Industrials

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

A Finnish elevator maker's downbeat outlook on China may have a takeaway or two for United Technologies' shareholders.

At an investor presentation on Wednesday, Kone Oyj said that demand for new elevators is growing but for one notable exception: China. No other individual country accounts for a wider slice of Kone's revenue -- or, for that matter, the overall market for new elevator orders.

Kone affirmed its projections for as much as a 10 percent drop-off in Chinese demand for new elevators this year, and then added that it sees declines extending into 2017 (albeit at a more moderate pace). The news put a damper on Kone's stock, sending shares  of the $27 billion company down as much as 3.8 percent.

No Chinese New Year
Kone shares dropped after it signaled Chinese orders will continue to decline into 2017.
Source: Bloomberg
Intraday times are displayed in ET.

That things aren't copacetic in the Chinese elevator market right now should come as a surprise to no one. Growth has slowed to a trickle as the real estate industry works through a supply glut. The question is whether Kone's drab outlook is a manifestation of deepening industry malaise that may also taint results at United Technologies' Otis elevator unit and other rivals, or a sign that the Finnish company is losing more ground to its American rival. The reality may be somewhere in the middle.

After a two-year downturn, there have been signs of life in China's property market recently, with building starts picking up. But Kone's less-than-sanguine outlook for 2017 crystallized the fact that improvements in the construction market are going to take a while to translate into rising elevator orders.

Tax reductions and lower down-payment requirements have helped drain some of China's inventory surplus, but developers in smaller cities are still grappling with oversupply. Meantime, the government's efforts to avoid a bubble in top markets like Beijing have slowed growth there somewhat. Even if the property market stabilizes, elevators are among the last things to go into new buildings. 

And yet, Otis saw an increase in new elevator orders by volume in the most recent quarter, while Kone saw a 5 percent drop. That echoed the dynamic of the first quarter, when Otis saw a 2 percent increase in elevator bookings by unit and Kone reported a more than 10 percent decline, forcing the company to acknowledge it had ceded market share in China for the first time in years.

If You Build It, It Will Cost You
United Technologies has been willing to sacrifice profitability in its quest to expand its market share in China.
Source: Bloomberg, company filings.

United Technologies -- which gets about a fifth of its revenue from its Otis unit -- has been upfront about the fact that it doesn't like playing second fiddle to Kone in China and has been willing to lower prices to get ahead. Thus, even though Chinese orders for its elevators increased from a year earlier on a unit basis, those orders amounted to 14 percent less revenue on a dollar basis. The discrepancy is partly tied to the kinds of projects United Technologies took on in the quarter, but pricing is a big driver.

Based on the company's current revenue and profit estimates, the Otis elevator unit is on track for an 18.8 percent operating margin in 2016 -- the lowest in more than a decade, according to Bloomberg Intelligence analyst Douglas Rothacker. While Kone CEO Henrik Ehrnrooth has said the company is trying to be more selective about projects because the economics don’t make sense, United Technologies doesn't seem to have the same hesitation. 

For now, investors seem to be taking Kone's China comments in stride. United Technologies shares were essentially flat on Wednesday. We'll have to wait until the company reports earnings for more specific insight on the Otis unit's China operations, but this is a potential clue worth paying attention to. Even if the U.S. industrial giant continues to rack up order volume gains, it could come at a cost.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Brooke Sutherland in New York at bsutherland7@bloomberg.net

To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net