Otis: When Manufacturing Couples With Recurring Revenue

Summary

• The elevator and escalator manufacturing industry is highly concentrated and sees only a few big players.
• Otis is the largest among them and, since its recent spin-off, it has been able to deliver improving results.
• Although orders are in decline, the service segment needs to be considered carefully as it reaches numbers worthy to look at.

Artur/iStock via Getty Images

Introduction

Mr. Market is odd. Last year, the economy was booming and the market tanked due to many reasons (the most important of which, as far as I can see, was rising interest rates). This year, with the economy cooling and order books in decline for many manufacturing companies, Mr. Market is really excited and keeps on offering higher and higher bids, up the point many investors start thinking we will soon see the major indexes break their previous ATHs.

Well, Otis (NYSE:OTIS) is a company belonging to the manufacturing industry that has a business model able to offset for the most part the usual cyclicality of the machinery industry.

The Company

Otis is the world’s leading elevator and escalator manufacturing, installation and service company. It sells its products in over 200 countries around the world. The company is organized into two segments, New Equipment and Service. Through the New Equipment segment, Otis designs, manufactures, sells and installs passenger and freight elevators, as well as escalators and moving walkways for residential, commercial and infrastructure projects. In 2022, its New Equipment segment had sales of $5.9 billion and operating profit of $358 million.

As we can see from the graphs below, since its spin-off, Otis has been able to gain market share in New Equipment, in a global market where the largest elevator and escalator market - China - has been slowing down. Since Otis is not as exposed to China as its main competitor KONE, it had the chance to take advantage from this situation.

Otis 2023 Investor Presentation

Otis' second business segment is Service, which performs maintenance and repair services, as well as modernization services to upgrade elevators and escalators. The company has a maintenance portfolio of approximately 2.2 million units globally, which includes Otis equipment manufactured and sold by Otis itself, as well as equipment from other manufacturers. In 2022, our Service segment had net sales of $7.8 billion and operating profit of $1.8 billion.

Having seen these numbers, we find the first surprise which makes this company (and the elevator and escalator manufacturing industry as a whole) so unique and so enticing for investors seeking reliable streams of free cash flows.

In fact, for the fiscal year 2022, New Equipment contributed 43% of the company's net sales, while Service generated the other 57%. We immediately see how the Service segment is bigger than the segment linked to the real manufacturing activity.

But even more interesting is that, as we move towards the bottom line, we find out that New Equipment contributed 17% of the operating profit, while the other 83% (yes, eighty-three) came from Service. This paints an even more interesting picture because we clearly understand how the Service unit is the higher margin one.

As we see from the slide below and the three graphs shown, the business model of the industry is quite simple and easily helps us understand why service is so important:

1. A strong urbanization trend increases demand for equipment such as elevators and escalators
2. New equipment orders thus grow accordingly
3. As the installed base grows, so does the need to maintain, repair or modernize it. However, this business doesn't grow at the same linear rate of the first one, but it is actually the compounding machine of the whole industry

Otis 2023 Investor Presentation

Investors should know how Otis has a 94% global retention rate of its serviced customers and a 64% global conversion rate of its new equipment customers into service customers.

I got interested in Otis after I read Terry Smith had replaced its position in KONE (OTCPK:KNYJF), the Finnish competitor of Otis, with Otis itself. Mr. Smith has been able to see the strong compounding machine Otis is and the tailwinds provided by the spin-off. Since 2019, the year before Otis started being a stand-alone company, Otis has seen its operating margin increase from 14.3% to 15.8%

Latest Financials

Otis recently reported its Q2 earnings, which beat estimates.

Organic sales grew 9.5% to $3.7 billion, operating margin expanded by 20 bps, GAAP EPS amounted to $0.90, up 18.4% YoY.

The company was able to generate $409 million in free cash flow in the quarter (conversion rate of 109% of GAAP net income), and returned $175 million to shareholders through share repurchases, taking year-to-date repurchases to $350 million. The company actually announced it will increase its share repurchases this year to $800 million. Therefore, we have still at least $450 million worth of shares to be bought back in the next few months. This is equal to 1.2% of the current market cap.

However, Otis is not immune from the economic slow-down we are seeing, especially among manufacturing companies. In fact, new equipment orders were down 12%.

Nonetheless, the strong trend in modernization of old equipment kept giving great numbers with orders up 16% and backlog up 14% in the second quarter. As Otis reported during the earnings call, "this is the fourth consecutive quarter of 10% or greater mod orders growth."

As a consequence of these good results, the company gave a new revised 2023 outlook. The company now expects to perform better than anticipated, targeting to reach the high-end of the prior outlook.

Otis Q2 2023 Results Presentation

Valuation

In my past article, I shared a discounted cash flow model that highlighted how Otis was trading a little above its fair price. Since then, Mr. Market has turned bullish and stocks are priced at higher multiples. However, rather than looking at Mr. Market's daily valuation, we have to look at the company's fundamentals.

Here is another discounted cash flow model I recently ran on the company, using the TTM data and forecasting a FCF of $1.5 billion for this year, given the company has generated $724 million of free cash flow in the first six months of the year. However, there are reasons to believe Otis will break the $1.5 billion barrier.

Just to help my readers understand my model, I awarded Otis a little premium because of the quality of its business model. Therefore, instead of using the WACC of 7.55% which the numbers give, I took off 1.5 percentage points and discounted the future cash flows at 6.05%.

My target price has been revised upwards and it is now around $90. The stock is actually trading in this range.

Author, with data from SA

What does this mean? If a stock trades around fair value, it is already a good deal. It is not a steal, but it is not even a crazy buy. Understanding the resilience of the industry and the company's business model, I am inclined to think Otis is relatively a much safer stock to own than most other stocks of manufacturing companies. Therefore, I initiated a small position to step into this investment. As Mr. Market will offer me other chances to increase my position, I will buy more aggressively during any unjustified sell-off.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of OTIS either through stock ownership, options, or other derivatives. 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.

Comments

[MATTINTERWEB]

Is negative shareholders' equity a concern in anyway for you?

[Luca Socci]

@MATTINTERWEB thanks for your question. I am actually studying the thing because it all starts with the IPO and negative retained earnings. Give me a little while to cross check the balance sheet with its competitors and understand better how the capital structure was built for the IPO and I will give you a deeper dive.

[MATTINTERWEB]

@Luca Socci thank you

[Luca Socci]

@MATTINTERWEB I have looked at the issue more thoroughly. The negative equity comes from three things: when Otis spun off from United Technologies, it had to pay around 6 billion to Otis, creating part of that negative equity which is carried on the balance sheet as negative retained earnings. Then the company started reducing this through its retained earnings. However, it also purchased treasury stock and it completed an acquisition in Spain which increased the negative equity. Overall, it is at the consolidated level. Therefore, it is not a real danger, but rather an accounting practice which in some countries would not be allowed. But overall, there is no real threat to the health of the organic business and I actually believe we will see Otis reach positive equity in a few years. Thanks for asking and let me know what you think.

[Steffen Jørgensen]

Otis has been around for 170 years and are still growing earnings and cash flows nicely. Why would you expect that from 2028 they would only be able to grow fcf by 2% in perpetuity? The market is growing 5% a year and their service biz is growing considerabmy above this at increasing incremental margins due to connected units

[MATTINTERWEB]

@Steffen Jørgensen is negative shareholders' equity a concern in anyway for you? Everything else looks very solid.

[Steffen Jørgensen]

@MATTINTERWEB Not at all. In general, please don't see neg equity as a concern in any company with a viable business model. Its just their choice of capital structure and allocation. Some of the worlds strongest businesses has negative equity. Almost no real value of any company is truly reflected in any balance sheet today. It was back 100 years ago when all assets were mostly material assets. Not today. Buybacks etc can turn equity negative. So no. It's not a concern. Only human extinction is a concern on Otis' service biz which is 85% of EBIT, hehe.

[Steffen Jørgensen]

And btw very disappointed in this author, not answering any questions. Useless analysis.