Executive Summary
The elevator and escalator business depicts several quality traits that have proven to be very wealth-creating for long-term owners. Amongst other factors, urbanization and the expansion of the middle class worldwide are two secular tailwinds that benefit this industry.
While the industry is well consolidated (with Otis holding share in excess of 15%) the competitive nature of the industry is highlighted by the large number of independent service providers, which, according to Otis’ management have an aggregate portfolio that comprises roughly 50% of service units (over 75% in China). Nevertheless, due to the types of units and maintenance levels these providers cover, they represent a smaller percentage of the service business when measured by value. The large fragmentation of small independents reminds us a bit of O’Reilly and AutoZone that have the opportunity to strategically acquire some of the smaller players.
Barriers to entry are reflected in the increased technological complexity, regulation, and safety concerns. The top players generate strong free cash flow, have negative working capital, and focus on the emerging opportunities on the service side.
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We believe Otis to be best positioned given its industry-leading profitability, proven stability over the past two years (which we’re full of challenges: supply chain constraints resulting in a substantial cumulative headwind to gross margin, primarily in New Equipment, unprecedented inflation), well-balanced global presence, and last but not least: reaccelerating organic growth following the United Tech spin-off. Over the past few years, Otis shares have well outperformed direct peers.
Prior to the spin-out, there was no incentive to pursue revenue growth that’s very well needed to drive S&GA leverage. That’s what made us change our mind about Otis’ potential to produce Compounding Tortoise-type returns going forward.
This quote from CEO Judy Marks earlier this year (during the Investor Day) sums it all up:
We are in the life safety business, and 2.3 billion people a day trust us. And you don't think twice about using our product. That's exactly the kind of company we want to be.
We know how to do this. We've shown you we know how to do this. And we have an organic growth opportunity called modernization sitting right in front of us that will allow us to accelerate even more. That's what gives us the confidence that even in a flat New Equipment market, portfolio is going to grow, mod is going to contribute. And while New Equipment on the top line and bottom line, it will be flat to low single digit. It's our Service business. Customer-centric, Service-driven business model is our Service business that's going to be up mid-single digits plus, which is going to drive the double-digit EPS CAGR. We've done 13% EPS CAGR since spin through some really interesting years, through some interesting times. But looking forward, even with a flattish New Equipment market, even with challenges in the property markets no matter where you are in the world, this business model and this company will deliver double-digit CAGRs.
Exhibit I (Otis’ San Sebastián facility)
It’s a bit like the case we outlined for Linde in our April deep dive. Whatever the world throws at it, they’re likely to emerge as an even stronger company with above-average and relatively stable TSR performance compared to other industrials and the S&P-500.
To summarize the investment case for Otis, the expected return potential will be driven by five pillars.
Resilience and Accelerated Top Line Growth Potential
As of today, Otis has approximately 2.3 million units in its service portfolio. Half of these units are located in EMEA, with the remaining 50% evenly distributed among Asia-Pacific, China, and Americas. Within the service segment, Otis has two sub-segments.
The first is maintenance and repair, which constitutes roughly 80% of total service sales revenue. Maintenance contracts serve as the foundation, typically spanning an average of four years globally, with annual price adjustments based on inflation indices. This feature provides an additional layer of stability and security for its service business. The second subsegment, modernization, currently represents a smaller portion but has the highest growth potential.
Although some investors doubted the lower growth in “New Equipment” prior the UTC spin-off, Otis has experienced accelerated market share gains lately, as it captured 20% of total industry bookings in FY23 versus its pre-COVID run-rate of about 14-16%. At the same time, prospects for its service segment look bright with an incrementally growing EBIT contribution from Modernization (“Mod”).
Improving Earnings and Cash Flow Quality
Otis’ long-term track record is somewhat misunderstood: new equipment sales account for roughly 37% to 40% of Otis’ revenues but don’t provide meaningful EBIT. As such, revenue swings are a little deceiving (yet, this number will always hit the headlines). Instead, investors should focus on the service/modernization backlog which is the future driver of EBIT growth, buyback optionality, and dividend growth.
While we’re not timing a potential shift in interest rates or the construction market, more equipment orders would fuel future services and modernization potential for Otis and thus help overall investor perception turn more favorable. And if we don’t get a U-turn in monetary policy any time soon, then the elevator multinational should still deliver strong results.
And long before the AI hype started to gain traction, Otis’ modernization strategy was already targeting the benefits from this technology by equipping its long-standing installed base with sensors and algorithms that can analyze the patterns of people's movements, predict future demand, and optimize elevator performance accordingly. Amongst other levers, technological advantages will drive S&GA savings and thus profitability.
Proactive Capital Allocation Strategy
Since Q3 2021 (the quarter that marks post-COVID performance better), Otis has generated 3.17 billion in underlying free cash flow, including the recent and fully seasonal working capital headwind of 261m USD. Exhibit II highlights the cash flow reconciliations (note: in our IRR model, we’ll stick with our approach of adjusting NOPAT and free cash flow for the portion theoretically destined to NCI (non-controlling interests), including the existing book value of equity).
