Geoff Gannon April 24, 2020

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 of visits and the amount of time spent per visit. While wages of these technicians would still rise over time – the gains in productivity combined with inflation like increases in the price of maintenance contracts could expand margins. This part of the business is a very, very good business. And I would put a high multiple on the EBIT generated from this business. I’ll talk about EBIT here. But, what I really care about is free cash flow. And Otis’s service business generates plenty of that. The company pays fairly high tax rates (it’s been as high as 35% recently) for a U.S. company. This is because a lot of earnings are from countries outside the U.S. (especially Europe). That’s the biggest factor reducing conversion of EBIT into free cash flow. However, reported after-tax earnings understate free cash flow. If Otis had no net debt – it does have quite a bit, as we’ll see – it would probably convert EBIT into free cash flow at like a 70-75% rate. So, revenue of around $7.5 billion would convert at about a 21% EBIT margin into EBIT of $1.6 billion and free cash flow of like $1.1 billion to $1.2 billion. This is a business that will rarely every shrink. It’s extremely predictable. It has a retention rate over 90% and uses very little in the way of net tangible assets to produce excellent returns. It deserves a very high multiple of free cash flow. If we assume the stock market might return 8-10% a year and Otis’s service business might grow as little as 3% a year (again, the company thinks it’ll grow quite a bit faster) – that’d tell us the right free cash flow multiple here should be about 15-20 times. That should be applied to enterprise value – not market cap. However…

I actually think the profit on new equipment can basically cover the debt. I want to be careful about how I say this. I think profit on new equipment will offset the interest on the debt – not allow for a lot of repayments of debt. However, Otis has less debt than Carrier. And Otis’s presentations and filings with the SEC are clear about the company’s intentions in terms of its debt levels. Otis only intends to pay down about half a billon of debt. It then seems to be saying it’ll maintain a steady Net Debt/EBITDA ratio of about 2 times. I believe the company can stay at this level with the new equipment business basically being worth about what the debt is worth and the service business being basically what shareholder own “free and clear”. I won’t talk a lot about Otis’s debt situation here. It’s meaningful. But, I think it’s fairly safe, cheap, and well-spaced out debt. I also think the service side of an elevator business is very capable of carrying a lot of debt. There are some risks as far as capital allocation. Otis is targeting a 40% payout in terms of EPS (this could be in the 90 cent to $1 range eventually – maybe not in a coronavirus year) combined with stock buybacks and possible acquisitions. I don’t think acquisitions will be big here. The industry leaders are basically an oligopoly controlling about three-quarters (or maybe even more) of the service contracts with big building owners, property managers, etc. By units, something like 50% of all elevators in the world are serviced by the little guys. But, I think that’s misleading. It’s similar to the ad agency business. The biggest brand owners in the world heavily use the biggest ad agencies. And the biggest property owners heavily use the biggest elevator companies.

Let’s use China as an example. Otis does okay in China for maintenance contracts among big property developers. But, it doesn’t do so well with smaller owners. And, overall, I don’t like China as an elevator market. The conversion rate of new equipment into a maintenance contract in China is poor. The Chinese new equipment market hasn’t grown in 5 years (while the rest of the world has). And Otis doesn’t expect China to grow for another 5 years. The economics also seem inferior as Otis sells through distributors more and much of its business is spaced out in a way where it is using more branches and more employees to serve fewer elevators.

This brings me to “the Americas”. There’s clearly a big difference in the productivity levels of servicing elevators in the U.S., Europe, and then the rest of the world. I’m assuming American elevators are more likely to be offices and malls and less likely to be low-rise residential and stuff like that. The number of branches and number of technicians used in the U.S. relative to the service revenue brough in is much, much lower. By some measures, “the Americas” segment is up to 3.5 times more efficient by number of branch locations and it’s about 2.5 times more efficient by number of technicians. It’s possible technicians in Asia and even Europe are paid less than U.S. technicians. But, it just seems like the U.S. business is better, the China business is worse, and the European (and Middle East) business is in between. Europe is really the biggest segment. There’s a publicly traded company in Spain that Otis owns the majority of. It’s called Zardoya Otis. That company might offer more insights into Otis’s European business. But, similar to what I’ve seen with country-by-country variation in companies that do armored cars, pest control, etc. where things like fixed branch costs, driver productivity, and route density matter – there look to be meaningful differences between countries based on both the type of elevators in those countries and perhaps the company’s historic position in that industry.

What is Otis worth?

I think it’d make sense to pay about 3 times service revenue. We could do enterprise value equals 3 times service revenue. That might be an attractive point to buy. But, it could be slightly unfair in the sense of undervaluing Otis because it doesn’t give credit to the new equipment business always bringing in some profits. Probably a fairer approach is to assume that the new equipment business and the debt basically cancel out. I want to be careful doing this – because, it means I’m assuming Otis will always maintain a fair amount of leverage. But, that is what the company says it plans to do.

So, the more aggressive assumption here would be to just use 3 times service revenue as the right market cap for Otis given current debt levels. Three times service revenue is about $22.5 billion. The company has 433 million shares outstanding. So, $22.5 billion / 433 million equals $52 a share. The stock now trades at $47.85. So, is it cheap?

No. I did a variety of different methods to value the company. I used service revenue alone. I used EBIT from everything. I used sales. I used some normalized approaches. Otis used to be a better business than it is today. The company’s 10-year average EBIT under United Technologies actually compares favorably to today. I made some different estimates incorporating more of management’s guidance about margin expansion and so on. These 5 or more different methods didn’t give me dramatically different valuations. The very lowest came in around $30 a share. The very highest came in around $65 a share. Today’s stock price is $47.85. That’s exactly smack dab in the middle of that intrinsic value range.

There’s nothing to see here. Not for a value investor. The business might be exciting. It’s an excellent business. It may be capable of improvement. And, if it does improve – EPS will really move here. In a couple years, Otis could start doing buybacks. I’ve seen companies like this that spin-off and then lap a couple years of messy financials while buying back stock, raising the dividend, etc. eventually get rewarded with a high P/E. This is a big business. The market cap is already $20 billion. It’ll be a consistent dividend payer. I assume it’ll be a consistent buyer of its owns stock. The business is really not as cyclical as people think it is. About 80% of earnings are tied to low-cyclicality service revenue. This is a business that – if well managed – will have slightly higher EPS and a slightly higher dividend year after year after year.

I don’t think it’s expensive at the price it’s at now. But, I’m not looking to pay a very full price for a big, well-known business like this. If you had to manage billions of dollars – there are much worse places to put it than Otis. The advantage investors like you and me have is that we don’t have to buy $20 billion market cap stocks if they’re not cheap. I can’t see any definitive proof that Otis is cheap. If you believe management’s medium-term guidance – maybe it is. But, there are a lot of cheaper stocks out there. There aren’t a lot of better businesses out there though.

Open a file on Otis. Keep track of the price. Study it now in case it ever gets cheap later.

Geoff’s Initial Interest: 50%

Geoff’s Revisit Price: $20/share (down 58%)