Otis Worldwide: Good Growth Prospects At Reasonable Valuation
Summary
- A high backlog level and pricing in FY2023 should drive the topline growth in the New Equipment segment.
- The accelerated maintenance portfolio growth, pricing increases, and a high backlog for modernization business should increase the revenue in the Service segment.
- Margins should also improve thanks to volume leverage, pricing, and productivity improvements.
- Valuation is at a discount to its historical levels.
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Investment Thesis
Otis Worldwide Corporation's (NYSE:OTIS) New Equipment sales are expected to increase in the coming years, driven by China reopening, a high backlog level, and pricing increases. Additionally, in the Service segment, accelerated maintenance portfolio growth, pricing, and a high backlog in the modernization business are expected to help the company generate increased revenue.
The adjusted operating margin should also improve in the coming quarters due to volume leverage, pricing, and productivity improvements. Currently trading at a discount to its historical average P/E ratio, Otis appears to be a good buy.
Revenue Analysis & Outlook
After being impacted by COVID-19-related headwinds in FY2020, OTIS's revenue accelerated in FY2021. However, in FY2022, the lockdown in China had a negative effect on OTIS's revenue, particularly in its New Equipment segment, slowing growth. However, as COVID-19-related restrictions were lifted in China in the fourth quarter of FY2022, the company began to see signs of recovery.
The Service segment has been much steadier, given the recurring nature of its revenues. The segment is also driving growth by increasing its maintenance portfolio and focusing on modernization demand. A good increase in the Service segment's organic revenue more than offset the decline in the New Equipment segment and resulted in increased organic sales YoY for OTIS in FY2022. Nevertheless, foreign currency translation headwinds due to the strengthening of the US dollar negatively impacted sales, resulting in a YoY decline in total net sales.
OTIS' Historical Revenue Growth (Company Data, GS Analytics Research)
Looking ahead, I am optimistic about sales growth prospects in both New Equipment and Service segments in FY2023, driven by an improved backlog-to-sales conversion rate, pricing increases, and accelerated maintenance portfolio growth. The long-term backdrop is also good, and healthy demand in the Asia region should help the New Equipment segment win more projects in the coming years.
In FY2022, orders for New Equipment increased by 7.1%, with growth in all regions except Asia due to the lockdown in China. However, with easing COVID-19-related restrictions, China's orders returned to growth with a mid-single-digit increase in the fourth quarter of FY2022. The company won major projects in the quarters, including 120 escalators and Gen3 elevators for Tianjin Metro, China. The increase in orders led to a high backlog level, up 11% YoY in FY2022, which makes me optimistic about the revenue growth prospects. Further, as supply chain constraints and labor availability continue to improve, it should facilitate a higher backlog-to-sales conversion rate and support revenue growth.
Additionally, pricing on New Equipment orders remained high throughout FY2022 and was up 3% YoY in the fourth quarter. These higher-priced orders are now in the backlog, and the company generally delivers the product within 12 months of bookings. Therefore, I believe pricing should also benefit revenue growth in FY2023 as this higher-priced backlog is converted into revenue.
Further, healthy demand in the Asia region should also help sales growth. China represents over half of the global New Equipment unit volume, so I believe the reopening of its economy after the 2022 lockdown should act as a growth tailwind for the company. Pent-up demand in the construction industry should help the company win more projects in the second half of FY2023 and generate increased revenue in FY2024. Additionally, growth tailwinds such as urbanization and increased infrastructure investments by developing countries like India and South Korea should create a healthy demand environment in the Asia region.
OTIS' Backlog and New Equipment Orders (Company data, GS Analytics Research)
In addition to the growth in the New Equipment segment, the Service segment is also expected to report increased revenue in FY2023, driven by accelerated maintenance portfolio growth, pricing, and a high backlog in modernization. The company is focusing on its OTIS ONE offering to drive growth. OTIS ONE, a digital service platform designed to continuously monitor equipment health and performance in real time, provides proactive, predictive, and transparent information to technicians and customers. These value propositions are helping the company to achieve higher conversion and retention rates and should continue to drive growth in the maintenance portfolio. The segment's revenue should also benefit from higher pricing implemented by the management to offset labor cost inflation.
Further, over the last few quarters, orders for the modernization business were robust, resulting in a high modernization backlog level which was up 7% Y/Y at the end of FY2022. As previously mentioned, supply chain issues and labor unavailability are expected to improve in the coming quarters, helping the company increase backlog-to-sales conversion and generate higher revenues in FY2023.
Management indicated that net organic sales should be up low-to-mid-single-digit Y/Y in FY2023, which I believe is achievable considering the growth prospects in the New Equipment and Service segments.
Margin Analysis & Outlook
The adjusted operating margin of OTIS improved by 30 basis points (bps) Y/Y in FY2022, primarily driven by margin expansion in the Service segment that more than offset the decline in the margin of the New Equipment segment. The scenario was similar in the fourth quarter of FY2022 as the margin improvements in the Service segment mitigated the decline in the margin of the New Equipment segment, resulting in flattish margin performance versus the last year. In the Service segment, higher volume, favorable pricing, and productivity more than offset annual wage inflation, resulting in margin improvement. Conversely, in the New Equipment segment, the benefits from higher volume, cost containment, and productivity were more than offset by the commodity inflation and foreign currency translation headwind.
Adjusted Operating Margin (Company data, GS Analytics Research)
Looking ahead, I anticipate that the adjusted operating profit margin of OTIS should improve in FY2023 due to volume leverage, pricing, and productivity.
As explained earlier in the revenue outlook section, I believe that the volume should increase in both the New Equipment and Service segments. So, the company's margin should benefit from the volume leverage in the coming quarters. Moreover, the management indicated that it intends to continue implementing price increases at a higher pace than inflation and keep price/cost positive in FY2023. This should help margins. The OTIS ONE technology should also continue to improve productivity by providing proactive, predictive, and transparent information to field professionals.
One thing which may impact the margins negatively is lower volumes of high-margin China New Equipment orders in the current backlog. However, I am not too worried about it. As explained earlier, China's orders have already started recovering with the economy reopening. So, as we move towards the back half of this year and the next year, this headwind should wane. Overall, I'm optimistic about the company's margin improvement prospects in the near as well as long term.
Valuation & Conclusion
OTIS is currently trading at a P/E of 23.36x consensus EPS estimate of $3.45 and 21.15x FY2024 consensus EPS estimate of $3.81. The company's valuation is to be lower than its 5-year average forward P/E ratio of 25.72x.
I like the company's razor/razor blade type business model, where it derives a meaningful operating profit from its already installed base of equipment.
Adjusted segment operating profit as a % of total segment operating profit (Company Data, GS Analytics Research)
Further, the company's near and long-term prospects look good with a high backlog, China reopening, secular growth opportunities in developing countries, and the company's focus on the OTIS ONE platform to achieve higher conversion and retention rate of service customers. Hence, I am optimistic about the company's growth prospects and have a buy rating on the stock.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
This article is written by Harshit K.
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