earnings have been at a standstill for the last few years. An untapped potential remains, particularly in China, and the management team is working hard to exploit this. As co-owners, we have every reason to believe that the company can deliver on their long-term targets.

It is best if elevators and escalators are things that users do not have to pay attention to. Generally speaking, if people do not pay attention, they are working properly. However, to ensure ongoing operations, elevators are very much a focus area for Finnish Kone, which is one of the world’s leading manufacturers, and has a methodical and long-term strategy to win market shares. In our view, Kone is the best managed company in a consolidated industry that is dominated by four western operators.

There are almost 15 million elevators in operation around the world, and a third of these are in China. Remarkable, as China had an insignificant share of the global elevator market at the beginning of the 21st century. In the year 2000, around 40,000 elevators were ordered in China, and this year the number was around 500,000. Things have been moving very fast, especially between 2004 and 2014, even if the growth in new orders since then has tapered off a little. Still, the Chinese market continues to count for two out of three new ordered units on a global level.

Kone profited greatly from this growth and went from being number four in China to being the market leader with a market share of almost 20 percent. However, during that same period China was also more profitable than before – and probably at a level that will be hard to match in the near future. The decline in growth of new orders combined with lower unit margins has also affected Kone. Earnings have thus not grown over the past three years. However, the Chinese market and the margin new orders are today perceived as stabilised.

As co-owners in Kone for the long term, we have a positive view on the management’s ability to maintain focus on what they can do to optimise the long-term value creation and exploit the continued untapped potential. Over the coming years, China is expected to surpass Europe (which currently holds the top spot and has done so for a long time) in the number of installed elevators.

Generally speaking, there are three phases in an elevator’s life cycle. First, a new elevator is sold, then it needs to be maintained over a typical lifetime of 20 to 25 years, and the final phase involves modernisation. After this, the elevator will once again return to maintenance.

The predictability is found in the lucrative service business

Elevator manufacturers do not have much influence on the amount of orders for new elevators. This depends on the amount of construction in the markets in which they operate. However, there is a long-term structural trend of urbanisation which means that more and more people are moving to big cities as their wealth and education levels improve. This is a long-term trend that results in a continual demand for more and more housing. The optimal use of scarce land is to build upwards – and the taller buildings are, the more they need elevators.

Previously, there were no mentionable profits made from selling new elevators. Instead, it was mainly about securing the lucrative subsequent service contracts. This is no longer the case, but maintenance is still the most attractive part of the business when measured by margins, stability and predictability. Elevators have mandatory maintenance intervals, but the frequency of these vary from country to country. The property owners are not allowed to cut corners on maintenance, and the inspections therefore do not depend on factors such as national economic trends, willingness to spend etc.

The predictability is further increased by large advance payments, and Kone has received approximately 1.5 billion euros in advance payments – equivalent to almost seven percent of the company’s market value. In essence, advance payments work almost as interest free loans from the customers, and they are a major contributor to a conservatively financed balance sheet where the annual earnings are by large converted to free cash flows.

When selling a new elevator, the first maintenance service contract is generally part of the contract. After the initial contract expires, other maintenance service providers will be able to bid for the job. Previously, there has not been any significant differentiation in the services provided from the various suppliers, and Kone is thus capable of providing services to Kone’s own elevators as well as those from other manufacturers. As a result, around half of the 1.2 million elevators that are maintained by Kone are from other manufacturers.

When the initial service contracts expire, Kone manages to retain four out of five of them. In China this number is only three out of five, but this proportion is slowly rising. In major urban centres like Shanghai the conversion rates are more like those in western cities – but in some small towns in “rural” China, it is not always beneficial for Kone to keep the elevator unit due to competition from small local suppliers who in some cases offer lower prices.

The profitability of a service business strongly depends on the density of the units. The more elevators that can be inspected by the same technician, the better opportunities to generate earnings. This allows some locally based service companies in small towns to undercut Kone’s prices. In large cities with taller buildings, the quality requirements for maintenance services are higher, and in such areas Kone converts significantly more contracts. The long-term potential in the Chinese maintenance service business is significant, and due to Kone’s position as the leading supplier of new equipment, the company is in a favourable position to remain a leading player in this area.

Increased levels of investment in R&D

Since 2014, Kone has been increasing its investments in developing new initiatives with a particular focus on the service part of the business. As mentioned, service has previously been very standardised and without significant differentiation between the services offered by the various suppliers. This has resulted in two initiatives – Kone Care and 24/7 Connected Services.

With these two initiatives, Kone is seeking to transition away from only providing standard contracts wherein all property owners more or less sign the same contracts. The plan now is to enter into dialogue and negotiations with the individual property owners about their exact requirements. It is early days for the rollout of these initiatives, but there are indications that they are received positively, and that they will be more profitable than standard contracts.

With 24/7 Connected Services, Kone will be connecting all elevators digitally for several purposes. The overall goal is for service technicians to be able to react as soon as an elevator indicates that a problem is occurring. Users often see elevators like a faucet; it needs to be there, and it needs to work. By being able to register potential signs of wear and tear or other problems, Kone’s technicians will be able to ensure that breakdowns are prevented and that operations remain uninterrupted. At the same time, the monitoring and use of data will also help the technicians to quickly identify the issues if a breakdown occurs despite these efforts.

Kone has increased its investments to be able to expand and optimise these solutions. Whereas previously it invested about 1.5 euros per hundred euros in revenue, this level has been increased to slightly below 2 euros, and the increased investments will be used to develop the maintenance service business.

Kone is not the only player focusing on this – however, small service companies will have a hard time finding the capital or the organisational resources to make these kinds of investment. Thus, we believe that these investments will result in a slow and gradual consolidation of maintenance services among the large companies. Naturally, Kone is one of these.

The four main elevator manufacturers represent over half of the global elevator market. They have a larger market share on the delivery of new equipment than they do in services. In China, the four western international companies only provide services to every fourth elevator, which is very low compared to three out of four elevators on a global level. With time, China is slowly expected to move towards these global levels.

Most of the time, we are looking to invest in consolidated industries where only a small number of players dominate the market. Two out of four of the global companies in the elevator industry, Otis (owned by US-based United Technologies) and German Thyssenkrupp are part of industrial conglomerates. Both companies are expected to become independent within the next three years. It is not without complications to split such large conglomerates, and Kone should thus be able to take advantage of the turbulence among the competitors to win attractive market shares. It is also believed that there may be strategic rationale for Kone to buy one of the elevator companies that will now become independent – this is another one of Kone’s opportunities.

If the opportunity arises to acquire the entire or parts of the competing companies, we have great faith in the discipline of Kone’s management to only pay what is deemed to make it a value-creating investment.

A demanding and active family of owners

The CEO is Henrik Ehrnrooth, who has been with Kone since 2009 – first as CFO and since 2014 in his current role. The CFO is Illka Hara. The management receives strong support from the Herlin family that owns more than 60 percent of the votes in Kone and 20 percent of the capital. The family has owned Kone since 1924, and they add an element of stability and long-term perspective. The bar is set high, and the family remains very active in the Board of Directors.

In our view, the corporate culture of Kone is an important and valuable asset. While the management works from Helsinki, the regional managers and division heads have a great amount of responsibility and autonomy. Generally speaking, people stay with Kone for a long time, and large parts of the management tier have worked for the company for more than a decade. A company’s culture cannot always be measured in the numbers on a short-term basis, but over time, it can have a big impact on performance.

The long-term financial targets of Kone are clear. At a minimum, the company expects to grow at market rates and, over time, to gain market shares. The operating margin is to amount to 16 percent, and finally, the working capital must be continuously optimised. The margin target is a long-term ambition, and it is to be a result of strategic and profitable management decisions. When China was growing at its peak, Kone approached an operating margin of around 14 percent, but today this has decreased to around 12.5. However, management maintains that the long-term ambition remains although main focus is on growing earnings in absolute euros more than the margin.

Several initiatives are meant to promote this objective. Firstly, the margin will be positively impacted if a larger share of revenue is from the highly lucrative service business. In addition, with its new initiatives (Kone Care and 24/7 Connected Services), Kone has managed to increase prices more than it could before, and thus they have increased the profitability and value of each service contract. This does not lead to any major level changes in the short term, but it will increase the margin in services even further over time. Finally, the management is looking to increase the margin on new equipment as well.

Kone has a solid and value-creating business model where return on invested capital is just over 75 percent, and the stability of the maintenance service business contributes to a steadily growing top line. Earnings have not grown in the last three years, and in the current year it is impacted by increasing raw materials prices and increasing salaries for qualified labour – particularly in North America and Europe. Kone pays annual dividends that are equivalent to a direct yield of four percent of the market value. The dividends are generally growing each year, and opportunities still exist for significant increases due to a strong generation of free cash flow and net cash equivalent to seven percent of the market value.

Even a well-functioning elevator does not usually take you from the ground to the top floor in one go. There will typically be stops along the way, and we continue to believe that this particular elevator will reach new heights – even if we have waited on the same floor for a bit longer than usual. We are co-owners with a long term view, and the opportunities for this strong market-leading company remain bright.