Conglomerates aren’t always the best at responding to the needs of individual businesses within the group; sometimes, it simply makes more sense to reinvest cash flow in more promising businesses. Given that spin-outs can often outperform once they’re out on their own and can make their own decisions (it’s a phenomenon that Peter Lynch talked about a lot). Investors in Otis Worldwide (OTIS) should hope that’s the case, as the company looks as though it needs to make up for some lost time and opportunities.
To be clear, Otis isn’t a bad business. It’s my opinion, though, that the company has been surpassed by rivals like KONE (OTCPK:KNYJY) and Schindler (OTC:SHNDY) in areas like digitalization and in the faster-growing Chinese market. Valuation already looks pretty healthy here, but that’s not uncommon in the space.
Making Up For Lost Time In China
China not only now makes up about 40% of the global installed base for elevators and escalators, but it also makes up about 60% of the new equipment market, and it’s one of the only markets to still offer meaningful growth. It hasn’t been the strongest market for Otis, though, and this is an area I believe management needs to address.
KONE was actually the third Western company to enter the market, but it now holds the leading share of around 20%, and China makes up about 30% of its business. Where Otis has focused on leading developers in Tier 1 and Tier 2 cities, KONE has instead focused on more market-driven differentiated offerings and, particularly, products for the housing market. While KONE’s differentiated offerings have helped it stand apart, Otis has had relatively less success separating itself from strong competitors like Mitsubishi and Hitachi that have also focused most of their efforts on top developers.
I don’t think it’s too late for Otis in China, but I do think some modifications in strategy would help. To be sure, competing in the new equipment side is not easy, as pricing pressure has been intense at times. But I do believe it is necessary, as the service market in China is going to become increasingly lucrative over time, and there is at least some evidence that the providers of the original equipment have a leg up in securing long-term service agreements.
Otis has recently launched its Gen2 Prime product for the entry-level market, and while I don’t see this as particularly attractive for the Chinese market, I think it will do well in markets like India, Africa, and Southeast Asia, and it gives me a little more confidence about the company becoming more market-responsive with product development.
Digital Investments Starting To Help
Otis was also slow to get onto the digitalization/IoT bandwagon, with the company being the last of the “Big Four” to launch its IoT platform in 2018. As time goes on, digital offerings are going to become more important, as building operators appreciate the convenience of connected sensors for condition monitoring and for access control.
Otis has also been using digital technology to improve its service offerings. Otis ONE is a digital interface that allows techs to remotely monitor and diagnose problems – an appealing offering during a pandemic. Otis has also developed apps that allow techs to sell parts and upgrades directly to the customer, as well as an app that can use sound and vibration to remotely diagnose problems.
A More Cautious New-Build Outlook, Supplemented With Retrofit Opportunities
As I’ve written in several other articles, I’m not bullish on the non-residential construction market over the next couple of years. The good news, relatively speaking, is that Otis is more leveraged to multifamily (about two-thirds of the mix), and while I don’t think multifamily will be unscathed over the next few years, I don’t think it is as vulnerable as an office, retail, or hospitality.
I do also see a retrofit opportunity for Otis in Europe. Otis has significant exposure to Europe (one of the reasons it has been a growth laggard over the last five years), and that is where the bulk of the world’s older elevators are (about 60% of the global base that is 20 years old or older). Twenty years is typically the point where building owners look to modernize equipment (aesthetics, propulsion technology, and so on), and given the push toward greener buildings, this upgrade cycle could be a significant one for Otis.
I like Otis’s strong service business. Otis is the share leader (around 12% versus 8%-9% for KONE and Schindler), and I believe the 50%-plus market share held by independent service providers is going to shrink over time. These providers typically compete on price, but service quality and consistency are becoming bigger issues, and I believe the shift toward more digital service offerings (including remote monitoring and predictive maintenance) will make it harder for them to hold share.
While I do expect the next couple of years to be below-trend due to pressures in the non-resi market, I expect Otis to grow revenue at a long-term rate of 3% to 4%. I do expect increasing service mix to support margins, as well as field productivity initiatives (reducing the number of physical visits), supply chain optimization, and SG&A spending rationalization. With that, I see FCF margins expanding a few points over the next decade, supporting mid-to-high single-digit FCF growth.
The Bottom Line
Otis’s valuation seems to already anticipate much of that, and the shares don’t strike me as particularly cheap. That’s not uncommon in the space now, and I can understand why investors may be bullish on Otis’s leverage to a recovering/growing Chinese market, opportunities to improve market share (particularly in China), and those European retrofit opportunities. That’s all fine as it goes, but I’d prefer a wider margin of safety before buying in.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.