Otis Worldwide Corporation

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

Otis Worldwide Corporation is a global leader in elevator and escalator manufacturing, installation, and service, with operations spanning across over 200 countries.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Otis’s business is divided into two main segments: New Equipment and Service. The New Equipment business involves manufacturing and selling elevators and escalators for new construction projects. The Service business focuses on maintaining, repairing, and modernizing existing units.

Business Explanation

  • New Equipment: This segment entails the manufacturing and sale of new elevators and escalators. It is characterized by large, often multi-year contracts, especially in the high-rise and commercial building sectors. The demand for new equipment is significantly linked to the construction market, which tends to have a cyclical nature.
  • Service: Otis’ service segment includes repair, maintenance, and modernization services for installed elevators and escalators. This segment provides a recurring revenue stream given service contracts and is less susceptible to market cycles than the new equipment business. Otis leverages digital tools to improve remote monitoring capabilities.

The primary business strategy of Otis revolves around three core principles: (1) Growing service portfolio by providing preventive maintenance, (2) Focusing on high-growth emerging markets such as Asia Pacific and (3) Technology innovation.

Revenue Distribution

  • Geographical Diversification: Otis has a global footprint, with operations in nearly every country. Revenue is derived from North America, Europe, and Asia, and other emerging markets.
  • Revenue by Segment: Approximately 60% of revenues are contributed by the Service segment, and approximately 40% by the New Equipment segment, reflecting the importance of recurring revenues.
  • Urbanization: The trend towards urbanization continues to fuel demand for elevators and escalators in new construction projects.
  • Aging Infrastructure: The maintenance and modernization of existing building stock is driving the growth of the service market.
  • Technological Advances: Smart technologies, IoT (Internet of Things) sensors, and digitalization have become increasingly important in performance monitoring and remote maintenance and are becoming key for future growth.
  • Sustainability: ESG requirements from customers are becoming increasingly important in terms of energy efficiency and responsible practices.

Competitive Landscape

The global market for elevators and escalators is an oligopoly, with a few major players like Otis, Kone, Schindler, and Thyssenkrupp dominating the industry. Each company operates with a degree of geographic strength, which adds complexity to the market. Smaller manufacturers compete more effectively with local and niche businesses. The barriers to entry are high due to the substantial investment required in manufacturing, distribution networks, and brand building.

What Makes Otis Different

  • Global Scale: The size and global presence of Otis are considerable advantage for its sourcing and reach for revenue.
  • Technological Leadership: Otis is increasingly focusing on technological innovations in its products and services, such as AI based preventive maintenance and remote diagnostics.
  • Service Business: Its strong service network generates recurring revenues with high margins, providing a relatively stable financial position, even during economic downturns.

Financials

  • Historical Revenue: Otis’s total revenue for fiscal year 2022 was $13.9 billion. The trend of revenue has been relatively stable showing slow but steady growth over the last 2 years. The business model is less cyclical than pure manufacturing because it has a large portion of recurring service revenue. Revenue growth is expected to continue on the long term, while fluctuations in yearly profits are not unlikely.

  • Profit Margins: Gross margin in 2022 has been roughly 31%, which is good for the industry, while the operating margin is around 14.7%. The service division has higher margins than the new equipment one. This high margin provides some wiggle room for profitability fluctuations.

  • Return on Invested Capital (ROIC): In the fiscal year of 2022, the return on invested capital (adjusted to exclude the effect of goodwill) was 13%. The company has managed to keep the returns on their invested capital over 10% over the last 7 years. A relatively high ROIC indicates an efficient use of capital and an economic advantage.

  • Cash Flow: Otis has a fairly high free cash flow generation, generating around $1.4 billion in 2022. This strong cash flow provides flexibility to continue investing in research and development, making strategic acquisitions, and return cash to shareholders.

  • Capital Structure: Otis has a debt-to-equity ratio of 1.29, and a long-term debt of $3.3 billion with an interest rate of approximately 2%. The company currently has a net debt of $2.5 billion with very low interest expenses. The debt structure does not look problematic and is under control. The company also repurchased stocks in 2021 and 2022, showing that the company is not only generating a good free cash flow, but also is capable to return money to the investors.

Moat Rating: 3 / 5

Otis’s moat can be classified as “narrow” because it has a combination of economic advantages that are not extremely strong but still give it an advantage.

  • Service business: The service business of Otis has a high degree of customer stickiness and recurring revenues, which provide some degree of moat, based on brand loyalty and difficulty of switching providers for maintenance contracts.
  • Brand Reputation: The company has a well-recognized brand, which is particularly strong in high-rise and commercial construction projects.
  • Technological Innovation: The company continuously innovates and maintains a strong technical and R&D staff, with the focus to generate new technologies to service existing contracts and manufacture new equipment.
  • Global Scale and Distribution Network: The extensive global reach of Otis and the high initial investments and costs associated with setting up efficient distribution networks make it difficult for smaller competitors to enter the market or achieve the same economies of scale.

While the company has moats, they are not as wide as those of companies with very strong network effects, strong technological superiority or a large cost advantage. Other players are catching up with technology, while the other incumbents are also increasing their service businesses.

Risks to the Moat

  • Increased competition: Increased competitive pressure may reduce pricing power for both New Equipment and service segments, and could narrow the moat by making its revenue more cyclical.
  • Commoditization of technology: Commoditization of the company’s technology and software may diminish the competitive advantages of the company by eroding its ability to establish customer loyalty or its ability to charge a premium.
  • Cyclical Industries: Otis is exposed to the cyclical industries of construction and hospitality. These are sensitive to economic downturns. A recession could lead to a decrease in new construction and therefore a decrease in new orders, while it can also lead to less upgrades for existing equipment.
  • Emerging market risks: Though opportunities are high in emerging markets, these also come with increased volatility in currencies, economic instability, and operational and reputational risks.

Despite these risks, Otis has been shown to be a very resilient business, due to a combination of its recurring revenue model, its global footprint, and its technological advantages. This provides a certain level of resilience to the company’s overall business. It should be able to weather a recession without severe impairment of its finances, and should quickly recover as soon as the market recovers.

Understandability: 2 / 5

The company’s core business is relatively easy to understand but its financial statements and operations, mainly due to its global reach and multiple business lines, can become relatively complicated. The main business idea of building, installing and maintain elevators and escalators is simple enough, but the complexity of the accounting and the financial information, means that the business is not easily understandable for a novice investor. For this reason the rating is 2/5.

  • The financial statements have some unusual terminology as they come from the engineering and construction business.
  • The segment reporting does not separate a lot of the relevant data and it is mixed with other data which obfuscate how well the business is actually doing.

Balance Sheet Health: 4 / 5

Otis’s balance sheet is considered healthy. Its strong recurring revenue model, good cash flow generation, and conservative debt levels, all indicate the company’s stability and long-term financial health. Some important points to support this rating are:

  • Good Free Cash Flow: The company has a consistently positive free cash flow. This means the business is capable of generating a considerable amount of cash after all the expenses are paid, which can then be used to invest or be returned to shareholders.
  • Adequate Current Ratio: The current ratio (ratio of current assets to current liabilities) for the company in 2022 is around 1.7, which represents that the company can easily cover its current and short-term obligations.
  • Manageable Leverage: Its debt-to-equity ratio is 1.29 which, while not perfect, isn’t concerning. Furthermore, because the interest rates are extremely low, the current debt obligations aren’t a burden for the company, giving it even more flexibility to act on any opportunities.
  • Large Amount of Cash on Hand: In its most recent statements, Otis has a good level of cash, and cash equivalents, which means it has enough cash to operate and also a safety cushion in case of unforeseen events. Because of all the aforementioned, the company has a good rating and should not have major financial troubles in the future.

Recent Concerns and Management Response

  • Supply Chain Issues: In recent earnings calls, Otis executives acknowledged that supply chain constraints, especially for semiconductors and raw materials, have had a negative impact on production schedules. This was a global problem, not specific to Otis, but they also admitted that disruptions will affect lead times and project schedules. To solve this, management stated that they are doing two things: diversifying their supply chains, and doing proactive planning for component availabilities. This issue was mentioned frequently on the earnings call of April 2023.
  • Inflation: Inflation has been a major concern for multiple companies in recent years. Otis is not an exception and their recent reports and earnings calls, have highlighted the fact that rising material and labor costs may negatively impact margins. To manage inflation risks, management have talked about making necessary pricing adjustments, while they are also focused on managing supply chains and streamlining business processes.
  • Geopolitical Risks: The risk of the global environment being politically uncertain is something that the management acknowledged as a potential risk factor. While they have operations across the world, they mentioned that they need to be ready for any change in regulations, political situations, trade, and economic agreements.

Overall, Otis appears to be a well-positioned company with a durable, but not a wide, economic moat. Its focus on both its service division, emerging markets, and technological innovation make it a good long-term investment. However, the risks involved with cyclical business and an increasingly competitive business environment should be closely watched. The intelligent investor should do a thorough research of the financials and the competitive environment, before taking any decision related to investing in this company.