|Shares Out. (in M):||197||P/E||10.6||0|
|Market Cap (in $M):||7,494||P/FCF||10||0|
|Net Debt (in $M):||-779||EBIT||850||0|
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Without getting into the industry-specific details here, we think it’s safe to conclude that elevator and escalator manufacturing in Asia is a promising business to be in for the long-term.
Golden Friends Elevator 崇友實業 www.gfc.com.tw, or “GFC,” was founded in Taoyuan, Taiwan in 1974 and is now the island’s third-largest elevator company with a new unit sales market share of roughly 22%. GFC began as the exclusive distributor of Toshiba elevators in Taiwan, but in recent decades has developed its own GFC brand which now accounts for roughly 70% of its new elevator sales. We met with GFC management three times since June 2016, when we started accumulating our stake in the company.
At ~10-11x or less 2016-2017 price-to-cash-earnings and a 5-6% cash dividend yield, GFC could be the cheapest publicly listed elevator company in Asia or maybe world. A handful of local Taiwan brokerages have issued reports on GFC before, and according to Bloomberg none of them currently have a buy rating (all are “hold” or “neutral”). We disagree, and believe that GFC is unjustifiably cheap given:
1) Majority of profit comes from regulated, non-cyclical elevator maintenance: The vast majority of GFC’s profit comes from steadily growing high-margin maintenance revenue on a portfolio of over 32,000 elevators. GFC’s elevator maintenance revenue has increased every single year since at least 1997 (CAGR: 4%) when the company went public, and is expected by management to keep growing at a 3-5% annual rate going forward. This is due to the fact that A) GFC secures lucrative maintenance contracts on 80-90% of the new elevators they sell each year, and B) elevator maintenance regulations tend to get stricter over time.
Steady growth in maintenance revenue also means GFC’s “normalized” profit permanently steps up over time. For example, GFC’s gross profit from maintenance alone in 2015 already matched/exceeded GFC’s total gross profit for 2009-2010. So unless GFC starts intentionally losing money on new elevator sales – something that has never happened in the company’s history – there is no way that GFC’s gross profit returns to that 2009-2010 level as long as the current elevator maintenance portfolio is sustained.
2015: maintenance sales: 1,464.6 maintenance gross profit: 663.3 total gross profit: 1,113.5
2014: maintenance sales: 1,360.9 maintenance gross profit: 610.7 total gross profit: 891.7
2013: maintenance sales: 1,352.9 maintenance gross profit: 619.0 total gross profit: 817.5
2012: maintenance sales: 1,277.6 maintenance gross profit: 582.6 total gross profit: 737.7
2011: maintenance sales: 1,231.4 maintenance gross profit: 572.9 total gross profit: 781.9
2010: maintenance sales: 1,113.4 maintenance gross profit: 498.0 total gross profit: 688.1
2009: maintenance sales: 1,085.6 maintenance gross profit: 474.8 total gross profit: 590.3
2008: maintenance sales: 1,073.8 maintenance gross profit: 488.7 total gross profit: 711.7
2007: maintenance sales: 1,036.7 maintenance gross profit: 463.0 total gross profit: 807.2
2006: maintenance sales: 967.3 maintenance gross profit: 429.1 total gross profit: 601.1
2) Cyclical new elevator sales will be less cyclical: The minority of GFC’s profit that comes from normally cyclical new sales orders linked to real-estate development is getting less cyclical. This is due to a once-in-a-generation structural increase in higher-margin “modernization” sales, or the replacement of older elevators. There are at least 57,000 older elevators in Taiwan that need modernizing, over 10,000 of which are already in GFC’s existing maintenance portfolio. Sooner or later, building owners will pay to replace these elevators, irrespective of the real estate cycle.
2017 Jan + Feb: new elevator sales: 300 modernization (replacement) sales: 80
2016: new elevator sales: 1,880 modernization (replacement) sales: 320 total elevator sales: 2,200
2015: new elevator sales: 1,602 modernization (replacement) sales: 226 total elevator sales: 1,828
2014: new elevator sales: 1,710 modernization (replacement) sales: 220 total elevator sales: 1,930
2013: new elevator sales: 1,666 modernization (replacement) sales: 184 total elevator sales: 1,850
2012: new elevator sales: 1,600 modernization (replacement) sales: 172 total elevator sales: 1,772
3) Healthy order book with favorable product mix: GFC’s new elevator order book on hand is for roughly 3,400 elevator units worth NT$4 billion to be recognized over the next few years. In other words, GFC has another two years’ worth of new elevator sales in the bag with upfront deposits paid for.
3,400 new unit sales divided over the next two years does not sound like a lot of growth relative to what GFC has done in the past, but the gross profit margin from these units could be higher than what was observed in the past thanks to an improved product mix.
In 2014, 87.15% of GFC’s new unit sales was from lower-margin residential elevators, 4.82% was from higher-margin offices/malls/hotels, and the balance was from hospitals/schools/factories. In the first nine months of 2016, however, the higher-margin offices/malls/hotels segment increased to 8.16% and management is optimistic this could reach or exceed 10% in 2017.
Why is GFC getting more orders from offices/malls/hotels? In addition to EPS growth, a major focus of the current Chairman Tang Bo Long唐伯龍, who took over in 2015 from his father (GFC’s founder, Tang Song Zhang 唐松章), has been to upgrade the image of GFC’s own-brand elevators. GFC has long been a major supplier of residential elevators with existing relationships with the top residential developers (i.e. Farglory Land), so all GFC needed to do was to introduce higher-end elevator models like the “Genesis” to get invited by the same developers to bid for commercial projects. GFC’s increase in higher-margin office/mall/hotel projects over the last few years suggests this plan to prioritize the house brand is working.
4) Won’t burn more money in mainland China: GFC has only kept a small presence in mainland China via a subsidiary in Shanghai that posted small losses ranging from NT$30-50 million per year for the last several years. Fortunately, GFC prudently refused to go “all-in” in the competitive bloodbath that is the mainland Chinese elevator market today (i.e. where older elevators are not generating meaningful maintenance fees, competitors are slashing new elevator prices, and maintenance regulations are loosely enforced). For 2016 and beyond, GFC management focused on further reducing the losses in Shanghai and limiting that subsidiary to smaller ticket niche opportunities that global competitors like Otis or Kone won’t fight over (i.e. 4 or 5 story residential low-rises).
5) A history of share repurchases and generous dividends: Since 1997, 83% and 76% of GFC’s cumulative of free cash flow and net profit, respectively, has been paid out as cash dividends. In the 10 years, over 100% of GFC’s cumulative net profit has been paid out in dividends, including very large repurchases and special dividends in 2008 that reduced then-equity by 30%. In fact, GFC’s equity base today is still less than what it was prior to the 2008 repurchases and special dividends, but pre-tax profit has more than tripled since then.
6) Low working capital requirements and valuable non-core assets: leading elevator companies don’t stress over working capital: GFC’s customer deposits for new elevators and other payables offset any cash tied up in inventory and receivables. In addition, GFC earns a steady stream of monthly cash payments from elevator maintenance contracts.
As of the latest balance sheet date, GFC has current assets minus total liabilities worth 11% of its current market capitalization and real-estate (self-used factories plus investment properties) worth 26% of its current market capitalization assuming the audited balance sheet is realistic.
7) Above-average transparency for a an elevator company: the financial statements of the largest publicly listed pure-play elevator companies like Kone, Schindler, and Fujitec do not disclose exactly how much profit is earned from maintenance services. We think this is by design, as they probably don’t want competitors or customers knowing too much. But this lack of disclosure makes it difficult for investors to really know how much recurring profit these companies make.
The Taiwan-listed elevator companies like GFC and Yungtay, however, have disclosed highly detailed breakdowns of revenue, gross profit, and operating profit from maintenance services for decades. GFC also produces detailed historical and even forecasted unit sales numbers.
8) Investing in investor relations: GFC’s Chairman, Tang Bo Long唐伯龍, who took over in 2015 from his father (GFC’s founder, Tang Song Zhang 唐松章), has made a big effort to enhance investor relations, which was effectively zero until recently. Despite being publicly listed for over 20 years, the percentage of GFC shares owned by foreigners was stuck at 0.1% for several years until April 2015 before increasing to 2% in April 2016 and 5% today.
GFC came to our attention in June 2016. Though we did not have an “in” with management at the time, we took a stab in the dark and asked for a meeting by emailing the addresses published in the annual report. We were pleasantly surprised to receive a phone call within the same day inviting us to visit GFC’s headquarters that week.
That phone call we received came from the Taiwanese investor relations firm that GFC hired in early 2015. Since then, GFC has conducted no less than four investor presentations (known in Taiwan as法說會) in front of large groups, with detailed PowerPoint slides promptly uploaded online. GFC has also hosted many more investor phone calls and one-on-one meetings. And if that wasn’t enough, GFC now produces highly detailed monthly press releases explaining changes in revenue.
9) Peers, even those with big problems, trade at higher valuations: Yungtay, GFC’s larger Taiwanese competitor, trades at over ~19x operating profit from maintenance even though the company is facing extremely tough market conditions in its principal market, mainland China, which could last for years.
Hyundai Elevator, the dominant elevator manufacturer in South Korea, now trades at over ~30x operating profit from maintenance. This is incredible considering it was only a few years ago that Hyundai Elevator’s controlling family, at the enormous expense of minority shareholders including Schindler Elevator, essentially misappropriated the financial strength of the healthy elevator business to bail out a distressed sister company within the same Chaebol, Hyundai Merchant Marine.
By contrast, GFC, which does not have A) any mainland China risk or B) history of bad governance, trades at only ~10x the company’s operating profit from maintenance. We don’t know of any other publicly listed elevator company with scale that trades at a higher dividend yield or a lower price to cash earnings multiple (where most of the earnings are from maintenance).
Major risk factors:
What is the risk to GFC’s revenue if Toshiba sells its elevator division to global rival?
It’s well known that Toshiba is in severe financial difficulty today thanks to a disastrous investment in Westinghouse. We have yet to read anything indicating that Toshiba might sell their cash-cow elevator division to a global rival like Otis or Kone, but if that were to happen it could negatively affect GFC in Taiwan.
The history of GFC’s cooperation with Toshiba as the exclusive manufacturer/distributor for Taiwan goes back to the early 1970s. Toshiba initially owned an equity stake in GFC, but sold it decades ago. In exchange for percent-of-sales royalty payments, GFC has been allowed to continue manufacturing, distributing, and maintaining Toshiba brand elevators in Taiwan on an exclusive basis, like a franchisee.
We asked GFC management recently what the impact on their business would be if Toshiba’s global elevator business were to be sold to a large rival. According to management, we were the only investors to ask this question, and they responded that if an Otis or Kone – companies with tiny market share in Taiwan today – acquired Toshiba’s worldwide elevator division they might immediately snatch back the Toshiba Taiwan elevator franchise from GFC.
What would the financial impact of this be to GFC? Toshiba brand elevators still account for 30% of GFC’s new elevator sales today and 40-45% of the total maintenance portfolio of 32,000 elevators. Losing this would clearly inflict a short-term P&L hit, but it would merely accelerate what GFC has already been doing for several years – developing their in-house brand and technologies.
GFC also noted two reasons why any hypothetical acquirer of Toshiba would think twice about snatching back the Toshiba Taiwan franchise from GFC. First, if an Otis or Kone did snatch back the Toshiba Taiwan franchise from GFC, they will need to have significant on-the-ground maintenance capabilities ready to go – capabilities they don’t have now and won’t be built overnight. GFC today has island-wide network of dozens of 24-hour, 7-days a week service centers and a 769 person corps of elevator engineers – all of whom are full-time staff certified by local authorities and trained to a productivity standard of 80 elevator maintenance jobs per month. For a giant elevator company like Otis or Kone, that is a ton of trouble to go through just to plant a flag in Taiwan, a relatively small country by Asian standards, and for what? To snatch back a stream of Toshiba-branded maintenance revenue that might only be US$20 million annualized?
Second, the GFC elevator brand has never directly competed with the higher-end, higher-speed Toshiba brand. So there would be minimal client overlap if GFC were to be allowed to continue the Toshiba Taiwan franchise. GFC’s highest-end models today are still not as fast as Toshiba’s and can’t service the mega skyscrapers like the Taipei 101, which uses Toshiba elevators.
If modernization is such a great opportunity in Taiwan now, why isn’t there more competition?
There is competition, and once in a while the incumbent elevator supplier gets kicked out when a building owner modernizes to a different brand (GFC did that recently at one university facility that previously used Yungtay/Mitsubishi elevators). But that’s a rare occurrence.
In Taiwan, the incumbent elevator company has a huge advantage in securing modernization orders because the incumbent’s maintenance staff are required to check up on a client’s elevators monthly – that regular face time gives them valuable information on what the client wants, when they want it, and how much they would be willing to pay. According to GFC, their experience has been that as long as the incumbent elevator brand has a track record of providing quality maintenance, satisfied clients are extremely unlikely to switch to another elevator brand, especially if the incumbent can meet the client’s modernization price budget.
The consensus is that Taiwan’s real estate cycle has already peaked. Can modernization sales really make up for slowing new sales at GFC?
According to GFC, this is the most frequently asked question they hear from investors. In GFC’s view, modernization really can make up for some/all of the slack in new sales going forward. For example, GFC still sold over 1,100 new elevators in 2009, the trough of their most recent cycle. If modernization sales can hit 400-500 per year or greater (it looks like they are on pace to), then that should still keep total elevator unit sales towards the ~2,000 level they’ve been hovering at in recent years, and with a potentially better gross profit margin.
Why is the gross profit margin better on modernization? One reason is that for many older elevators, only the inner component parts require replacement but the elevator shell itself will remain untouched. For the elevator manufacturer, these component-only modernization jobs are often more profitable at the GP margin level since they really only involve selling parts at a mark-up.
Won't Taiwan new labor laws negatively affect GFC?
In December 2016, Taiwan issued new worker-friendly labor laws designed to boost overtime pay and enforce regular rest days http://www.chinapost.com.tw/taiwan-business/2017/02/25/492355/55-of.htm. GFC employs a lot of engineers that work around the clock, so they were negatively affected like any other company. According to their own estimates, however, the financial impact would only come out to NT$26 million.
This is not a small amount of money, but it’s manageable because GFC has received an unexpected boost from the strong New Taiwan dollar in 2017, which is now trading at $30.6 to the US dollar versus $32.3 at the end of 2016. The strong New Taiwan dollar makes GFC’s imports of steel, the key component in their elevators, cheaper than it was in the past, which should benefit gross profit margins overall.
GFC’s past track record in the 1990s and early 2000s doesn’t look so stellar, why?
The main reason is GFC used to have a sizable business distributing and maintaining Cummins brand power generators. That business, which was less profitable than elevators, has been wound down over the years and while it still exists today it’s only a rounding error in the annual reports now.
Also, GFC was more committed to spending money in China back in the day, losses which they are no longer willing to tolerate.
Furthermore, GFC’s maintenance cash-cow segment took a decades to build up; while it was earning the same 45-50% gross profit margin year after year, it was simply much smaller in absolute terms in the 1990s than it is today.
 Why? Asia has lots of urbanization, a growing middle class, aging populations, and effective regulators (at least in the more mature markets) to enforce regular maintenance – the profit center of any elevator/escalator company. For more details, see: http://www.kone.com/en/Images/KONE%20Equity%20Story%20November%202016_tcm17-20010.pdf
 #1 Yungtay has 30% market share, #2 Mitsubishi has 25% market share, and #4 Otis has 7% market share. GFC’s latest investor presentation is available here: http://mops.twse.com.tw/nas/STR/450620161209E001.pdf
 If you have ever traveled to Taiwan for business or leisure you have probably rode in one of their elevators in these famous landmarks: http://www.gfc.com.tw/project_list.php?PC_ID=1&startAt=0
 2015 free cash flow, defined as OCF – capex, was already NT$672 million. 2016 EPS exceeded NT$3 according to media reports citing the company, while 2017 is already showing more growth on top of that https://www.moneydj.com/KMDJ/News/NewsViewer.aspx?a=56c0832d-c639-4f03-b1b7-f86f7b81dfbd
 The typical GFC elevator is sold for NT$1-3 million per unit and generates an average of NT$3,000 in monthly maintenance revenue indefinitely.
 For example, in 2016 Taiwan’s Ministry of Interior enforced a new regulation (“建築物昇降設備設置及檢查管理辦法”) that all elevators, especially those over 15 years old, will require more frequent safety inspections http://www.cpami.gov.tw/chinese/index.php?option=com_content&view=article&id=10458&Itemid=100.
 GFC’s larger competitor, Yungtay, also agrees modernization in Taiwan will be a near-term growth driver (see page 26 http://mops.twse.com.tw/nas/STR/150720160824E001.pdf) and predicts a 30% CAGR in modernization unit sales going forward. GFC is expecting a more conservative 10% CAGR in modernization unit sales for the medium term.
 Buyers can still cancel, and that’s the reason why the forecasted unit sales figure in GFC’s annual reports is not always exactly correct. The direction of the forecast, however, has more often than not been correct.
 In fact, the maintenance segment usually operates with negative equity.
 Key real estate assets: 1) 7,254 Taiwanese Ping坪 (1 Ping = 3.3 square meters) of land and 7,040 Ping of factory building in Yangmei楊梅, slightly west of Taoyuan where the island’s major international airport is located. 2) 1,200 Ping of undeveloped land in Taichung currently generating rental income from Nissan and Luxgen car dealerships. Other smaller self-occupied office and other properties are scattered around the country.
 By comparison, GFC’s larger competitor Yungtay was 46% owned by foreigners according to its latest annual report.
 In Taiwan, public companies must disclose changes in monthly revenues.
 See https://www.ft.com/content/bdd1ccd2-0e9f-11e5-9ae0-00144feabdc0 and http://www.businesskorea.co.kr/english/news/industry/14932-implication-breaking-hmm-will-hyundai-elevator-recover-relationship-schindler
 GFC brand elevators today do not rely on any technology from Toshiba; the components are all manufactured internally or sourced from other vendors.
 As an incentive, GFC will sometimes extend credit to clients on a modernization sale and/or provide a year of free maintenance on the modernized elevator.
 The previous trough before that was just over 800 new elevators sold in 2003, the tail-end of a price war and market share consolidation phase for the whole Taiwan elevator market that started in 1994.
Continued maintenance growth
Modernization sales growth
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