KNYJY - KONE Has A China And Market Gravity Problem

Summary

• Reopening will be challenging in China; every company in our coverage has assumed that.
• Moreover, China has demographic threats that may change the economics of its maintenance business there over time due to labour inflation.
• KONE is very exposed to China both in terms of maintenance but especially in new build volumes.
• Thankfully, which cost headwinds continue to affect profits, they are mostly concentrated in the sale of new units which has fallen further in the mix.
• Operating profit rises in Q4 on account of this. While there are challenges, they don't call it razor-and-blades for nothing. Still, we cringe at the perpetuity valuation-type multiples.

KONE (KNYJF) is one of the three main pureplay elevator plays on the markets together with Otis ( OTIS ) and Schindler ( OTCPK:SHLAF ). The razor-and-blades business model is characterized by the vast majority of margin coming from maintenance activities and little coming from new units. China is a big market in both regards, but as a growth market, new units matter more for revenues. Cost headwinds have affected the year substantially, but thanks to mix effects and the beginning of lapping inflation figures, profits continue to grow despite pressures. Still, we see secular dangers around China that may not have been appraised by markets. Furthermore, the credit situation in China is not great for the company's working capital intensity. Overall, a great business, but the discounting going on in its price makes some sense given the elevated multiple from before.

Q4 Notes

Orders are not looking good in Q4 , and China is a major factor. While latest orders are being priced more properly given the inflation environment, and that backlog will liquidate nicely, it is a bit concerning to see the declines as a consequence of a struggling Chinese property market - one that won't come back for years. While the banks are stepping in according to new government policy to make sure that there is some safety credit to the real estate industry, in particular developers, the growth will no longer be the same as evidenced by the order performance and the guidance for 2023 at flat revenues. On the bright side, while orders are beginning to decelerate into actual declines, the marginality on this backlog is going to be higher than it has been in the past, which give KONE and its markets time to reboot at least partially as it's income will get some further lift into 2023. These pricing initiatives really started in Q3, and may also partially explain some of the new slowdowns in orders.

Margin pressures are evident, but the growth in maintenance services more than offset declines in new unit sales to produce overall revenue growth. Mix effects by increases in maintenance have helped preserve performance on top of improvements in pricing while inflation still persists.

Due to Chinese demographics, it's concerning that wage inflation is such a big contributor to headwinds, and is expected to continue into 2023.

So we are roughly speaking over €100 million in wage inflation as an extra cost as a result. So instead of 1%, maybe 2% plus.

Ikka Hara, CFO

Wage inflation is enough to eat a couple of percent further into margin, although some cost easing will offset this as well as better margin on new backlog.

China is apparently already driving it, and with a large number of people generally leaving the workforce over the next 5-10 years , the exposure to China is likely to mute the benefits somewhat of the maintenance economics in that regions as the fleet of installed elevators matures. Markets may not be carefully considering pronounced wage inflation considerations in interaction with demographic effects.

Another thing about China is that for the near-to-medium term, in addition to pressures on new orders and growth, working capital intensity is rising due to tighter liquidity in China. Since usually there is a tradeoff between working capital intensity and scope for sales growth, there may be latent sales pressures coming from KONE's credit term measures as China stabilizes that could affect things negatively in terms of growth.

Bottom Line

Sales guidance is flattish, as the markets with growth, North America, have slower sales velocity, and the markets with typically highs sales velocity, China, is seeing pressure on orders. Moreover, the Chinese exposure generally seems to be losing its luster in terms of the economics it'll provide KONE.

While KONE's business model remains top quality, the multiples are very high close to 30x in PE, and those sort of multiples suffer when capital cost changes and even more so when their perpetuity growth valuation becomes threatened in markets like China. Moreover, structural pressures on the economics of the business, even if slight, impact KONE's ability to hold value at this valuation.

We recognize that this may still be the type of bet people are still willing to make, but we see too many opportunities in the market in companies with equally good economics and a lot of room for disappointment at the current KONE multiple. We pass.

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