Otis Worldwide Corporation (NYSE:OTIS) Morgan Stanley 10th Annual Laguna Conference September 16, 2022 12:20 PM ET
Judy Marks - Chairman, President and CEO
Conference Call Participants
Josh Pokrzywinski - Morgan Stanley
All right. Good morning, everybody. We're going to keep it rolling here, and I really appreciate everybody's participation and for a great conference so far. Joining me on stage we have President, Chairman and CEO of Otis, Judy Marks. Judy, great to see you in person. Thanks for making the trip out and kind of rounding out a good conference with a great message from Otis.
Just want to remind everybody before we get started here, any questions about our research disclosures, please visit the Morgan Stanley research disclosure website or reach out to your salesperson.
With that, Judy, anything kind of to lead us off here on what you're seeing and what you guys are focused on and we'll dive into some questions.
Yes. Thanks, Josh. And if you'll allow me to read our disclosure. So please note, except or otherwise noted, I'll speak to results from continuing operations, excluding restructuring and significant nonrecurring items.
A reconciliation of these measures can be found in the appendix of our second quarter earnings presentation on our investor website. We also remind listeners today that today's discussion contains forward-looking statements, which are subject to risks and uncertainties. Otis' SEC filings, including our Form 10-K and quarterly reports on Form 10-Q provide details on important factors that could cause actual results to differ materially.
Thank you. Thanks. No, it's great to be here and great to be in Laguna with everybody as well as the listeners. Listen, I'm really pleased with our performance since spin. We're a more agile company. We're a focused company. We're executing on our strategy, and I think we're seeing a pace that just wasn't inherent in a conglomerate.
We're really creating and executing on our destiny, and I think the proof is in both our operational performance but just as much in our financial performance. If you look between 2019 and 2021, we've grown share 2 points. We've had about 3% CAGR in terms of organic growth, and we've grown our margins by a full point in a period where there were some unusual headwinds. So the team has been performing really well. And it is about focus on executing our strategy.
So we've driven product innovation. We've driven sales coverage. We've driven our IoT implementation and really just operational productivity and excellence, and that's what gives us really confidence going forward.
Our service business is the jewel of the company. It's 80% of our profits. And let me just spend a minute on that because we really now improved across every element and every metric we measure in service, retention, conversion and then recaptures especially in Asia. And that's what led us to a 3.5% portfolio growth in the second quarter, which is our best in over a decade, and we intend for that to continue to improve. So, services is moving forward. I would tell you to remember the three Ps, when we talk about service in terms of how we're going to continue to grow, not just top line, but bottom line as well. That is our margin expansion opportunity not just for '22, but for our medium term. It's portfolio growth, productivity and pricing. We're seeing all of those now, and we're going to continue to see that. And I think what that does is it also gives us the ability to absorb some headwinds we're seeing in the New Equipment business.
Lastly, we are very focused on shareholder value. This is an incredible business in terms of generating cash. We don't need a lot of net working capital. We don't need a lot of cash on our balance sheet and are not just our intent, but I think we're proving to you that we will return this cash to our shareholders.
So we've paid down the debt to the place where we're feeling very comfortable, including making about a $500 million payment by February 1. We've increased our dividend 45% since we spun, including our most recent increase of just over -- a little over 20% earlier this year. And we've been buying our -- we've been doing stock share buybacks. This year, we've announced we'll do $700 million, and that's in addition to $725 million last year.
So we're driving the company, we're pleasing our customers. I have to thank our colleagues across the globe for making it happen. It then all translates into an efficient, productive company that absolutely generates capital and return it to our shareholders. So it's an interesting time, but let's get started.
Q - Josh Pokrzywinski
Excellent. You talked about kind of several fronts where you guys are executing on kind of post separation there. Maybe as you guys have emerged through that, is there any sort of narrowing of focus or as the world has changed, where that's starting to really focus down on kind of one or two that are really big value drivers for you or where you're spending more of your time?
Yes. So the single biggest value driver, where we've got all 1,400 of our branches focused and incented is the portfolio growth. We have 2.1 million units in our service portfolio. You could argue we had anaemic growth over the last decade, about 1% a year, while the market was growing closer to mid-single digits. We brought that up few years ago, was it 2%, last year was it 3%, as I said 3.5% this quarter. And we do that through everything from implementing our IoT strategy so that we have access to our equipment. 1/3 of our portfolio now has IoT on it, our Otis ONE offering. We do that through specializing our sales workforce. And really, we do that through making sure we delight our customers so they don't cancel us and that's part of retention.
So keep your eye out. We're really shooting for higher than 3.5% before the end of the year. A lot of that driven by China. Our China colleagues are growing mid-teens to high teens. And everyone says, is there still room left. We have 300,000 of our 2.1 million units in China. There's 300,000 are out of a market segment of 7 million. We've got lots of room for growth.
Yes. So I guess maybe a couple of things there. I'd love to drill down further. I guess, first on China, obviously, a lot going on, a decent amount of volatility, especially in the property sector. What are you seeing on the ground? How much of kind of Otis' success in China is sort of going to be kind of governed by the market versus what you said? You mentioned that there's still an opportunity to drive a lot of share though. So I guess that sort of answers part of the question. But how do you see kind of the landscape in China today?
Yes. So we're in China. Think of us with about 16,000 colleagues going to business every day in China. It's an interesting time right now in China and we're seeing some of the same data points everyone is in terms of housing prices, housing sales.
As we kind of came into the year, we were feeling somewhat bullish on China. It was pre-COVID lockdown. We had gained share each of the last two years in China. We're still gaining share in China. It's an absolute focus of our strategy.
I said -- but we're seeing the COVID lockdowns had an impact in the second quarter. And so April and a few weeks in May, really had an influence. Our team came back and really had a record deliveries and shipments in June. I think what folks aren't as -- have as much visibility -- don't have as much visibility into is where the COVID lockdowns are today.
And if you look at today, the cities or parts of the cities that are locked down, they account for about 1/3 of China's GDP as we speak this week. And what that means for Otis is we cannot go, we can't cross border to that city to ship our elevators, we can't install our elevators and they're getting delayed.
It's delay, it's not going away, but it's something we're watching very closely. And we had -- as we came out in the second quarter, the second quarter, think of China last year, 650,000 units available in the segment. We came out second quarter, the segment was down 20%. We did better than that. We gained share.
And we came out and said, we thought the rest of the -- we thought full year China will be down 10%. A lot of volatility now. We're keeping our eye on it. Our teams are working hard, but without that access with the COVID lockdown, we're watching that. But we can't control the market, but we can control everything else we can control.
So our strategy of continuing to go to market with our agents and distributors has helped us gain that share. Pre-spin, we had 1,000. Now, we got 2,250. Gives us great and effective sales coverage. It gives us coverage with key accounts who do the majority of the buying, [Indiscernible] developer business has been consolidating, and many of them are state-owned enterprises.
So regardless of what you see with the financial difficulties in the three red lines, at least half of our key account customers are stayed on enterprises. And we've just -- we've improved our product. We have a common product platform in China, and we're very efficient. We've driven material productivity. We've seen commodity prices, steel come down in China. So we're ready to go.
We're seeing some stimulus in infrastructure. That's about 15% of the China segment. But I think we're all kind of just watching right now. I think between COVID lockdown and the pending National Congress, the week of October 16, I think we're going to learn a lot as we kind of head into the latter part of the year, and we'll see.
Got it. And then on the COVID lockdowns, obviously, it's a very dynamic situation and has been for some time. How much of your success is maybe kind of attributable to some competitive element of being kind of fortunately outside some of the worst of it. And as that has evolved, does that continue to be mostly in your favor? Or are some of those kind of nipping at your heels?
I would tell you, it's been in our favor. If you look at where our factories are in China, we didn't have any that were shut down to absolute lights off, couldn't get in, had no access. It didn't mean in April and May, they were at a 100% capacity or capability because you have suppliers who were shut down. So we were probably at 1/3 of a capability -- at capacity in the first two months of the second quarter. But again, some of that -- and actually, that extends to Europe, right, in terms of where your manufacturing facilities are there, too, with the pending energy challenge there. But I think we're in a good place, and I think we're going to leverage that competitive advantage.
But I think it's all about, again, having a common product platform, our Gen3 product in China is selling very well. We introduced Gen3 last year, Gen360 in Europe, through the first half of the year, it's already 20% of our orders booked. So people are automatically now going for more capability, more technology, and we've got it priced really competitively.
Is there anything in terms of kind of the competitive environment that hopefully, as all these lockdowns are lifted that sort of changes that share dynamic or kind of mute some of that outgrowth you've seen? Or do you think that there's kind of other factors beyond kind of that lockdown dynamic that are helping you out or that you're creating yourself?
Yes. So I think we're creating -- I think people are seeing a new Otis in China since spin. And I think it's our coverage, and I think it's our product set, and I think it's just really the excellent performance by our team, both in our factories as well as in the field. And we're seeing good field productivity. There's two elements of cost in our New Equipment segment. Think of it as really factory which includes commodities, raw materials, subcontract costs and then installation.
So we have the opportunity to drive productivity in both parts, and we've been doing it. And that's really -- if we can do that in a noninflationary environment, and offset input costs, then we're real -- in a good place. We do that in an inflationary environment where we -- we're also getting price, then we're really able to realize that.
And our New Equipment, our New Equipment price we’re up 2% last quarter. Service was up 3% globally. So we're getting price. We're getting productivity, and we're seeing a difference.
Got it. And then I guess, lastly on China, and I think about kind of the different verticals there. You mentioned the property sector pretty well documented. You mentioned infrastructure that would be kind of more -- a bit more of a tailwind. Anything else that we should keep in mind on the vertical front?
Yes. So within the verticals, China is a residential-heavy market. That residential is mid- to high-rise, but mainly mid-rise residential and there's lots of it.
Listen, there is still -- urbanization is still real in China. If you believe that China wants to still raise their urbanization rate another 5 points, you're talking to seven to eight more Manhattans before 2030. So there's ample opportunity in China. We're still seeing building the 650,000 segment goes down to 600,000 or 550,000 it's still the largest market in the world with lots of opportunities.
I think I had seven to eight Manhattans last night, so I sympathize.
This is your last one. Isn't it?
You could tell.
Of the conference. You can tell I'm your last guest.
Maybe talk a minute on the New Equipment side in terms of backlog conversion. You guys aren't alone in terms of kind of building a backlog and throughput is kind of uniformly challenged across most manufacturing verticals. How do you see that phasing out? Is there sort of like a resolution timeline I can't imagine there's any step function process that you've seeing. But -- maybe just kind of give us a lay of the land on how you see that flowing.
Yes. So backlog is critical. And I would tell everybody, as you - China specifically, you got to look at what our backlog is at year-end to know how -- what '23 will bode. Because our backlog in New Equipment drives – globally, drives -- as we start the year, drives 2/3 of our revenue for that year and the rest is kind of book and ship. Our backlog is high. We ended second quarter with 10% backlog. I'm going to only talk constant currency and backlog, 10% backlog in New Equipment.
And so that's higher than we've had in a long time. And we've got the capability to deliver it, but in certain markets, we're seeing some challenges here in North America. We're doing -- we do not have a labor issue. We have a great relationship with our skilled labor. We just came to a great labor -- a fair and great labor agreement that starts in January for the next five years. So we have price certainty but other construction trades and other general contractors are having trouble staffing jobs.
So jobs are extending a little, especially on the construction and the installation side and regardless of us being in the critical path. Some of our revenue that we would have thought would have come from backlog in North America and '22 is going to roll into '23.
But our backlog is strong. Our orders book was just really, I think, amazing in the second quarter. New Equipment orders were up 16.5%. [67%] (ph) in North America, 29% in Europe. Everybody says, you have New Equipment in Europe? 29% in Europe. And the only thing I'd point you to is New Equipment orders can be lumpy. So we always share what our 12-month role is, and we ended the second quarter with an 8.5% 12-month roll on order. So backlog is there. We're ready to convert. The job sites have to be ready. That's the mix we're dealing with in terms of is it going to be fourth quarter revenue this year or move into '23.
North America looks like it's going to move into '23. Some of it, but it's not -- it's there. And I think the difference for everyone to understand in our industry is when we take an order and book an order, we get an advance. And that advance from the customer is ours. So we don't have this double ordering. You may have heard about this week. We don't have that risk.
Customers are serious because if they then cancel, we keep the advance. So it's a great cash cycle we have in the business as a whole. But I think that separates us out from a lot of short-cycled businesses and others.
If you think about kind of that labor bottleneck that is one kind of supply chain or kind of general impediment to growth that is a little harder to solve for, right? I don't know if I want a robot installing my elevator anytime soon. But how do you think about how we move past this? Is this going to be a governor of growth for some time? Is there anything you guys can do productivity-wise in the process that sort of unlocks that?
I hope that you all heard his pun, governor, because there's a governor that is a safety element of an elevator.
I'm big on elevator pun.
There you go. There you go. But no, so it's interesting. We -- and again, we have 41,000 field professionals in Otis spread throughout the world, and they truly are skilled craftsmen and craftswomen. And this is the career they choose, they apprentice here in the United States. They apprentice for four years. So they don't go to other trades. So they're really committed to this, and many of them are generational. Their parents did this. Their grandfathers did this. So we -- when we look at our attrition rate with everything going on in the construction trades, service industry, because remember, we're a service company, first and foremost, when we look at all of that, our attrition rate right now is lower than it was in 2019. We're talking mid-single digits across 68,000 colleagues and I say 68,000 because we used to -- we divested our Russia business. So I just people want to understand that bridge. So this is -- labor is not -- Otis labor is not our issue.
People are committed. Hopefully, they're engaged and you're seeing that, and you're seeing that in terms of our operational performance and that eventually translates to our financial performance. Some of the subcontractors we use, especially in Europe, I think we're going to see with the low unemployment rates there, we're going to see some stress points, but we've seen them before, and we'll manage them.
And then you mentioned kind of the pricing element earlier. With being a longer cycle business, I would imagine kind of book pricing is higher than bill pricing. How should we think about that laying out here kind of over the medium term?
Yes. So we talk about booked margin and backlog margin. So when we take a job very different from probably almost anybody else you spoke to in the last three days here, first, we bid a job, takes a little time to win the proposal and to work with the customer, whether it's an architect, a developer and eventually the general contractor who puts us under contract.
And then from that point on, again, they give us the advance cash deposit from that point on, it's probably 12 to 18 months. And what that gives us is an opportunity to drive productivity in our factories. So we know what we price something at. We understand the margin it has at the price time and then the price we realize is what's really important. And that price -- that differential is what has allowed us to have our success New Equipment profitability and margin expansion ex commodity supply chain challenges that we've been wrestling with. So that's really where there's a field component to that, too, because of the field installation, and that's really where we've had a lever there and we've had a lever on the material productivity side.
What can we do from an engineering perspective to redesign things to make them more cost effective? How can we have better supply chain agreements? How can we hedge commodities, get them at the right price? We've got $110 million this year of commodity exposure, all in our New Equipment segment. We disclosed that in terms of our full year outlook that we're offsetting. I mean that's $0.18 a share of EPS that we're offsetting. And then you add that to FX, which is $0.24 and we're still having EPS growth of 7% to 9%.
So the team is really doing well at productivity and bottom line, taking out taxes, working on our debt, more importantly, our interest. And then also, I think you know earlier this year, we closed our transaction on our Zardoya enterprise and are now not just the majority, but we're the sole owner and we brought it back into the company, and that's going to add about $0.12 of EPS accretion this year, too.
Got it. And then I guess on the other side of that, the input cost side, I mean, we're seeing some -- a little bit of deflation, at least a little disinflation maybe on the rest. How should we think about that as you kind of have your early look into the cost of '23?
Yes. So we don't -- our input costs come from a few places. In terms of the raw materials, we're now almost $600 million of our New Equipment cost base is raw materials. 80-plus percent is steel. So where we have the ability to take advantage of that quickly and where we're seeing that steel price come down, like in China, the team, we're doing a great job doing that. In other places, we've locked in appropriately, certainly through the rest of this year because we didn't want -- you have to make those calls. We'll see where '23 takes us.
We also, though -- there's a little bit of a lagging cost impact from our second-tier suppliers. So we've been managing that as well. But at the end of the day, '23, '24 should turn from headwind to tailwind on those. I mean, if nothing else in '23, it's net neutral. But if we do really well on managing input costs, it should be a tailwind.
And then you mentioned earlier kind of lower attrition rates and moving the needle on that. I mean just kind of zooming...
On the headcount people side or the portfolio side?
The portfolio side.
I guess, sort of zooming out and kind of looking at the broader industrial economy or maybe any piece of the economy, switching costs are just sort of higher now, right? How much of that do you think is playing into it? How much of that do you think is sort of on the back of the Otis team's work? And is that an environment that's sort of generally positive for the OEMs relative to the ISPs?
Yes. So we don't -- if you ask me, so our retention rate is a little over 94%. It's best in the industry, and I would argue top 5 world-class when you look at other service industries who have a retention ability. You could call it a subscription, but who have that kind of maintenance subscription kind of service.
People don't tend to leave us the majority for price. And it's really not switching costs, but it's just -- it's a comfort. And if you look at our 2.1 million portfolio, 55-plus percent of that is residential. So these aren't high-rise buildings in the majority. These are story buildings in every city, they're hospitals, their medical office buildings, their schools, and they have 1 to 4 elevators.
And so they're used to dealing with us. So as long as we provide excellent service, they renew. So it's on us. And that's really, I think, what we're seeing is this renewed customer focus, the application of Otis ONE that's giving us a lot more 1/3 of our portfolio is already instrumented, a lot more real-time data -- we've specialized our mechanics so that if there is -- we have those that do regular maintenance and those that respond to issues and we've just also implemented recently now in almost 300 branches route optimization software. So we have 1,400 branches. And you would think after 169 years we've had the routes down pretty well. There's still so much room for improvement.
So when we drive route optimization, we get -- first of all, our mechanic has less non-productive time. So they're more satisfied. They're not sitting in traffic. Our customer has more uptime. They're happy, which is why they retain us. We use less fuel. We use 12 million gallons of fuel a year, so less fuel is good from a cost perspective with the price of fuel and tires get less wear. But also just as importantly, is we emit less greenhouse gases. With 22,000 vehicles, it matters to us. As we look at our Scope 1 and Scope 2 emissions, it's not in our factories. It's in our fleet and it's in our real estate portfolio of all these branch offices.
Got it. And then just on the service side, I mean, '22 is kind of ahead of your medium-term outlook. How should we think about -- is there a convergence there? Is the medium term have opportunity to maybe go higher? And what would you need to see to sort of get more constructive on where ours can go over the next few years?
Yes. So when we put out medium term, and this was the second in our -- since we -- the first Investor Day was two months pre-spin before COVID had really taken off, but this was our second one this February.
Yes, we're always -- we always want to meet or beat it. So we're usually a little conservative when we do that, but we also we're young, right? We've only been independent 2.5 years. So we think we need to prove it quarter after quarter, year after year. And one cycle doesn't count. So I think the medium-term guidance, we believe, is achievable. We just did our next cycle of long-range plans and plans instantiate that. So we feel comfortable there. There are certain places we've already beaten it on tax rate. We're going to finish this year around 26.6%, and we had guided, I think, 25% to 27% in the medium term. And that's the 26.6% is actually structural. It's not 1 timer. So we've done a great job.
We're down 7 points there in 2.5 years. There's not another 7 points unless there's major tax overhaul to get. But -- so that will slow down a little. But I think if you really look at anything in the medium-term guidance, it's the leverage on service. So how much more can we get through portfolio growth through productivity and through price.
And we've got inflationary clauses in Europe and North America in most of our service contracts. And we had to teach our team, and they've responded wonderfully. But we have a sales force that didn't -- never grew up or experienced inflation. They dealt with the opposite. So they were used to discounting. So we had to say, "No, not only aren't you going to discount, you're going to raise prices. And we've been seeing that, especially on service, really pleased 3% price like-for-like already on service on our maintenance, and that's -- we're going to go get it again next January. So it goes throughout the year, but most of it is in the first quarter.
Got it. And then I guess, sort of in the same discussion, how is Otis ONE deployment going? And kind of where you're seeing the opportunity there?
Yes. So all the OEMs have an IoT solution. But I think what differentiates ours is we really have a 3-tiered solution with the most basic and foundational tier focused on installed base. We wanted to get out there quickly. We wanted to get out there with a low-cost data center with the gateway so that we could start proliferating this across that 2.1 million portfolio that we have, which is significantly larger than our closest peer. The reason we did that is because just putting out IoT doesn't help you in a world where the strategy is all about density, routes and density. And that's the discriminator we have at Otis in our service business were at large, but especially with Otis ONE.
So we selected where it was going to go versus sending it everywhere in the world and waiting for customers to buy it. That gave us a foundation. Then we did product enhanced. And we took our eView product, which is our -- basically our multimedia product that we've now originally deployed in Europe.
Now we're bringing it to North America to Asia in China. We took that product and added that to Otis ONE. So now we have data, we have voice and we have video. And all of those now beyond the data center, which we did on our own CapEx on rate per year, CapEx and OpEx, we didn't have a special program, but it's paying dividends.
For us, it paid in productivity, and we think it got more customer loyalty and stickiness. And then you add voice and video. And now all of a sudden, you're going to get more in your service contract, you're potentially going to get a subscription service or you may actually what we believe is going to happen in several markets where we just -- where we added voice is right now every elevator by code has a phone in it. That phone line doesn't go through us. That the building owner, the manager, that's a separate bill with the phone company. We're going to most likely be able to replace that either through IP or VoIP or other technologies and have that revenue come through us as well.
So you start thinking about a lot of units we've got an uptick subscription services for the multimedia when you want to create and have content, and then we're going to get the productivity side as well. So it's going to be top line growth and bottom line is going to fall through.
Got it. And then you mentioned some of the earlier comments around FX, obviously, the dollar is helping really anybody here. How do you go about offsetting that? Where do we stand today if you were to snap the line?
So if you look at our revenue split, 26% of our revenue is in U.S. dollars. Another 20-ish in euros, another 20-ish in RMB and the remaining third in a lot of other currencies. The strong U.S. dollar, when you're this global and this distributed has an impact. We've not put that impact on the backs of our four regions and our operators. They can't control it. So we've told them, here's what we need you to do to hit your plans and we measure them at constant FX appropriately. But we have a responsibility to do the best we can to offset it. And that's what we've been trying to do below the line. So as we started the year, we've really figured out what structural levers we could do in tax. We brought that down.
The Zardoya transaction gave us some offset as well. And then we just -- every opportunity we have below the line, the share buybacks as well. So everything is kind of merging to where have we fully offset $145 million of FX, which is what we said in second quarter, again before current right now where the dollar is, we'll have to reevaluate that at third quarter earnings, and between that and commodities. So $110 million of commodities, $145 million of FX in the headwind column, we’ve offset most of it because we're still going to be -- I think, we're at $3.19 at the midpoint versus $2.95 last year for our EPS. So we're still talking 7% to 9% growth with that headwind.
So I think, again, executing strategy below the line, above the line, and I think we're seeing it.
Great. Well, I see we're at time, Judy. I appreciate the time. Great to have you here, especially in person, and I appreciate everyone's attention on the line.
Great. Thanks, Josh.