EUR 850.00 For Business Accounts Only

Morningstar | Weaker Underlying Margins in China and Raw Material Prices Stall Kone's 2Q Margin Expansion

We do not plan to change our EUR 42 fair value estimate for wide-moat Kone after its mixed second-quarter results. Orders and revenue grew above our expectations at 6% and 8% organically (vs. our 3% full-year forecast) but margin expansion was meager at just 10 basis points. That implies a tougher pricing environment given that the company operates an asset-light business (most elevators are assembled at the customer's premises), and therefore the company doesn't benefit as richly from volume increases as other European capital goods suppliers. We plan to tweak our forecasts, but the net effect of higher near-term revenue but on lower margin is neutral to our fair value estimate. Shares look expensive.

Pricing in China, where Kone is the leader and takes in 40% of its revenue, looks to still be tough, despite an improving demand environment relative to the last two years. Sixty percent of the market is in hands of the large non-Chinese elevator companies, the remainder of the market remains highly fragmented with small local players. The market doesn't seem to have consolidated much or enough despite being far off from peak margins, which in China were around 2015-16 coincident with peak property inventory levels. Kone's margin reached 14.7% in 2016 and has contracted about 240 basis points since then. We would expect local players with far less global scale to spread costs to have fared much worse.

We think the company's midcycle margin is close to 14%, implying 160 basis points of expansion from current levels. Raw material prices are still weighing on near-term revenue and are temporary. In a highly fragmented competitive environment, such as China, the multi-year steady pricing pressure will eventually push the smaller competitors either to exit or consolidate with an eventual stabilization in pricing. That said, we would not chase the shares at current levels.