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Otis (OTIS): The World’s Largest Elevator Company Gets the Vast Majority of Its Earnings From Maintenance Contracts With a 93% Retention Rate

Otis Worldwide (OTIS) is the world’s biggest elevator and escalator company. Like Carrier (CARR) – which I wrote up two days ago – it was spun-off from United Technologies. However, shareholders of United Technologies received one share of Carrier for each share of United Technologies they had while they only received half a share of Otis for every one share of United Technologies they owned. As a result, the market caps of Carrier and Otis would be the same if the share price of Otis was twice the share price of Carrier. Otis isn’t trading at double Carrier’s stock price though. It’s at $47.85 versus $16.25 for Carrier. So, closer to three times the price of Carrier than two. Carrier, however, does have more debt than Otis. Nonetheless, as I’ll explain in this article – the bad news is that while I like Otis as a business a lot better than Carrier: Otis is the more expensive stock.

Reported revenues are unimportant at Otis. The company did $13 billion in sales. But, only about $7.4 billion of this comes from service revenue. Service revenue makes up 80% of EBIT while new equipment sales are just 20%. Service revenue is also less lumpy. A major reason for this is that more than $6 billion of the total service revenue is under maintenance contracts. This more than $6 billion in maintenance contracts has a 93% retention rate. The contracts don’t actually require much notice or much in the way of penalties to cancel. However, cancellation is rare. So, a very big portion of the economic value in Otis comes from the roughly 2 million elevators covered by maintenance contracts that bring in about $6 billon in revenue per year. My estimate is that the after-tax free cash flow contribution from these 2 million elevators under contract is anywhere from $1 billion to even as much as $1.2 billion. Basically, if we set aside these maintenance contracts – there is almost no free cash flow beyond the corporate costs etc. that need to be covered at Otis. There is an argument to be made that as much as 20% of the company’s economic value comes from new equipment sales. However, I think it’s trickier to value the company if you count those sales in the period in which they occur. Rather, I think it makes sense to look at the business the way you might a movie studio, book publisher, etc. with a substantial library. Or – if you’d prefer – the way you’d look at an insurer that usually has a combined ratio a bit below 100, but basically makes its money off the return on its “float”. Otis’s service business has very stable revenue, EBIT, and free cash flow from year-to-year. I expect it to rise at least in line with inflation (the company expects better than that). And there are some possible productivity gains here from digital initiatives. Smart elevators, technicians using iPhones, etc. could cut down on the number …

Carrier (CARR): A Big, Well-Known Business that Just Spun-off as a Cheap, Leveraged Stock

Carrier (CARR) is a recent spin-off from United Technologies. The company has leading brands in Heating, Ventilation, and Air Conditioning (HVAC), fire & safety, and refrigeration. The best known brand is the company’s namesake: “Carrier”. About 60% of profits come from HVAC. About 30% of  profits come from fire/safety. And about 20% of sales and profits come from refrigeration. Although you may be familiar with the Carrier name in terms of residential air conditioning – there are just under 30 million residential Carrier units in the U.S. right now – the company is skewed much more toward commercial, industrial, and transportation uses than some of its competitors. Carrier’s market position is strongest in “the Americas” where it gets over half of all sales (55%). About three-quarters (72%) of sales are for new equipment and the rest (28%) are some form of parts, maintenance, or other “after-market”. Gross margins for both sales and services are basically the same at around 29%. Gross margin variability seems very, very low here. Return on capital is high. If we use only tangible assets excluding joint ventures accounted for under the equity method of accounting – more on this later – Carrier’s pre-tax return on net tangible assets invested in the business would be greater than 100%. After fully taxing these results and then adjusting for a slightly less than 100% conversion (I’ll assume 90% conversion as the possible low-end of a normal 90-100% of EPS converting to FCF range for the company) you’d still be left with unleveraged cash returns on net tangible assets employed greater than 50%. By any measure, the business is incredibly profitable. But, does that matter?

Does Carrier grow?

The company’s investor relations team thinks it does. They explicitly model faster than the market organic growth. There is, however, no proof of this in the five years of financial data included in the spin-off documents. After adjusting for changes in currency, acquisitions, and one-time pick-ups and drop offs of big business in various units – I really can’t tell if this business was or wasn’t growing under United Technologies. Organically, it looks like it was flattish over the last 5 years. Earnings Before Interest and Taxes (EBIT) ranged from about $2.5 billion to $3.7 billion. The central tendency – to the extent there is one – seems like about $3 billion in EBIT. Just to keep us dealing with nice, round numbers I’ll assume Carrier as a spun-off entity will average about $3 billion in EBIT. Obviously, you shouldn’t expect $3 billion in EBIT during 2020 or 2021, because of the virus. Purchases of everything Carrier makes are very easy to defer. This is all cap-ex. If you don’t need a new refrigerated truck – you don’t need to buy from the refrigeration business unit this year. If you aren’t building new stand alone homes, new townhomes, etc. – you don’t need to put in residential Carrier units. Commercial customers who run everything from …

Mills Music Trust (MMTRS): A Pure Play Decades Long Stream of Future Royalties on Old-Timey Songs Available at More Than an 8% Pre-Tax Yield

Mills Music Trust (MMTRS) is an illiquid, over-the-counter stock. In fact, it’s not a stock at all. The security traded is a “trust certificate” that entitles the holder to quarterly distributions from the trust. These “dividends” are not dividends. The trust has not paid taxes on the income. So, you will be taxed on the income received. As a result, you’ll need to adjust the after-tax return on Mills Music Trust as compared to other stocks you might own. Since I don’t know your tax situation, I don’t have a way of doing that.

The trust was created in 1964. Its life may extend till something like 2088. The way it’s written the trust will be dissolved at the end of the calendar year during which the last copyright expires and can not be renewed. Based on a table of the 50 top performing copyrights in the Mills Music Trust catalog – I believe this won’t happen before 2088. However, the trust renegotiated something important with EMI (the publisher that collects royalties on behalf of Mills) that makes the end date for the trust less important. The original trust arrangement required a minimum royalty payment of $167,500 per quarter. This is not a small number when you consider that there is a copyright that won’t expire till 2088. So, the contingent payment made to Mills would presumably have been $670,000 a year in 2087 (and for many, many years before that). Now, it’s likely the dollar will have depreciated quite a bit in the 67 years between today and 2087 – but, $670,000 a year is still a ton more than the songs in the Mills Music Trust catalog will be producing in royalties in that year. This is because the vast majority of the copyrights on valuable songs will expire in about 25-30 years. Mills provides information on when copyrights for songs may expire. But, as most of these songs are all governed by the same copyright law, a pretty good guess is simply date of creation plus 95 years. So, these valuable songs I expect to come off copyright (and go into the public domain) in the next 25-30 years were created in like the 1920s. Almost all of the royalty streams you’ll be getting here are derived from pre-1958 songs. And then, because of the general rule that a song will be off copyright after 95 years (no matter what is done to try to renew it) – we can assume that these songs don’t much pre-date the early 1900s. In fact, almost all the songs of value seem to date from 1922-1958. There’s about a 30-year period where many of these more valuable copyrights were created. And those were the roughly 30 years before the trust was created. Mills gives details on what these songs are. Some of the biggest royalty producing songs for Mills right now are:

Little Drummer Boy

Sleigh Ride

Lovesick Blues

Stardust

Hold Me, Thrill Me, Kiss Me

It Don’t Mean a …

Interpublic (IPG): An Ad Agency Holding Company Trading at 10 times Free Cash Flow and Paying a Nearly 7% Dividend Yield

Interpublic (IPG) is one of the big ad agency holding companies around the world. Other examples include Omnicom (also a U.S. company), WPP (a U.K. company), Publicis (a French company), and Dentsu (a Japanese company). There are countless other publicly traded advertising stocks. Some are affiliated with one of those big groups. Others aren’t. Interpublic might be the first real ad agency holding company. The name Interpublic dates back to 1961. If you read the 10-K, you’ll notice PriceWaterhouse has been auditing Interpublic’s financials since the 1950s. Before the name change in 1961, the company was called McCann-Erikson. Late in the TV series Mad Men this is the agency that buys up the company all the main characters work for. Mad Men ends with the “Hilltop ad” (I’d like to buy the world a Coke) for Coca-Cola. That’s not made up just for the show. McCann-Erikson did make that ad. The McCann-Erikson combination dates back to the 1930s. Each of those two agencies (McCann and Erikson) were founded in the first decade of the 1900s. Omnicom and other advertising agency holding companies that came later were probably based in part on Interpublic in the early 1960s. For decades now, it’s been a common strategy for publicly traded advertising companies to own different agencies and provide certain centralized functions (basic corporate functions, capital allocation, setting compensation of top executives at the agencies, managing conflicts of interest between agencies they own, etc.). To some extent the individual agencies are independent and run sort of like Berkshire Hathaway runs its subsidiaries. But, in other ways they aren’t very independent. For example, Interpublic explicitly says that corporate HQ provides guidance, advice, etc. on both certain human relations stuff and on real estate. The cost structure of ad agencies is very different from most companies. At Interpublic, close to 65% of revenues are spent on base salaries, benefits, rent and office expenses. A huge proportion of the company’s total cost structure is really just base salary and rent. These are both very fixed. This is a pure service business. It’s largely “cost plus” – though how that works is a bit complicated.

So, the actual way ad agencies bill can be pretty complicated. Interpublic gets 50-60% of its revenue from its top 100 clients. Usually, client retention rates among big accounts are incredibly high. This is not due to contracts. The industry standard is for all contracts to allow either the agency or the client to fire the other with 30-90 days’ notice. Each of the contracts are customized. So, in theory, profits could vary a lot relative to the amount of revenue booked depending on the client. But, in reality, this does not happen. The contract can be created to involve a lot of cost plus, a lot of commission, flat fees, incentives for hitting certain quantitative targets for the effectiveness of campaigns, etc. If you look at the long-term margins of all different ad agencies around the world that once took very simple …

Miller Industries: A Pretty Good, But Very Cyclical Business that Sells its Car Wreckers and Car Carriers Through a Loyal Distributor Base

Miller Industries (MLR) has a lot of things to like about it. But, the timing of buying this stock now definitely isn’t one of them. Miller is in a very cyclical, highly durable capital good industry – it produces “car wreckers” and “car carriers” – that depends heavily on business confidence and especially access to capital. It is very easy to defer the purchase of a new wrecker or carrier. And it is very hard – impossible, really – to sell wreckers or carriers without easily available credit. To give you some idea of how important credit is in this industry – Miller Industries is currently promising lenders to its distributors (these are all technically “independent distributors”) that it will buy back up to $74 million of its own wreckers and carriers if the lender repossess that collateral from the distributor. Miller makes this kind of promise all the time. In recent years, it has not had to buy back any of its equipment. But, you see the problem. It might have to do so. And, the fact that distributors are using financing that depends on the lender getting a promise from Miller (the original equipment manufacturer) gives you some idea of how important credit is in this industry. The distributors – there are 80 of them in the U.S., and Miller estimates that about 68 of them don’t actually sell any wreckers or carriers other than Miller products – rely heavily on floorplan financing.

The industry is also very cyclical. In the last economic cycle, Miller’s sales peaked at $409 million in 2006 and bottomed out at $238 million (down 42%) in 2009. Gross profit dropped by the same percentage (42%). Operating profit – however – went from $33 million in 2006 to $7 million in 2008 (down 80%). Could the same thing happen in this recession?

Yes, it could.

So, Miller’s P/E, P/S, etc. ratios are all very suspect right now. Maybe price-to-tangible book value would be a better guide to the company’s valuation. The good news is that the P/E and P/S ratios here are low. But, that’s what you’d expect with a cyclical stock that everyone now knows is at the very top of its cyclical (the recession has already started as I write this, and Miller reported earnings less than a month ago that were its best ever – so, we can call this the official peak). The P/E ratio on those peak earnings is between 7 and 8. The P/S ratio is about 0.4 times. The company has a tangible book value of $21.60. As I write this – the stock is trading at $25.89. So, the P/B ratio here is 1.2 times. That makes it pretty easy to compare this company’s long-term history with its current stock price. Miller probably doesn’t convert all its reported earnings into cash. So, if stocks generally return say 8-10% a year – and we use that as the hurdle rate you, as an investor are looking for …