Otis Is A Long-Term Compounder (Analysis)

Last Updated on March 6, 2021 by Oddmund Groette

Otis is the world’s biggest elevator company. It manufactures and installs elevators, escalators and moving walkways. The name origins from the founder, Elisha Otis, who in 1852 invented a safety valve to stop the elevator should the cables fail. At the time, many were reluctant to use elevators or other hoisting mechanisms because of frequent accidents. Because of Otis’ invention, elevators made skyscrapers possible.

Otis was acquired by United Technologies in 1976 but spun-off in March 2020 and is now an independent company.

We believe Otis is a great stock to own and will outperform the markets in the coming decade(s). Moreover, in case of increased inflation, Otis should provide an inflation hedge by increasing its prices in line with the inflation rate. We expect >=10% CAGR.

Elevators are a good business, because:

Some bullet points explain why we believe Otis has a great business:

  • Urbanization, population growth, and increased living standards equal both a long runway and tailwind. The middle class is growing.
  • Recurring revenue from service, maintenance, and increases elevator base.
  • The market resembles an oligopoly with four players dominating the market: Otis, Schindler, Kone, and ThyssenKrupp. The top five represents 70% of the industry.
  • The business model is asset-light. Hardly any working capital is needed.
  • High returns on capital.
  • Highly regulated and thus barriers to entry.
  • Digitalization means more upgrades for the existing elevators. Modernization is 19% of the service income. 21% of Otis’ elevator base is older than 30 years.
  • Elevators cost an insignificant amount to install in bigger buildings, yet it’s vital for the building to work. Thus, the brand is important and new competitors are unlikely. Safety is paramount.
  • Otis is the biggest in the business and has scale.
  • High switching costs.

Otis has a recurring business model:

The first box on the graph below shows why this is a great business:

New bookings of new equipment/elevators result in more recurring services later. Typically, a building installs an elevator and Otis gets the service agreement for the annual inspection, service,  and maintenance of the elevator. It’s a sticky business, the conversion rate is 90% in the Western world, though a bit lower in China.

The Service segment has the highest margins:

Any building management is free to choose whatever company for the annual service and inspection, but most management companies chose the one which installed the elevator. The annual service fee is expensive and typically only requires just one annual visit, which of course doesn’t cost much time nor money for the elevator company. This is a very lucrative business. The building code makes it a requirement to have a service agreement.

Moreover, this is a multinational business with diversified sales:

 

Otis is a cash cow:

Despite operating in the building business, the CAPEX and cash requirements are low. Working capital to sales is only at 2.6, down from 3% some years earlier. Furthermore, CAPEX is only at 1.5% to sales. Most customers pay upfront before the equipment or services are delivered. Kone, the Finnish elevator company, has negative working capital.

Despite being an elevator company, most of the equipment is assembled, not manufactured, from external components. Most of the New Equipment segment is ordered via developers, architects, and real estate managers which prefer to use brands they know.

The Service segment is a bit more fragmented than the New Equipment segment. Otis can service whatever company installed the elevator and we expect the bigger players like Otis to gain market share in the future. Be aware that independent service providers have gained some market share lately by underbidding on price. Around 50% of the elevators are serviced by independent companies. We can expect Otis to acquire smaller independent service contractors in the coming years. Asia is more fragmented than the Western world.

Otis said on their Investor Day in February that Otis has installed 3.5 million elevators and service two million – 1.5 million “theirs” and 0.5 million competitors’.

Capital allocations:

40% of the earnings are planned paid out as dividends. During 2020 and 2021 excess capital is spent on deleveraging, but buybacks are planned from 2022 if the debt ratio allows. The debt limit is at 2.3 net debt to EBITDA. Additionally, Otis performs small bolt-on acquisitions all the time.

Otis’ future growth:

Otis expects high single digits EPS growth. This is likely because of:

  • The 30% of the industry not in the top five will continue being consolidated into the top five.
  • Urbanization is structural and unlikely to stop, despite Covid-19.
  • New technology is ready to be installed in new and existing elevators (IoT, etc.).
  • Otis expects New Equipment to grow low single digits, and Service (maintenance) at mid-single digits. Acquisitions is on top of that.
  • Small margin expansions.

About 15% of the revenue comes from China, the fastest-growing market in the world. Otis has a high share of new installments, around 20%, but only a 3% market share of the service market. The Chinese market is much more fragmented than the rest of the markets, but we believe Otis stands to gain from the expected consolidation of the market.

Valuation:

Otis is currently trading at around a PE of 24. That is high, but still considerably lower than the Finnish competitor Kone which trades at around 32. Both companies deserve to trade at a premium to the overall market. We don’t think this is expensive considering the 10% growth and the prevailing low interest rates.

Negatives with Otis:

The building sector is, of course, a cyclical business. Thus, during a recession, we can expect Otis to suffer, but the real money comes from the Service segment which is by law a requirement to have. Otis has currently more than two million service contracts, the biggest in the world, that need to be serviced – recession or not.

Conclusion:

Otis is a quality company in a desirable business, despite being slightly cyclical. It requires almost no cash to run and recurring revenue is high. Tailwind from urbanization, continued modernization, digitalization, and consolidation make this an interesting investment. We expect 10% annual return, which we believe offers better risk and reward than the overall market.

 

Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities. 

  •  
  •  
  •  
  •  
  •  
  •