It’s not every day that you hear “recurring business model”, “razor / razor blade”, “route density will drive margins higher” story associated with an industrial company, but here we are. Otis stock has officially spun out of United Technologies so here’s my initial read. In other words, a starting point to see if there should be more work done. I like to take quick looks at topical names (and spin-outs can get interesting) so more of these will likely follow.
Things I like:
- Service Drives Profitability:
- New equipment sales were 43% of sales, but just 20% of operating profit. That means service revenue, while 57% of sales, makes up 80% of operating profit
- This is positive, as it means revenue is much more recurring. Represents a “razor / razorblade” model too in that once the new equipment is installed, the customer needs to come back to Otis for service
- The model is pretty simple: Otis sells new equipment and operates under warranty for a couple years. After that, Otis sells long-term service agreements that typically last ~4 years.
- According to the company, an elevator will generate 2.5x its original purchase price in aftermarket service
- In fact, service is contractual. And I like that the company reports “Remaining Performance Obligations” because it gives a sense of what sales will be in the next 2 years.
- Generates a lot of unlevered FCF:
- I was somewhat surprised at the low capital intensity of the business. I would say that this level of capex spend based on my experience is top quartile and that checks a box for Otis stock
- Further, working capital is really low relative to total assets & sales
- This means the company likely can use a lot of cash for dividends (looking at 40% payout ratio) and buybacks plus possible M&A of other service providers as the company says the space is fragmented.
- Consistent business model – life threatening to “skimp” on the service:
- I like how this business really hasn’t changed in 100 years. It tells me that the next 10 years will probably look similar to the last. That’s something you can’t say about every business so perhaps this deserves a “consistency premium”
- If I was a firm deciding which elevator to choose, I’m not sure I’d take the lowest offer. I think a firm with a solid track record actually matters here. Elevators not only get people to work
- Failure here might be unlikely, but the cost is so huge it makes no sense to change. For me, I sense that being true on both new sales and maintenance.
- In fact, the company says it has a 93% retention rate following end of the warranty period – not bad!
Things I don’t like
- Operating Margins have been declining
- At first glance, I thought this might be due to new equipment sales becoming a larger portion of the mix. However, that’s not the case. It has been relatively consistent.
- It seems to be China sales are the issue. The company has called out this “mix” effect, but also Otis doesn’t not have leading share there. In this business, density matters. So it will take time for the company to build density and improve margins.
- Quote from prior call on Otis on the importance of route density:
“So today, if you look at us versus our peer competitors, we have a 200- to 300 point — basis point premium margin. We believe with our scale and density that will continue through the future. Add that to, again, this drop-through of productivity enhancements. But scale and density matters in this industry. You go to any city, whether it’s this building, anywhere else, if you’ve already got mechanics, if they’re already out on a route and you can add new customers, you get, obviously, a little additional incremental cost, but you get to add to the portfolio significantly.”
- Mitigant: Company is targeting supply chain savings (3% of gross spend per year) and thinks it can reduce SG&A from 13.6% of sales to ~12.25% over the medium term, but somewhat of a “show-me story”
- China is the growth story
- China’s construction growth worries me. The talk of “ghost cities” being built to support GDP makes me concerned that a reckoning is eventually coming. And the problem is that many of these buildings may be unoccupied and therefore you don’t need to service them.
- China is the largest elevator market – 60% of global volume. It’s also more competitive it seems.
- Mitigant: China is getting more focused on building maintenance code, which should support global players like Otis. It should allow more sales to the big players as well as larger service contracts. Real estate developers in China are also consolidating, so it likely means they will want to work with one supplier.
Otis Stock Valuation:
I would say the valuation here is reasonable. Not super compelling in the COVID world, but at least it should be a long-term compounder.
Thysennkrupp’s elevator business was acquired by private equity for $18.7BN, or roughly 17x forward EBITDA. That would point to Otis stock being very cheap on that basis… Given it’s stability and strong cash flow, I can see why P/E would buy out a player. Otis stock is actually a mid-cap, but not too big for someone in Omaha…