Description

Overview:

The current market malaise is giving us an opportunity to purchase a piece of a truly great business. We believe Schindler is a unique franchise that would be hard, if not impossible, to replicate. Its moat is wide and increases over time. Schindler is the second largest elevator and escalator company in the world (E&E). Schindler generates a very high ROIC and produces large amounts of FCF every year. With razor / razor blade like business characteristics, Schindler’s earnings are much more stable than perceived and provide an ever increasing installed base of customers. It was rumored that Buffett visited the management of Schindler during his recent European trip. Assuming we don’t enter a massive global recession we believe Schindler is worth at least CHF 100 for a total return of 45% or 20% IRR over two years.

Current Valuation (CHF mm):

Price: 69 CHF

Shares: 121

Market Value: 8,349

Net Cash: 733

ALSO Stake: 215

Enterprise Value: 7,400

Schindler has two classes of shares; the Registered shares and the Bearer Participation shares. They both have the same financial stake in the company; however, the Bearer shares do not have any voting rights. When adding them together and taking away the treasury shares it leaves roughly 121 mm shares outstanding. There are few options and the company awards very few each year which is good for a long term holder. The participation shares have more volume and trade under the symbol SCHP.SW on Bloomberg.

Schindler owns roughly 64% of the shares of the publicly traded ALSO Holdings which is a technology distributor. ALSO represents around 6.5% of the total company’s EBIT so it’s not extremely important to Schindler’s overall value, but we separate it for valuation purposes because it is such a different business. Management has mentioned very explicitly that they plan to separate ALSO from the company once it reaches scale. ALSO recently bought out the remaining stake in another IT company GNT Group. Management has said that this is a step forward in helping ALSO achieve stand alone scale. We think it’s just a matter of time before ALSO is spun-off or sold. Obviously, with the economic slowdown this business has been hurt a bit. It seems fairly valued at around .1x sales and 7x ’09E EBITDA. Sell side analysts have written that they think Schindler will get a better valuation in the market once ALSO is separated as Schindler will become a pure play E&E company. Most investors are focused on the E&E division and view the ALSO segment as a distraction.

In the most recent financial report on March 31, Schindler reiterated it goal of achieving total group net profit of CHF 630 mm and a 10% operating margin in its core E&E division. Schindler’s E&E multiples look like:

TEV / ‘08E EBIT: 8.5x
TEV / ‘09E EBIT: 7.5x

Most analysts are very skeptical of Schindler continuing to achieve margin expansion. As a result, most estimates, even in 2010, assume less than 11% operating margins.

Below are some historical figures (CHF mm):

	2003	2004	2005	2006	2007
E&E Revenue:	6,133	6,404	6,890	7,829	8,752
Y/Y Growth:		4%	8%	14%	12%
E&E EBIT:	395	508	632	717	802
Y/Y Growth:		29%	24%	13%	12%
Margin:	6.4%	7.9%	9.2%	9.2%	9.2%
Total Co. CapEx:	81	82	98	112	103
Dividends:	77	87	111	159	199
Y/Y Growth:		13%	28%	43%	25%

Comparables:

The E&E industry is broken up into three major groups. The large Western firms: Otis (division of UTX), Schindler, ThyssenKrupp (large conglomerate w/ E&E division) and Kone. According to CSFB, these firms have about 70% of the market. Large Asian firms like: Mitsubishi, Hitachi, Toshiba and Fujitec have about 20% of the market. The remaining 10% is from small players.

Kone:

Kone is the best pure play E&E comparable company. Schindler has consistently traded at a 10 – 20% discount to Kone on an EBIT basis due to its better track record of improving margins. Kone has stated its goal of achieving 12% operating margins in 2008 and has stated they think there is room to grow after achieving that goal.

TEV / ‘08E EBIT: 9.6x
TEV / ‘09E EBIT: 8.2x

UTX:

United Technologies is not a great comp because it has several other divisions that have nothing to do with the E&E business. However, it is relevant because UTX’s Otis division is arguably the best in the industry. Otis is UTX’s largest segment by EBIT with about 30% of the total. Otis has operating margins approaching 20% which are by far the best in the industry. This division is a cash machine for UTX. Management says the margin superiority is due to good management as well as density of the maintinence base. UTX has been in some of the emerging countries like China for a longer period of time and have achieved a level of scale that makes it much more efficient to service. We happen to think UTX is pretty cheap here as well.

TEV / ‘08E EBIT: 8.5x
TEV / ‘09E EBIT: 7.9x

Investment Thesis:

• Schindler is an opportunity to own a truly great business. Schindler generates 40% + ROIC and large amounts of FCF with low levels of maintinence capital. If one calculates ROIC excluding goodwill Schindler’s ROIC would be greater than 75%. While Schindler is obviously dependent on the ebbs and flow of construction and development, the cash flows are very stable. It is estimated that 70% of its EBIT is related to the maintenance business (Schindler does not break this out in its financials; however, some research arrives at this estimate). Like most E&E companies, Schindler sells its new installation for little or no profit and earns a majority of its profit on the follow up maintenance contracts. Due to the legal and safety requirements in most countries, regular maintenance is a very important part of owning an elevator or escalator.

It is common for customers to sign multi year service agreements when purchasing a new E&E. It is very difficult to get good figures on renewal rates. There are firms that just offer maintenance services and try to underbid the major players when the contracts come up for renewal. Schindler and most of the major E&E guys have bought most of the independent service firms around the world over the past decades so presumably they are fairly protected. There is also some advantages of being very familiar with the new technologies and having ready access to all appropriate and up to date parts. This offers a competitive advantage to the majors.

• There is a long term trend toward urbanization. This will require more tall buildings which require E&E’s. In 2008, for the first time in history, more than half the world’s population is living in cities according to the U.N. By 2025 more than 60% of the world’s population will be in urban areas. It is estimated that by 2015 there will be 33 mega cities with more than ten million people. China is moving even faster. Twenty years ago China was 75% rural. Now it’s roughly half of that. This trend is likely to continue on a global basis. This provides a stable long term end demand for Schindler’s product. We have read recently that some economists think that if energy costs stay high that this trend will become even more pronounced as people move back to cities from the suburbs to save on commuting costs.

• Currently, there is booming construction in Asia, Middle East and India which is providing for a major new round of new installations for all the major players. In addition, the EU recently passed legislation requiring the modernization of its old elevator infrastructure called Safety Norms for Existing Lifts or (SNEL). This should give a nice tailwind to companies like Schindler which have a large exposure to Europe. In 2007 55% of Schindler’s sales in E&E were in Europe, 29% in North, Central and South America and 16% in Asia, Australia, Africa.

• Industries like the E&E business which are dominated by a few large players offer a great barrier to entry. A new player would have to develop a new elevator with its own technology and then try to build a base of business from which to earn maintenance revenue. Few companies would be able to endure the decades of negative cash flow while the installed base is being built. This type of Oligopoly market place is very positive for Schindler’s long term health.

• Schindler has demonstrated the ability to create innovative solutions for the marketplace. Its 7000 model high rise elevator was designed to reduce energy costs well before energy prices were front page news. They also have been a leader in destination control systems which help optimize traffic. You may notice one of these features in an elevator in major office buildings. The passenger keys in his floor destination in a control panel outside the elevator prior to getting in the elevator. Schindler refined this technology over the past ten years of being the only volume installer of destination control systems.

• Schindler's management is extremely conservative. In fact, this is probably one of the reasons for its discount to Kone. The management is perceived as not being as aggressive as they can in pushing results. They carry a large cash balance which makes them very independent of outside financial forces. Management has taken steps in the past couple years that indicate they are making strides in becoming more shareholders friendly:

1) Last year Schindler completed a 10 for 1 share split to increase liquidity.

2) Schindler recently started reporting quarterly for the first time this March. Previously they had reported semi-annually.

3) Schindler has consistently increased their dividend over the past few years. It currently stands at 2.2%.

4) Schindler has consistently bought back stock over the past year, although not as aggressively as we would like. They currently have authorization to buy back 10% of its capital back. This is constrained by some arcane Swiss rules that limit buybacks to certain levels of retained income.

5) Openly discussed their intention to separate the ALSO business once it reaches scale. Based on ALSO’s recent acquisition this appears to be getting closer.

• If you are bearish on the dollar this is a nice way to get exposure to a very stable currency.

• The potential margin expansion story at Schindler is probably the most compelling investment attribute. Over the past years Schindler has struggled to achieve peer level margins in its E&E division. Management has blamed this on various supply chain bottleneck issues due to tremendous demand, the introduction of a new model which required workers to learn new skills as well as some management issues.

After consistently failing to meet expectations in 2007, Schindler finally was able to deliver good news on the margin front in its Q1 report in 2008. The Company finally achieved 10% E&E margins and is promising to do this for all of 2008. Management also laid out some ambitious long term goals: 14% E&E margins and CHF 900 mm net profit in 4-5 years. Considering that Kone is already at 12% margins and Otis operates at 19.5% this doesn’t seem like pie in the sky management talk. Management is very conservative and we think they feel that after ironing out all the logistical issues of the new model rollout and capacity issues driven by strong demand the Company can finally start to become more efficient over the coming years.

The UBS analyst is estimating E&E revenues of around CHF 9,000 mm in 2008. If Schindler can achieve Kone levels margins in 2 years and E&E revenue grows by 5% per year Schindler should be a good investment. Some detail:

Valuation calculation (CHF mm):
		2008	2009	2010
E&E Revenue:		8,975	9,424	9,895
Growth:			5.0%	5.0%
EBIT:		867	1,037	1,187
Margin:		9.7%	11.0%	12.0%
EBIT Multiple:					8.0x	9.0x	10.0x
EV:					9,499	10,687	11,874
current cash:					733	733	733
Cash Build:		500	600	700	1,800	1,800	1,800
ALSO Stake:					215	215	215
Sum value:					12,248	13,435	14,622
per share:					101	111	121
premium:					47%	61%	75%
IRR in 2 years					21%	27%	32%

Risks:

• Schindler and the major E&E companies have been involved in major anti trust lawsuits from various European countries. In 2007, Schindler paid a fine of CHF 236 mm imposed by the EU and a CHF 57 mm fine imposed by the Austrian cartels court. Schindler is currently appealing these rulings. Its unclear how this will turn out. There is a risk that other countries file suit and try to extract money from Schindler. Schindler has stated they disagree with these ruling but are cooperating with the investigations. One could view this as a positive. In my experience companies that are attacked for having anti trust issues tend to be great companies with very wide moats.

• The company is managed by the Schindler and Bonnard families. While it is hard to argue with their track record there seems to be a consensus among investors that they could be more aggressive managers of the business. In times like these it is hard to fault them but Schindler tends to avoid debt and carries a very large cash balance. Hence the sleepy hyper conservative reputation on the Street. The Schindler and Bonnard families own roughly 50 mm shares or 41% of the capital and 69% of the voting rights. One could view this as a major positive as the management has a lot ‘skin in the game’.

• Company continues to have bottleneck issues with the new elevator systems which slow down the margin expansion potential.

Catalyst

1) Finally achieves margin potential of peers and improves further. Recent evidence is
encouraging.

2) Spin out or sale of ALSO. Eventually will happen.

3) Collapse of share structure. Unclear.

4) Increase of dividend. Has increased the last four years.

5) More aggressive buyback program. Somewhat likely.

6) Sells to BRK or a financial sponsor. Somewhat unlikely in near term.

7) Multiple expansion as the market begins to realize the stability of cash flows.