Category: Security Analysis

Otis Stock Spin-out from United Technologies – Quick Thoughts $OTIS

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…

Will Exxon Need to Cut its Dividend? $XOM

Saudi Arabia and Russia are in a price war — increasing the supply of crude oil at a time when we are seeing an unprecedented collapse in demand due to the coronavirus (COVID-19). Exxon has gotten crushed this year, down 45% YTD with a 9% dividend yield. They’ve consistently paid, and grown, the dividend over the past 37 years. Exxon’s dividend offers a juicy proposition for a company that is rated investment grade and at a time when the 10 yr treasury yield is <70bps.

But let’s do some quick math to see if the dividend is covered, first by looking at 2019 figures. As shown below, Exxon did $1.5BN in FCF.

This is not good. The Exxon dividend cost $14.6BN in 2019.

One thing we could do is look at what bare-bones capex is. In other words, what did the company spend in 2015/2016 when the oil outlook was also bleak? Cutting capex down to those levels would help preserve cash:

So now we have ~$10.5BN of FCF, but that still doesn’t cover the Exxon dividend. The other problem is that cutting capex is not what the company wants / intends to do. As stated in their March 5, 2020 investor day, they will actually be spending more than 2019:

On April 8, Exxon said it would cut this figure by 30%

Even so, cutting capex back doesn’t help. And the bigger problem is that oil was roughly 100%-200% higher in 2019 than it is right now.

What other ways could the Exxon dividend be maintained?

  • They could sell assets, but what price would they get in a time like this?
  • They could issue a bond to help cover it – but do you want an increase its debt load? Is jeopardizing the company for the dividend worth it?

I think its a matter of when, not if. Besides, I personally don’t think the oil industry is dead – there must be good long-term investment opportunities out there for them now that so many players are distressed.

Should you buy Homebuilder stocks?

Given the market selloff, I’ve seen a lot of doom and gloom articles on buyers’ appetites for homebuilding. Will buyers still show up to buy a home with COVID-19 going around? What will the impact on interest rates have?? All of this makes me wonder if Homebuilder stocks have reached attractive levels…

I personally like to buy when people are fearful…

Check out these headlines:

All these headlines essentially result in one thing… Agh! Panic!

Panic

Since most people hold a majority of their net worth in a home, these headlines draw eyeballs.

But let’s think about this for a moment. Yes, the coronavirus may impact my willingness to go out to eat. To ride the subway. To cheer on my favorite team at a sports bar (looking at you March Madness).

But is it going to cause me to stop buying a house? Especially when credit is readily available and interest rates just hit all time lows for a mortgage?

I personally have trouble seeing it. And so far, we aren’t in quarantine and the data has been supportive:

  • Redfin noted in early March, “Demand is still growing at surprisingly healthy levels. And growth in the number of people submitting offers is much higher.”
  • Even at ground zero for coronavirus in the US, Seattle, they noted, “Now coronavirus fears have spread from Seattle to other parts of the country, but we haven’t seen a big impact on home-buying demand yet.”
  • Hovnian, a national builder, had a lot of positive things on its results call:
    • Talking about reported results:

“Some may say that the strong increase was against an easy comparison last year. I’m pleased to say we were also up 33% compared to the first quarter of 2018. Additionally, our sales pace was the highest level of contracts per community for any first quarter since 2005. It’s clear that the housing market is rebounding and demand for our homes continues to gain momentum.”

    • Regarding the virus impact specifically:  “Sales feel particularly and perhaps surprisingly steady and solid”

It makes sense. The 30 year mortgage rate has made it super compelling to buy a home. This will obviously help the homebuilder stocks.
30 Year Mortgage Rate Chart

30 Year Mortgage Rate data by YCharts

At the very least, those that own a home can refinance and keep some more cash in their pocket each month.

At the same time, we’ve been underbuilding in this country since the downturn. While we overbuilt in the last downturn, we’ve been growing as a country (creating new households) but new starts haven’t kept up. We were just now getting to mid-cycle levels before coronavirus caused a drop off.

I think this will lead to pent up demand when we come out of this which will support Homebuilder stocks

I personally am looking at the homebuilder equities. Toll brothers and Lennar are trading just above 1.1x BV. These are companies that have cleaned up their balance sheets and are generating ~13% ROEs. That seems cheap to me. Toll has also been buying back stock like its nobody’s business. This could even be a shot to buy NVR, a great blue-chip.

Could we see a pause? Sure. But I think the longer-term fundamentals are strong and that this virus won’t impact their intrinsic value.

Is it Time to Buy Cruise Stocks? Intrinsic Value Impact from Coronavirus

People are saying that no one will ever take a cruise again. It’s over. Done. Pack those cruise ships up and send them home… But do people actually not remember the PR disaster Carnival dealt with in 2013? Here’s a great headline from that time:

Stranded cruise ship on which ‘sewage ran down the walls’ and ‘savages’ fought over food finally docks amid jubilant scenes“.

This came not too long after Costa Concordia wrecked and the Captain jumped ship (literally). 32 people died.

Beware of anecdotal evidence!


I bet you can imagine what happened to Carnival’s sales in 2013 then?

Oh, that’s right – they were up. In 2014 they were up… they’ve basically been on an uninterrupted pace for a long time. In fact, many of these cruise lines have been public for so long that you can see how they performed after SARS, 9/11, 2008, Zika, Ebola – they pretty much kept on humming. Apparently nothing will stop college kids and boomers from taking a cruise. So is that an opportunity to buy cruise stocks?

I’m not saying you should buy them today, but they’ve historically traded at 10-13x EBITDA and are now trading at 5x. The market is currently pricing in death. I can confidently say that because they now are trading below the book value of cruise ships as well.


Now, one problem with cruise stocks is liquidity.

Cruise companies do have ship deliveries, which is something to monitor. This could crimp liquidity as they also take a demand hit in the next year.  But they also likely have tools to pushback on shipbuilders during times of stress. These are the shipbuilders main customers, so not like they want their customers to go into bankruptcy either.

However, some names like Royal Carribean are investment grade and “December 31, 2019, we had liquidity of $1.5 billion, consisting of $243.7 million in cash and cash equivalents and $1.3 billion available under our unsecured credit facilities, net of our outstanding commercial paper notes”. Norwegian just announced at $675MM revolver with JPM priced at L+80bps.

I think the liquidity situation is fine to support a year of weakness, though admittedly, I’m not sure they could survive a whole year of lost revenue. Plus, the ships must be very expensive to dock and that is an ongoing fixed cost….


Lets just try to understand if this virus or 1 year impact should have that much of an impact on cruises (people will fight me on this, but I don’t think cruises are dead… people will still take cruises) but this is relevant for all businesses right now, not just cruise stocks.

Here is a company that is expected to earn $10 in EPS in year 1 and grow ~2% a year. I discount these earnings, and the terminal value, back at 10% to arrive at ~$120 in value, which foots to a 12x P/E. P/E is just short hand for a DCF and that is what I am trying to show here so you can think about if a multiple compression actually makes sense.

*Note: terminal value is the value of a the future cash flows of a business beyond the forecast period, assuming a constant growth rate, in this case 2%.

Now lets say year 1 earnings are toast – they get cut in half. But year 2+ are the same because demand comes back. As you can see below, this had a ~4% impact on the intrinsic value of the business… not 50%! People may say, “well investors only look at earnings over the next year or two, so applying a 12x multiple to $5 in EPS is why the stock gets crushed.” Thanks – I realize that, but the math says that is wrong and an opportunity to make money.

Buying cruise lines is risky right now and up to you. Sorry for the headline, but hopefully you use this as a tool to find other companies who have not had their intrinsic value meaningfully impacted.

When Buybacks Fail… IBM Buybacks and Stock Performance

I typically look for underappreciated, high FCF businesses that are shareholder friendly. As I was screening for new ideas, an old giant popped up – IBM. IBM is famous for buybacks. This is a personal opinion, but with so much focus on Google, Facebook, Amazon, Microsoft and Apple it seems as though no one even discusses IBM anymore.

Could this be a Microsoft-in-2011 moment? At that time, MSFT was trading at a P/E of 9-10x and was viewed as a slow, lagging behemoth, and certainly not exciting anymore… just a dividend paying stock. They got a new CEO after many years of Balmer and reignited excitement and ingenuity at the company. The rest is history.

IBM currently trades with a 4.8% dividend yield, 9.5x 2020e EBITDA and 10.1x 2020e EPS. And with IBM buybacks staying strong – it is essentially returning all cash to shareholders.

The business in total has not grown much, but does have some exciting segments like Watson (“Cognitive Solutions”) which is wildly profitable – in 2018, Cognitive Solutions had nearly 68% gross profit margins and 38% EBITDA margins…

Should we compare Microsoft then to IBM? Clearly over the same time frame as Microsoft, IBM has been floundering.

Cognitive Solutions is clearly an exciting segment, but at the end of 2014 the company did $93BN in revenue and $24.6BN in EBITDA. In the past 12 month, the company did $77BN in revenue and $16.6BN in EBITDA. Moreover, if we go back to the end of 2003, the company’s market cap was $161BN. When they reported Q3’19 results, IBM’s market cap was $120BN. Meaning after nearly 16 years, no real value had been created.

So what happened? What were the drivers of these abysmal returns?

Clearly, a significant driver is the changing technology landscape. Over this time period, IBMs standing as a leader in tech has been eroded by competition. Over this time period, net income is up only $1.2BN, from $6.5BN to $7.7BN, which is a 1% CAGR.

With its changing position, investors no longer valued the company as an exciting leader. At the end of 2003, IBM was trading at 24.5x LTM earnings. By the end of Q3’19, it is trading at 15.5x LTM earnings. That de-rating of 10x had a significant impact on its stock performance.

Secondly, I think the company made some really poor investments. What investments you ask? Buying its own stock in large amounts. Admittedly, without these buybacks, the price performance of IBM would have been abysmal.

I pulled the company’s cash flow statement over these ~16 years and analyzed what it did with cash. While we have hindsight bias, the company deployed too much into its own stock instead of trying to strengthen its position in a changing climate. You could even argue that they should have done more acquisitions. Excluding the recent RedHat acquisition, which was $33BN, the company did not actually spend that much on acquisitions over this time frame.

Outside of acquisitions, you could even argue that they should have just distributed cash to shareholders with special dividends. Again in hindsight, that would have allowed investors to purchase other businesses that are allocating capital for growth.

Let me be clear, I am a huge fan of buybacks and not trying to beat the drum that politicians like to use (buybacks aren’t an efficient use of resources and stifle growth etc.). It is a return of capital though. One might say its a return of capital to selling shareholders (because the buybacks would create a new buyer in the market to lift the price) but I view it as a return to existing shareholders – my proportional share of each new sale increases. 

One of my favorite companies is LyondellBasel (ticker LYB). While it is a cyclical, commodity chemical company operating near peak, they’re capital allocation decisions make sense. First, invest in their equipment for safety. Second, ensure that they are well prepared in an evolving landscape. Third, return cash to shareholders while managing a prudent balance sheet. They have bought back 10% of their outstanding shares each year for the past few years.

In this case, however, it seems like IBM bought back shares just to buyback shares.


I wouldn’t be surprised if we see an activist approach IBM. Following Elliot’s success with AT&T, it seems like an activist could approach IBM regarding a spin-off or sale of its Cognitive Solutions business. I think a split of “old business” and “new business” similar to what happened at HP could be very interesting.