“After 3-plus years as a public company, in which we’ve grown new equipment share, expanded operating margins, grown EPS, built a formidable backlog, and returned approximately $2.7 billion in cash to shareholders, we’re designing Otis for the next phase to ensure high performance and resiliency regardless of the economic environment we may face in the future.” - Judith Marks, Otis CEO, Q2 ‘23 Call

In February’s Flywheel Growth, I concluded:

"Therefore, despite the model suggesting OTIS shares are fairly valued, I have no intention of adjusting my position. I believe the company represents an incredibly durable asset that can likely create long-term value above what is modeled. Additionally, there is the old adage “markets take the stairs up and the elevator down.” I would love nothing more than to see OTIS shares partake in a broad selloff with fundamentals intact. Perhaps there’d be an opportunity to take the escalator back up."

We have yet to see a steep selloff. Although the company reported a strong H1, shares are priced barely under what they were at the start of the year—a likely expression that concerns around China and competition have been amplified. However, when looking at the company as a whole, the outlook is markedly positive.

Let’s break it down.

$OTIS is an old dog (169 years) with new tricks - in the form of modernization and digitization.

This is a straightforward formula for long-term value creation, but it’s been somewhat shadowed by concerns surrounding China.

The market for New Equipment in China has been rather lackluster, and while many have expected a recovery, it has yet to materialize. How detrimental is this to Otis’s results? It’s worth walking through some comparative numbers between H1 2023 and several years prior.

Looking at the sales geographic mix, China has indeed grown to take ~2% of the total in the last several years, up from 15.6% in H1 2020 to 17.5% in H1 2023.

But weakness in New Equipment orders, down 12% in Q2 2023, fails to recognize several key points:

Not only are NE and Service dissimilar in pressures faced, but it’s integral to recognize that the margin profile of Service is substantially higher, resulting in it being the primary contributor to operating income.

Granted, this does downplay NE’s importance. While lower margin (currently hovering between 6-7% OI margin), the conversion rate post warranty supports growing the Service portfolio. Additionally, new offerings, such as the Gen3 core elevator, in which Otis’s connected Otis One is preinstalled, should support a greater conversion and retention ratio, as evidenced by results from the installed base already using Otis One. All in all, even with prolonged weakness in China, aggregate NE sales should be able to grow at a modest low to mid-single-digit rate, thanks in part to strength from demand in other countries such as India.

Further supporting the company’s trajectory is its ever-growing backlog, reaching its highest level as of Q2. NE has experienced 6 consecutive quarters of LSD price increases, which flow through as old contracts are worked through and replaced with higher-margin contracts with higher pricing.

At this size, the company estimates that they’re looking out 18-24 months with the backlog. These numbers support continued operations, as decommits are at a low single-digit level due to the critical nature of work and the nonrefundable deposits the company takes. And even as they work through it—and even if there is weakness through H2 of this year—there is not an expectation that the backlog shrinks when entering 2024. During the Q2 call, Anurag Maheshwari, Otis CFO, offered excellent insight regarding how the backlog can actually continue to grow even without order growth (emphasis added):

"Even if we assume there's no orders growth, we would expect our backlog to be up low single digit by the end of the year. And the reason for that, Julian, is because we tend to book more orders in any given year than we ship as some of the orders are larger projects and multiyear in nature.

At this rate, in H2 of next year, we could be looking at a backlog that spans closer to 30 months, providing an exceptional buffer and allowing the company to continue to fully deploy its resources to grow both NE and Service.

While concerns about NE orders persist, Service is on a completely different trajectory. The segment carries an operating margin of more than x3 of NE and represents ~84% of operating income—it is also more stable, less cyclical, and has a full suite of distinct growth drivers.

And then there is Modernization, the small sub-segment of Service that is deserving of greater focus.

Modernization made up 18.62% of total Service revenues in Q2 2023, but it is going to be a major growth driver moving forward. In Q2, Mod orders were up 16% at constant currency, and the Mod backlog grew by 14%. Critically, this sub-segment also represents a massive opportunity for repurposed buildings as the shift to multi-use and WFH persists, as Judith Marks highlighted on the quarterly call (emphasis added):

The first bolded portion should also be taken note of. Otis’s total service retention has run between 94-95%, and Mod is likely 97-98%. While this difference appears inconsequential, it represents 50-66% reduced churn. With this context, while growing at a higher rate, it should be noted that Mod is currently margin dilutive to the segment. This is due to the nature of the work: often time-intensive and complex and customized on a unit-by-unit basis. Otis aims to streamline the process with more uniform Mod offerings, which should act as a positive tailwind for segment margins. Conversely, it will be critical to observe how less tailored offerings may alter growth. Notwithstanding, this sub-segment appears to have a long runway ahead, with deferred repairs on top of a further aging global installed base ensuring demand remains robust.

The success of Mod runs alongside further digitization and connectivity, which should continue to improve retention and margins for the entire segment, as Judith Marks’s continued comments highlight (emphasis added):

Alongside efforts to further improve each of the company’s operating segments is the newly coined program Uplift, in which Otis aims to recognize $150m in annualized cost savings that will be in turn reinvested back into the business. The program will be predominantly aimed at G&A and improving aspects of the company’s supply chain. It should be noted that this is entirely additive to other cost-saving measures, and Otis remains an obscenely capital-light business, with Capex and working capital combined making up <5% of net sales. With the previously mentioned >105% conversion rate of net income to free cash flow, the end result is significant capital to return after reinvestment needs. Continued excellence in this regard can be observed by the company increasing its 2023 share repurchase target from $700m to $800m.

My valuation, last published in February, remains largely unchanged—an attempt to remain conservative by not adjusting to what I view as favorable developments. To distill simply, at Friday’s closing price of $83.73, the forward yield is 1.62%, the company will likely be able to retire >2% of shares outstanding per year, and free cash flow can grow at a rate of 5-7% per year. This durable asset—effectively a tax on human mobility—has the potential to compound near a ~10% rate.

Questions or thoughts to add? Comment on the site or message me on Twitter.

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