I’m looking at KONE, a Finnish E&E that has huge exposure to China. Largest market share in China in New Equipment. And 4th largest globally. KONE is a great business with a tremendous record of ROIC (Including goodwill) with the 15 yr avg at 31%. Return on Tangible Capital as you expect is higher with a 15 yr avg of 85%. This is helped by the fact that the business always has negative net working capital as customers prepay with advance and progress payments and being Asset and Capital light with minimal CapEx with the 15 yr avg being 2% of Sales.
Obviously this is the long term view and COVID19 will significantly impact new equipment orders and ''modernization'' aftermarket business in the next 12 to 24 months, I believe their New Equipment Orders and modernization will take a massive hit in the double digits but recurring revenue in maintenance will be stable. Kone is under leveraged at 0.4x EBITDA and is capital light. However, they have significant OpEx around 3.7B EUR primarily in wages. They currently have a cash balance of 2.25B, a revolver of 1B which they haven't drawn and uncommitted commercial paper of 500M. With how underleveraged they are, I believe they'll be able to secure debt albeit at a higher cost.
New equipment orders in China won’t be like last decade and will probably grow 2% each year but as it becomes a more mature market, sales mix will shift to recurring revenue in maintenance and aftermarket. Keep in mind, even if China’s New Equipment TAM doesn’t grow, It is still significantly larger than Non-China TAM. China’s New Equipment market is 600k units per year. The rest of the world is 300k.
KONE’s sales mix in mature markets is 1/3 New equipment and 2/3 service. In China, it’s 85% New Equipment and 15% service. There’s potential upside here for service revenue. Service is maintenance + “modernization”.
Another important metric is conversion of new equipment orders into maintenance contracts. New equipment usually comes with 2 years of maintenance and after that, the customer can choose to enter into a new longer contract. KONE also services non-KONE E&E in its installed base. Kone’s conversion ratio for mature markets is 80%. For China, it’s around 50%. Again, potential upside. With increased conversion ratio, installed base could potentially grow 6% each year.
Another opportunity for growth is the aftermarket “modernization” business of upgrades and replacements. By 2025, 30% of Kone’s Installed base will be > 10 yrs old. Currently, that number sits below 10%. Modernization revenue grew by double digits last year and will probably continue to do so in the next decade. Right now Modernization is only 15% of total revenue.
Kone’s opportunity to shift the sales mix and increase the maintenance contract conversion ratio is helped by the consolidation of Property developers in China, where top 100 developers market share has increased significantly over the past 5 years due to increased regulation and costs. From 22% in 2014 to 55% in 2019. Top 10 market share has also increased in that time period and Kone has relationships with 9 of the top 10.
It should be known that China’s maintenance service market is highly fragmented (top 4 E&E OEM only holds <30% of market) due to the large number of small independent maintenance providers that small building managers and owners choose to save costs. Large developers demand higher level of service and top OEMs will be able to gain significant market share in the next decade as property developers consolidate even more.
At the current price of 50 EUR, EV is trading at 14x 2019 EBITDA and at the Jan high of 60 EUR (Went down before US end of Feb high due to large exposure to China), it was trading at 16x NTM EBITDA. With similar margins to last 5 years starting from 2022 (Which I think is a conservative assumption as mgt has outlined that they will achieve an EBIT margin of 16% in the next decade through improvements in margins on their KONE care and KONE 24/7 as they scale more and more ''connected'' E&E penetration in their installed base) and 2020 and 2021 will have lower margins due to covid19 impact. 14x 2028F EBITDA and Cashflows discounted at 7% gives me a TP of 63 EUR, which is 26% upside. With the targeted 16% EBIT margin, the TP is 70 EUR, 39% upside.