Kone: Upgrade to Buy on Better Earnings & Lower Share Price

Rating Change (KNEBV FH) (Upgrade to Buy)

Highlights

• Kone shares have fallen 18% year-to-date; the P/E is now about 22x

• EBIT rebounded 41% in H1 and is guided to 95% of 2021 level for 2023

• Maintenance sales continue to build; Modernization is gathering speed

• EPS can grow at mid-single-digits even if China macro stays weak

• At €40.33, we see a 47% total return (13.2% p.a.) by end of 2026. Buy

Introduction

We are upgrading our rating on Kone to Buy, based on a lower share price and an improved P&L.

We downgraded our rating on Kone to Neutral in April, and shares have fallen by another 15.5% since then:         

Kone Share Price (Last 1 Year)

Source: Google Finance (21-Sep-23).

We believe elevator companies are good businesses, and have maintained a Buy rating on Otis since July 2020. (See our April article on Otis for the favourable characteristics of the elevator industry.) We originally had a Buy rating on Kone, but changed our mind because of its larger exposure to China and its higher valuation relative to Otis.

We believe Kone shares are again attractive, even with weak Chinese macro. Shares have fallen another 18% year-to-date. Adjusted EBIT has rebounded 41% in H1, and guidance implies that it will recover to within 5% of 2021 level for the full year. Recurring Maintenance sales have continued to build up structurally, and growth in Modernization sales has begun to gather speed. New Equipment sales are recovering from the disruption from last year’s COVID lockdown in China. Adjusted EBIT Margin has improved from 8.1% to 10.6%. The main negative is the decline in New Equipment orders, notably in China but also in other regions. The order book is down nearly 10% in Euros (2.9% excluding currency), but is still large by historic standards. China’s importance has shrunk to around 25% of sales, of which New Equipment is down to about 75%. At €40.33, shares are at around 22x 2023 estimated EPS. We believe Kone can return to mid-single-digit EPS growth and a 25x P/E after 2023 even with a weak Chinese construction market, in which case our forecasts indicate a total return of 47% (13.2% annualized) by 2026 year-end. In the event of a rebound in the property sector in China, the upside would be much greater. Buy.

We discuss each of the above in more detail below.

Adjusted EBIT Rebounded in H1

Kone’s Adjusted EBIT has rebounded by 41% year-on-year in H1 2023, though it was still 8.0% below H1 2021 (€624m):

Kone P&L (H1 2023 vs. Prior Year)

Source: Kone company filings.

Adjusted EBIT Margin has improved from 8.1% to 10.6%, driven by a variety of factors including pricing, better input costs, operational leverage and management cost actions, as CFO Ilkka Hara explained on the Q2 2023 call:

“The orders that we booked previously where the pricing is improving is now materializing in deliveries. We still see lower material cost contributing positively in this quarter and continue to see a better environment from that perspective. Also with a strong growth we get and had a stronger fixed cost absorption. But I will also highlight that I'm very pleased about our fixed cost control, which has contributed also to this profitability improvement.”

In addition, Kone has also lapped the production disruption from the COVID lockdowns in China last year, to which management attributed a total cost of around €100m (including some one-off costs not in Adjusted EBIT).

As with other elevator companies, Kone has benefited from a fairly consistent growth in its Service sales (including both Maintenance and Modernization), while New Equipment sales have been more volatile:

Kone Sales By Type & Adjusted EBIT By Quarter (Since 2021)

Source: Kone company filings.

Tota Service sales grew 13.5% organically year-on-year in H1, including Maintenance sales growing 9.5% and Modernization sales growing 23.8%:

Kone Net Sales By Region & Business (H1 2023 vs. Prior Year)

Source: Kone results release (Q2 2023).

The growth in recurring Maintenance sales is structural, driven by a unit growth of “a bit more than 5%” and price/mix, while the growth in Modernization sales appears to be gathering speed, helped by an ageing install base globally, including in China where construction was particularly strong in 2005-15.

New Equipment sales are recovering from the disruption in last year’s COVID lockdowns in China, though they remain 12% lower than the €2,797m figure reported in H1 2021.

The positive drivers described above are expected to continue into H2, and these are reflected in the full-year outlook.

FY23 Guidance Implies Large Recovery

Management guidance implies that Adjusted EBIT will recover to within 5% of 2021 level for the full year.

Kone’s actual 2023 guidance, released with Q2 2023 results on July 20, includes:

• Sales growth of 3-6% excluding currency

• Adjusted EBIT margin of 11.0-12.0% (compared to 9.9% in 2022)

• Currency headwind worth €50m to Adjusted EBIT (of which €6m in H1)

We believe the mid-point of this guidance implies a 2023 Adjusted EBIT of €1,261m, just 4% lower than in 2021:

Kone 2023 Sales & Adjusted EBIT Forecasts

Source: Librarian Capital estimates.

We believe these figures are achievable. With Adjusted EBIT already at €574m in H1 2023, the €1,261m figure implies a H2 Adjusted EBIT of €687m, about 9% higher year-on-year excluding currency.

Decline in New Equipment Orders

The main negative is the decline in New Equipment (“NE”) orders expected in multiple regions in 2023. Orders received were down 6.6% organically in H1 (down 9.8% in Euros).

Kone expects New Equipment orders across the market to fall by 10-15% in China in 2023, as the property sector there continues to show signs of distress, and to show a “significant decline” in North America and a “clear decline” in EMEA, driven by weakness in the northern part of each region due to weak business confidence (following interest rate hikes):

Kone 2023 Market Outlook

Source: Kone results release (Q2 2023).

Otis management has similar expectations for these NE markets, as we have described in our recent update.

Lower NE orders do not immediately translate into lower NE sales (Kone’s NE sales still grew 8.3% organically in H1), because the orders go into the order book before being gradually turned into sales over time. As of June month-end, Kone’s NE order book stood at €9.04bn, down nearly 10% in Euros from the record €10.0bn figure last June (but down only 2.9% excluding currency), but equivalent to 1.7x 2022 NE sales and large by historic standards:

Kone Order Book By Quarter (Since 2019)

Source: Kone company filings.

However, the size of the order book is not conclusive, because not all orders have the same margin. The proportion of the NE order book being from China has likely fallen, and China NE sales has higher-margin than NE sales elsewhere; in addition, China NE orders has also experienced negative pricing and mix, partially mitigated by lower local input costs.

Overall, we believe the 2023 guidance will be achieved in spite of declining NE orders, because management has already taken the existing order book into account, but 2024 may be more at risk from further NE order declines.

New Equipment in China Now Less Key

New Equipment sales in China, the part most vulnerable to Chinese macro, has become less important to Kone.

China represented around 25% of Kone sales in H1 2023, down from around 35% in 2021. Within sales in China, New Equipment accounted for 75%, while Maintenance accounted for 20% and Modernization accounted for the last 5%, compared to 85%, 10% and 5% respectively at the time of the last investor day in June 2022. New Equipment sales in China are now around 19% of group sales (though potentially a modestly higher percentage of gross profit):

Kone Sales Breakdown (H1 2023)

Source: Librarian Capital estimates.

Kone’s Maintenance sales has benefited from a rapid rise in units in China, which management described as its “fastest-growing service base” globally. Kone’s unit growth in China is likely to be similar to that at Otis, described as mid-teens plus year-on-year. This growth should help offset any further declines in New Equipment sales in China.

Mid-Single-Digit EPS Growth Achievable

We believe Kone can return to mid-single-digit EPS growth even with a weak Chinese construction market.

Kone’s Chinese New Equipment orders declined by more than 20% in 2022, were down about 15% in H1 2023 and are expected to be down “slightly under 10%” in 2023 (based on a market that Kone expects to decline by 10-15%).

China New Equipment Order Growth – Kone vs. Market (Since 2006)

Source: Kone results presentation (Q2 2023).

Chinese government policy is the key variable for 2024, with Otis management expecting a flat market if bank lending is loosened but a 10% market decline if it is not. However, in any event, the rate of decline seems to be flat or getting smaller, and the importance of China’s New Equipment business to Kone sales is also falling.

Kone has guided its 2023 organic sales growth to be 3-6% (compared to 4-6% guided at Otis, which has a lower sales exposure to China of about 20%). We believe this implies organic sales growth in 2024 and beyond could be similar even with a weak Chinese construction market, because these years would see the same or smaller decline in Chinese New Equipment sales which in turn are becoming less important to Kone.

Another way to think about this is that, even if we assume a 10% decline in China New Equipment sales, Kone group sales growth can still exceed 3% if Non-China New Equipment sales grow at 2.0%, Maintenance grows at 7.5% and Modernization at 10.0%:

Illustrative Kone Sales Growth Breakdown

NB. Sales breakdown based on H1 2023 comments. Source: Librarian Capital estimates.

Kone’s Adjusted EBIT Margin should continue to improve from the 10-11% guided for 2023. It was as high as 14.4% in 2015 and management has always maintained an aspirational target of 16%. (Otis’s Adjusted EBIT margin was 15.5% in 2022, though different sales mix and accounting mean the figure may not be comparable.)

With an organic sales growth of 3%+ and continuing margin recovery, a mid-single-digit EPS growth should be achievable. In the event of a rebound in the property sector in China, both sales and EPS growth would be much higher.

Kone Stock Valuation

At €40.33, relative to last-twelve-months, Kone shares have a 22.8x P/E and a 2.7% Free Cash Flow ("FCF") Yield:

Kone Earnings, Cashflows & Valuation (Since 2020)

Source: Kone company filings.

Relative to our estimated 2023 Net Income of €963m (implied by management guidance), the P/E is 21.6x.

The 2022 dividend was €1.75, implying a Dividend Yield of 4.3%. The regular dividend has remained flat at €1.75 since 2020, but a special dividend of €0.50 in 2020 was cut to €0.35 in 2021 and not repeated in 2022. Paying the €1.75 regular dividend currently costs about €900m.

Net Cash was €641m as of June month-end, down 49% year-on-year (from €1.26bn), but enough to support the regular dividend while it is not fully funded by current FCF.

When comparing Kone’s P/E with that of companies in other sectors, note that Kone’s cash conversion (FCF / Net Income) had historically exceeded 100%, due to CapEx being lower than depreciation and working capital bringing in cash. This has not been the case since 2022, due to lower advanced payments, deferred revenues and accounts payable, all attributable to the slowdown in new orders and temporary in nature in our opinion.

Kone Working Capital (H1 2023 vs. Prior Periods)

Source: Kone results presentation (Q2 2023).

We believe Kone would merit a trailing P/E of 25x in the event that EPS growth returns to mid-single-digits sustainably. (We assume 28x for Otis, with its near-10% EPS growth). This would be much higher with a China construction rebound.

Kone Stock Forecasts

We amend our assumptions and extend our forecasts to 2026. Our new assumption include:

• 2023 Net Income to be 95% of 2021 figure, implying a 24% rebound (was 5%)

• Thereafter Net Income grows at 5% annually (was 15% in 2024 and 10% in 2025)

• Dividends to be on a Payout Ratio of 95% (was 100%)

• Share count to be flat (unchanged)

• Exit P/E of 25.0x (was 28.0x)

Our new 2025 EPS forecast is 3% higher than before (€1.98), and our 2026 EPS forecast is €2.16:

Kone Illustrative Return Forecasts

Source: Librarian Capital estimates.

With shares at €40.33, we expect a total return of 47% (13.2% annualized) by 2026 year-end.

In the event of a rebound in the property sector in China, the upside would be much greater. For example, if we were to assume a 10% EPS growth from 2024 and a 28.0x P/E at 2026 year-end, our forecasts would instead indicate a total return of 86% (21.9% annualized).

We upgrade our rating on Kone to Buy.

Ends

Stocks mentioned: KNEBV FH, OTIS 0.00%↑ . We are long Otis.

Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.