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Otis Spin-Off: Most Profitable Elevator Company At The Lowest Valuation (NYSE:OTIS)

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Via SeekingAlpha.com

Long Otis Worldwide (OTIS) – UTC spinoff

Summary

Founding the commercial elevator in 1852, OTIS has been the world’s uninterrupted industry leader. OTIS originally listed on the NYSE in April 1920 but was acquired in 1976 by United Technologies. Exactly one century after original listing, this month’s spin-off reintroduces OTIS to investors.

  1. Industry: stable and profitable, with durable growth

The elevator industry has been stable and profitable for its oldest and largest participants, the “Big Four”: OTIS, Schindler (OTC:SHNDY), Kone (OTCPK:KNYJY) and ThyssenKrupp (OTCPK:TYEKF). Economics of density in the maintenance market drives a cost moat. Safety – and hence track record – is paramount, which drives switching costs and a brand premium. Lastly, a typical buyer is an agent (facility and building managers, governments, architect) and does not pay the bill of the end-consumer but suffers reputational damage when hassles or safety violations occur. This dynamic cements (perception of) quality as the primary basis of competition, and makes price a distant secondary consideration.

This industry is asset-light, helped by customer advance payments and the fact most work is done at client premises. Capex and working capital together are at 3.9% of sales. This translates into very high returns on tangible assets and FCF conversion.

This profitable earnings power is augmented by durable above-GDP growth, driven by urbanisation, growing middle classes, and ageing.

2. Big Four outlook: set to gain share, spurred by Internet of Things

The largest OEMs will benefit further from steady market share gains. While these giants already dominate the new equipment market, 50% of the maintenance market is still served by a very fragmented base of small independents. The Big Four have invested early in R&D to grow real-time analytics and connectivity of their installed base. As we will see, these Internet of Things (IoT) technologies bring multiple benefits to the table: increased cost efficiencies and superior client satisfaction drive a price premium, and a higher conversion and renewal rate.

3. OTIS: well-positioned leader

In one sentence, we argue that OTIS should simply be the biggest benefactor in this thesis thanks to its size. We discuss how this squares with management commentary and recent reality.

OTIS business is the most profitable and most defensive play in the industry, as it is geared to recession-resilient maintenance revenues at 80% of operating profit. Elevator maintenance continues unabated during lockdowns, as safety laws dictate.

4. Return profile & outlook

The Big Four have tangible ROICs over 50%, and growth is highly likely to be profitable. With Chinese construction cooling, the industry expects low single-digits revenue growth in the near term. In this environment, OTIS believes it can grow EPS high single-digits with a 2% dividend yield.

Valuation

OTIS commands the highest industry profitability primarily from economies of density in its maintenance portfolio (25% bigger than number 2 Schindler), but there’s still equity valuation rerating potential of 10% and 30% based on resp. EV/EBITs and P/Es averages for Schindler and Kone.

Conclusion

Elevators have become a ubiquitous – and hence boring – part of modern life. Shareholder returns tell a different story. Most of these returns are simply from profitable organic growth installing elevators (razors) and servicing them (blades). Ever-connected elevators in the 21st century will drive more market share for the OEMs in the highly attractive service market. Similar to how electronics have driven small car repair shops out of business, the same is about to happen to the many independent elevator maintenance shops.

Returns for shareholders will mostly be driven by defensive and cash-generative EPS growth (5-10% p.a.) and dividends (2%). A rerating return of 20% or 30% towards the Schindler and Kone EV/EBIT or P/E valuation is more speculative, but time has proven to be a friend of investors in elevator OEMs.

1. Industry: stable and profitable, with durable growth

Elevators are a stable and attractive industry to operate in, as evidenced by the relatively static competitive landscape in the last century. OTIS has always been the world leader with relatively stable market share, compared to the remaining players in the “Big Four.” All of them started more than 85 years ago. OTIS’ revenue today is roughly 20% higher than Schindler and Kone. ThyssenKrupp is another 20% smaller off that lower base. On a relative basis, this is broadly unchanged in the last decades, with the exception of Kone’s success in China.

What are the secular growth drivers for elevators?

  1. Urbanization: urban population is estimated to swell to 5B by 2030, from 4.2B today
  2. The global middle class is estimated to grow +60% in the next decade
    1. Household formation is further supported by declining household size. An important underlying driver here is growing wealth.
  3. Ageing populations: the number of +60-year old people will increase 50% by 2030. By 2050, their share of overall population will almost double from 12% today. This is one of the drivers of urbanization, but an increasing need for elevators outside of cities as well.

Figure 1: OTIS Investor Day 2020

Figure 2: Elevator and Escalators growth drivers. From Kone 2018 annual report.

A focus on growth alone can be a fatal mistake. I propose two checks related to growth:

1. Fast growth stories bear heightened risk of new entrants

Above average, yet boring growth, i.e. single-digits. The value of growth derives from the longevity here.

2. Is the return on incremental capital invested good?

Elevator companies’ reinvestment needs for growth are low as both fixed assets are low, and customer advances are paid for both services and equipment

Let’s look at stability and profitability. The elevator industry is a slow moving and lucrative industry. Going through the annual reports of the largest OEMs, you will roughly find the same innovations and commentary. The large OEMs count on the razorblade model. In the oligopolistic market of new equipment “NE” (Big Four 67% share), the new elevators “razors” are actually profitable (7% operating margin in OTIS’ case), but the maintenance and repairs “blades” eventually make 2.5X of the razor’s profit. This doesn’t count the profit pool after a potential modernisation job, which typically occurs after 20 years. As one can imagine, the original equipment manufacturer “OEM” has the first foot in the door in the accelerating global modernisation opportunity, as the world’s installed base ages.

At 43% of revenues, OTIS sells new elevators (NE) to architects, real estate developers, governments etc. In mature markets ex. China and Russia, OTIS converts 90% of these sales into highly lucrative maintenance contracts, which have a typical duration of 4 years, but with a longer tail. I estimate the effective average to be almost 5 years, triangulating between disclosures of the contract book, NE order book, and the purchase obligations timetable. These contracts also feature price escalators to protect against inflation. In China, while the NE segment is the most profitable in the world, the conversion rate into maintenance contracts is lower in general (40%), but industry leading for OTIS (60%), given its iconic brand. As China’s biggest real estate developers and building managers are consolidating quickly and regulations are becoming stricter, conversion rates are rising consistently from a low base (e.g. 30% in 2012). The OEMs have yet to conquer 75% of the maintenance market from independents.

As for the remaining 57% of revenues (but 80% of profits), OTIS sells services to building or facility managers, governments, etc. These services break down further into maintenance contracts, and repair and modernisation:

Figure 3: Based on OTIS spin-off Form 10 filing.

There are 16 million elevators in the global installed base and 0.9 million get installed every year. Note that if we neglect demolishing activity, the maintenance market grows with the grand historical sum of NE installs. As such, even if the world matures and construction/elevator NE activity starts declining, the quality of earnings keeps on improving for elevator companies, as the building base and hence maintenance still grow in their revenue mix.

There are several reasons for the presence of competitive advantages in this industry.

Cost advantage is present in the lucrative maintenance market – with 70% of total maintenance costs from transportation and labour – with economies of density. A denser client footprint is a double win as not only fuel and expensive wages to technicians are saved on the road, it also allows for faster reaction time to issues, and hence client satisfaction through better uptime. Issues range from annoying to downright frightening. As you can imagine, a quick reaction time is one of the most important KPIs here.

Brand drives loyalty and premium. The Big Four dominate prestigious projects (e.g. OTIS’ unfair share of the best examples: Eiffel Tower, Chrysler, Empire State building, One WTC, Burj Khalifa, Petronas (OTC:PNADF)). All have long and storied existences of consistent product delivery and innovation. Theoretically, brands are important when uncertainty and/or complexity is rife for the consumer. Passenger safety definitely helps brand advantage.

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Figure 4: From “A History of OTIS,” from PDHonline.org

The typical buyer does not pay the bill as an agent (building managers, governments, developer) for the end-consumer (residents, metro users, taxpayers etc.), but it is the agent that suffers reputational damage when hassle or safety violations occur. In the book “Quality Investing”, these agents are called “friendly middlemen.” This dynamic further cements the (perception of) quality as the primary basis of competition, making price a distant secondary consideration.

Once a reputation of quality products and services is built with the client, the context of safety, agent, and brand drive high switching costs. For example, OTIS renewal rate for maintenance contracts is 93%. These quotes summarize agents’ renewing decisions with the Big Four:

If it ain’t broke, don’t fix it

Worldly wisdom teaches that it is better for your reputation to fail conventionally than to succeed unconventionally – Keynes

Lastly, this industry has low capital needs. This follows from both low needs for capex and working capital. Working capital is close to zero thanks to customer advance payments for both NE (typically paid in phases towards completion) and maintenance services. And both fixed assets and working capital are kept low by the fact most employee activity is at the client’s site. As opposed to e.g. car manufacturing, labour-intensive assembly costs occur just before completion in the client’s building, helping working – and fixed – capital. Also, there’s little need for corporate buildings (mostly on cheap industrial sites) as the sales force and technician functions are mostly on the road.

2. Big Four outlook: set to gain share further, spurred by Internet of Things

Note we focused our competitive advantages discussion on the maintenance market. Through steady share gains in all segments, the Big Four already largely won the global NE market with 67% market share. In maintenance this number stands at 50% globally.

The Big Four have grown revenue high single-digits in the last decades through the secular themes discussed, as well as share gains.

I expect market share gains for the larger players to continue in both segments as smaller players get squeezed out. Economies of scale and brand have already forced many independents out of the NE market. This time, big fours continued investments into Internet of Things is putting pressure on small player’s 50% global maintenance share. In short, IoT will drive cost efficiency, client satisfaction and stickiness. In fact, research by Redburn identifies the elevator companies as the biggest beneficiaries of IoT in their overall Capital Goods universe, out of a coverage group of both IoT sellers and users.

IoT

What are these technologies? In short, connected elevator sensors connect the elevator to inform both the technician and the client. Ideally, elevator companies can more efficiently schedule maintenance pro-actively as sensors detect signs of wear before an issue. This improves elevator uptime, eliminates vague calls from clients which can be frustrating on both sides, improves route costs (less distance per unit is incurred in a route of scheduled maintenance visits), improves hourly wage cost on-site (issue is identified beforehand). Both issues can be resolved, and add-on subscriptions can be sold and activated remotely with software updates, not unlike Tesla’s approach. In fact, the Big Four are lobbying the Chinese government for a pilot run to prove that many issues can be resolved remotely. The end result should be more modern regulations lowering the mandatory visit counts per year.

While the term IoT is relatively new, most technologies under this catch-all term have existed since the ’80s, albeit in the high value elevator market. The Big Four have always been most dominant in the high value markets of high rise and/or high-speed elevators. Today they are simply monetizing amassed experience and early investments by deploying – once considered elite – technologies, to the general base of new elevators (and cheap retrofit toolkits for existing elevators). There has been a recent more elevated total R&D spend associated with this in the last 5 years, at around 1.6% of sales for OTIS, compared to an approx. 1.1% prior spend. Note that Big Four peers are all investing around 200 MUSD p.a. in R&D and patenting many technologies related to smart connectivity. To OTIS this represents a lower percentage investment.

OTIS completed a few iPhone apps, building on connectedness:

  • for the client and service salesforce
    • dashboard to follow up the resolving of issues in real-time
  • for the technician
    • connected elevators dashboard lists all elevators with issues, proposes day routes, and parts to carry (avoiding forgetfulness)
    • for non-connected elevators: iPhone rests on an elevator floor with a diagnostic app using only iPhone sensors. The app identifies the issues after instructing technician to push certain elevator buttons to allow the iPhone to measure all vibrations
    • workflows/instructions/remote instructor/online course app: teaches technician how to resolve an issue on-site
    • sales app proposes sales of parts and upgrades using the leads in a maintenance or repair visit (e.g. defective lamp). App enables technicians to push proposal to clients and close the sale end-to-end (avoid paperwork/back-and-forth to HQs)

Figure 5: Examples of recent apps allowing technicians to be more pro-active, reducing diagnosing issues, and sell upgrades. From OTIS investor day.

The roll-out of IoT is driving cost efficiency, while improving customer satisfaction through better uptime without the hassle of confusing calls. OTIS points to fewer unit costs over the last years: 3% less visits since ’17, with 2% and 4% less technician time spent per visit since resp. ’17 and ’16.

Regarding customer satisfaction, OTIS management points to the improving conversion rates (at an 11-year high today, now offsetting the recent dilutive mix effect of general Chinese growth) and its industry leading maintenance contract retention rates improving a few percentage points in the last 4 years.

Yet, OTIS reports only 20% of its serviced elevator base is already connected and I estimate this is growing to 30-35% in 2020. This speedy roll-out should drive OEM market share gains in maintenance, eating into the 50% “blades” share that small independent technicians still hold.

Figure 6: Comment from Sales & Marketing VP. From OTIS Investor Day.

3. OTIS: well-positioned leader

As the industry pioneer, OTIS estimates it has number one global market share (17%), driven by an 18% market share in maintenance and a 16% market share in NE.

Does OTIS’ size and iconic brand as the pioneer in the industry translate into better profitability? Overall, operating margin at OTIS runs at 14.5% versus 11-12% for the other three in the “big four.”

Revenues are segmented into NE and services. In OTIS’ case, 57% of total revenues is from services. In terms of operating profit, services account for 80% of total. Let’s look further into services to understand this discrepancy. Services can be broken down further into maintenance, repairs and modernization. The crown jewel is maintenance revenues.

In a recessionary environment, OTIS has the best mix, geared most towards maintenance revenues which are highly recurring and high margin. For OTIS, maintenance accounts for 47% of top line and 80% of operating profit. Only Schindler comes close at an estimated 44% (with Kone and ThyssenKrupp at around 35%).

By applying peers’ revenue mixes on the segment operating margins of OTIS, I find only ~60% of the gap in margins with peers can be explained by OTIS’ favourable mix gearing towards maintenance. The remaining can be explained by footprint (OTIS has a bent towards profitable EMEA), economies of scale, and perhaps the United Technologies efficiency culture.

Figure 7: OTIS Segment revenues and operating profit (note not all service revenue is maintenance). From OTIS spin-off form 10 filing.

Figure 8: New equipment drives growing recurring maintenance base. From OTIS February ’20 investor presentation related to the spin-off.

Revenue exposures compared to peers

OTIS sales are roughly equally split between the Americas, EMEA and Asia. OTIS is number one in all those regions, except for its close second place after Kone, if we were to break out China.

While the NE segment only accounts for 20% of OTIS operating profit, it is heavily geared to China (approximately 66% and 80% of NE revenue and profit). The maintenance base is geared to EMEA.

Compared to the average OEM peer, OTIS is overweight

  • Slightly to Asia, and Americas in revenue terms
  • Maintenance, with EMEA being the important contributor
  • large / high value / prestigious projects
    • large infrastructure (escalators)
    • high rise
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Part of OTIS’ slower growth in the ’12-’17 period can be explained by the European debt crisis. We know Italy and Spain have the highest elevator densities in the world:

Figure 9: Southern Europe (stronghold for Otis) has the highest elevator density in the world. From Credit Suisse (CS) elevators 2014 report.

OTIS is overweight Spain in particular, also evidenced by the manufacturing plant in Spain. On a more positive note, the fast consolidation in China for both construction and real estate maintenance, together with the recent strength for infrastructure, makes OTIS optimistic about its strong position in high value/large/ prestigious projects. For example, in Chinese infrastructure, OTIS sports a 20% market share. And while the conversion rate for NE in China is 60% for OTIS, this is 80% when we talk about high value projects, large developers, infrastructure.

Recent Trading

Informed by an ex-employee manager that left OTIS in 2018 on good terms, I learned more about the company’s 2017 inflection after a complacent period going back to at least 2012. The inflection coincides with the current CEO Judy Marks stepping in and making painful restructurings. UTC CEO Greg Hayes made this telling comment about the decade prior to spin-off plans on the November 2018 UTC separation conference (emphasis mine):

Greg, you’ve talked about a more focused company throughout this. Is there any other sort of investments that were overlooked as a larger organization and maybe if you could talk about that a little bit and if you could talk about maybe more color on COGS and SG&A and how the split up of the organization will look? – Sheila Kahyaoglu, Jefferies

Sheila, that is a great question and it’s one of the key questions that the board asked management as we were going through this process: “Were there investments that Carrier or Otis did not make over the last decade that they would have made as an independent company?” And I think obviously the answer to that is, yes. I think the fact that Otis lost a lot of market share over the last decade in pursuit of higher margins was something that Otis would not have done as a standalone business. I think they would have bit the bullet and been more aggressive on pricing. They would have been more aggressive on the market share side. And they would have invested more. That meant margins probably wouldn’t have gone up as much, but they would have been a stronger company for it. – Greg Hayes, UTC

Under UTC, OTIS seems to have rested on its laurels: “we have the best brand and products,” without proving this enough to clients. There was not enough focus on keeping or growing market share as OTIS was mainly a cash cow for UTC, with cash needs for its long-cycle aerospace investments. OTIS operating margins were abnormally high with a 22% peak in ’12 (on a stand-alone spin-off basis) and bottomed after a difficult period in 2018 at 14.3%. One example of complacency I understood from my contact: previous management refused to pro-actively renegotiate and renew abnormally profitable legacy contracts with clients. Instead, competitors visited OTIS’ clients to show how much they were overpaying. Many old guard managers chose the option of losing some market share, which was great for them in the short term, but obviously negative in the long haul.

Figure 10: Big Four organic growth estimates by Credit Suisse ’17 Kone report. Underperformance period OTIS ended in 2017.

This changed when Marks stepped in and let go of many managers and employees with an old-fashioned static mindset. OTIS has been recording annual $50-70M one-time restructuring charges since 2017 (on a downward trajectory), each resulting in $30-50M of durable annual cost savings.

United Technologies already ramped OTIS R&D in 2016. Just one output indicator are the 3400 patents pending for OTIS, on an issued patent base of 2500 (Form 10 filing page 74). With Marks, company culture was changed, and a mindset of winning share was imbued, with a lot of motivated younger employees getting promoted. Salesforce incentives were reoriented from short-term profitability to a blend with the long-term indicator of net volume gains. According to my contact, middle management internal mobility was slowed down from a high base, to avoid an undue focus on the short term.

My contact notes the more vibrant and empowering environment by the time he left in 2018 “probably a great place to work right now.” This is supported by employee attrition which has fallen from 25% in the difficult period, to mid-single-digits today, as noted by Marks on the OTIS Investor Day. This is showing in the results, with 6 consecutive quarters of services contribution growth, and the last 4 consecutive quarters showing broad-based contribution growth in every single region.

Otis’ organic growth rate in ’18 and ’19 has been in line again with Kone and Schindler, with stand-alone operating margin stabilizing at both exactly 14.3%. Note that part of the fall in operating margin in the decade was shared in the industry due to unfavourable mix shift towards new equipment growth in China: while new equipment in China has the best profit margins in the world (and maintenance the worst), these margins are still below overall maintenance margins. Fast growth in China meant that fierce competition led to general deflationary pressures until growth cooled and price inflation reappeared in 2018.

Figure 11: From Redburn

Figure 12: From Redburn

Figure 13: Chinese New Equipment pricing YoY. From Redburn

3.5 million out of the 16 million global elevator installed base were originally manufactured by OTIS. Out of these, only 1.5 million are serviced by OTIS today (OTIS also services 0.5 million non-OTIS elevators). This gap (3.5-1.5 = 2M today) was allowed to grow until ’18. Because the moats of the large OEMs are growing, I expect the favourable trend of independents being squeezed out of the maintenance market to continue. This large existing 2M gap of unserved OTIS elevators is the low hanging fruit in the company’s conquest. OTIS developed retrofit digitalization kits for its installed base called OTIS One. There are two types of kits: one with complete capabilities, and a cheap one which can be installed in 15 minutes which is solely focused on maintenance as opposed to add-ons such as screens. Management has seen an improvement in selling maintenance, client retention and costs because of this, and expects to roll-out another 100 000 retrofit kits in 2020. This grows the existing 400 000 connected OTIS elevators base, on top of NE sales.

A leading indicator for future business – OTIS overall NE market share – is up 2 percentage points from 2012, at 16% today. Importantly, when new equipment orders inflect (since ’18), benefits in terms of maintenance contract conversions only percolate into the financials 2-3 years afterwards, as it takes time before the sale is closed, and the 1-2-year warranty period expires.

4. Return profile & outlook

ROIC

OTIS’ 2019 pre-tax return on invested capital was 64%. In the nominator, we used operating profit (1.9B$). Total capital employed stands at 3B$: we counted all liabilities incurring interest: debt and leases (6.7B$) and added equity incl. minority interests (a negative 3.7B$).

For Kone and Schindler, we use the same methodology, but we deduct the excess cash balance they hold compared to OTIS. We assume they need a similar amount of cash like OTIS, corrected for their smaller revenue base, this adjustment boosts their calculated pre-tax ROIC to 38% and 39%.

This methodology does not give full credit for the business quality, as it implicitly includes goodwill and intangibles. When we exclude these from the capital bases, we get a 2019 pre-tax ROIC of 232% for OTIS, 79% for Kone, and 61% for Schindler. Redburn research found similar numbers for the 15-year average after-tax ROIC of 77% and 65% for Schindler and Kone.

What makes these great businesses?

The razorblade model, where most profits are made in the aftermarket (21% operating margin), helps overall operating margins. While fixed asset turnover is at 10X, capex and working capital needs are 3.9% of sales in total. For example, capex needs (1.3% of sales) are lower than the average capex intensity of any GICS industry. This is helped by a low need for both fixed assets and working capital by virtue of both salesmen and technicians being mostly on the road, customers prepayments and cost of assembly taking place last minute, in situ.

Total shareholder returns for Schindler and Kone have been stellar in the last 15 years at 13% and 15% CAGR, mostly explained by high organic sales growth at 6% and 8% CAGR, and margin expansion. Multiple expansion accounted for 2% and 3% CAGR. Multiple expansion is arguably on a sustainable upwards path: as we noted, the maintenance market grows with the grand sum of historical new equipment. As the installed base grows ever higher and percentage growth declines (i.e., the NE market), the OEMs revenue mix has (and is expected to) shift further towards the highly recurring, stable and profitable maintenance income stream.

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Outlook

In late February, OTIS management guided for 2-3% organic growth in 2020 and free cash flow conversion (defined as FCF/net income) of 110-120%. This included (early) China corona effects.

The low revenue growth outlook is consistent with the outlooks of Kone (0-6%) and Schindler (0-5%) and is explained by flat NE China expectations (China is adding 600k elevators on a 6M base).

Medium-term OTIS guides for LSD to MSD revenue growth, MSD operating income, HSD EPS growth and 110-120% FCF conversion. The variance between revenue and operating income is driven by 20-30 bp annual margin improvement from three sources. Firstly, cost efficiencies from IoT as field productivity improves (fewer and shorter visits). Secondly, consolidation in materials procurement (although OTIS has assumed most of these efficiencies are given back in pricing). Thirdly, robotic process automation should improve the SG&A cost base, and the spin-off stand-alone costs will be driven down, as the priority shifts from speed to implement spin-off to costs.

Beyond the medium-term, management thinks elevated R&D spend reverts to its historical baseline. While this is not counted in HSD EPS growth, this could expand the margin by another 50 bp.

5. Valuation

The headline valuations for Schindler and Kone are resp. 16.2 X EV/EBIT (at 220 CHF per share) and 18.5 X EV / EBIT (at 52.2 EUR per share). For Schindler this adjusts to 17.5X EV / EBIT if we exclude the dilutive effect of minorities.

The smallest of the Big Four – ThyssenKrupp’s elevator unit – was sold in February for 21X EV/EBIT in one of Europe’s largest private equity deals to date (17BEUR). This offer topped a consortium of Blackstone and Carlyle, while it matched Kone’s withdrawn offer as anti-trust risks loomed.

OTIS trades at 15.2X EV/EBIT (at $46 per share) after adjusting for minorities dilution. To find “normalized earnings power” for OTIS we will make two adjustments:

  1. Structural tax difference (applies to relative valuation)
  2. Low hanging fruits in the cost structure (applies to relative valuation)

Firstly, while peers have an almost identical 22.5% tax rate, OTIS pays 33%. Obviously, this is not in our EV/EBIT assessment, so the question becomes: how much of this is structural? The guidance variance between medium term EBIT “MSD” and EPS “HSD” is mainly because of easy gains in tax as the CFO explains tax was not optimized “at all” under UTC. The high tax rate is explained by additional US taxes on international cash repatriation to the US, and the plan to redomicile OTIS’ currently 100% US debt should go a long way towards tax rate convergence with peers. However, the CFO remained vague in the Q&A when asked about the sustainable tax rate for OTIS. We assume the EPS versus EBIT growth variance are fully from taxes (while in reality there’s also some backloaded share buybacks and M&A) and assume a five-year horizon for “medium term,” take 8% for “HSD” and 5% for “MSD.” We then back the tax rate in year five into these assumptions and interestingly find a 23% rate. Now, because these assumptions are somewhat aggressive it’s probably safer to assume 26% as a sustainable rate. This presents a 4.5% headwind after-tax for OTIS investors in the EV/EBIT exercise we will adjust for.

Secondly, let us account for some of the low hanging fruits in the new spin-off cost structure (and the typical management sandbagging at the start of spin-offs). Out of the three cost saving initiatives laid out in “Outlook” we will only credit a part of the SG&A initiative as low hanging fruit. Specifically, 14% of revenues will be SG&A, with approximately half of these from “stand-alone” spin-off costs. Management admits the priority here was implementation speed, and improvements can be made to this added cost base. We think it is safe to add 0.7 pp of revenue to normalized earnings power.

These adjustments pan out to an adjusted OTIS valuation of 15.5X EV/EBIT. If OTIS were to rerate to Schindler’s or Kone’s valuation, this is worth resp. 15% and 23% equity upside.

In terms of P/E’19, we get 18.8x for OTIS, 24.2x for Schindler and 25.1x for Kone. In OTIS’ case, we used pro-forma stand-alone and interest costs on ’19 financials, and excluded one-time costs incurred related to spin-off.

The larger delta when we look at P/E valuations is driven by OTIS’ cheap and sizeable debt load.

Everything else equal, my personal preference is for OTIS’ net debt load (at 2.3X EBITDA; with high and stable FCF conversion) compared with the net cash positions for Kone and Schindler. The debt was entered into in February: cheap (2-3% rates) and all fixed and termed out debts to be paid back 3 to 30 years in the future, with an average 8-year duration.

If we further normalize OTIS P/E with the same tax and spin efficiencies we mentioned above, we get a 17.7X normalized OTIS’19 P/E:

If OTIS’ P/E were to rerate to Schindler or Kone, this is worth 29% and 34% upside.

While we will not model the effects of corona for this relatively stable industry, this exercise was based on 2019 numbers and we note that OTIS is best protected in recession years thanks to its leading maintenance profits which represents 80% in the EBIT mix. Comparing peers on 2019 numbers is hence unfavourable to OTIS.

3. Conclusion

Elevators have become a ubiquitous – and hence boring – part of modern life. Shareholder returns tell a different story. Most of these returns are simply from profitable organic growth installing elevators (razors) and servicing them (blades). Ever-connected elevators in the 21st century will drive more market share for the OEMs in the highly attractive service market. Similar to how electronics have driven small car repair shops out of business, the same is about to happen to the many independent elevator maintenance shops.

Returns for OTIS shareholders will mostly be driven by defensive and cash generative EPS growth (5-10% p.a.) and dividends (2%). An equity rerating return of 20 or 30% towards the average of Schindler and Kone EV/EBIT or P/E valuations is more speculative: OTIS has only inflected from underperforming organic growth in 2018. On the other hand, it has always been the biggest and most profitable elevator company, hence it should be the biggest beneficiary of the trends discussed, especially with a now independent and focused management.

Risks

COVID-19 disruption

Uncertainty surrounding COVID-19 is high, but what is certain is maintenance activities continuing unabated, evidenced by multiple OEM comments on the earlier China lockdown. For OTIS in particular, maintenance as a percent of operating profit stands at an industry high of 80%.

Instead of making predictions about the NE segment, let’s check how far it can fall before OTIS breaks even. If we assume fixed costs in the NE segment are 30% of sales, I estimate OTIS NE segment can fall by 50% YoY to reach overall profitability break-even. Given OTIS’ order book for NE stands at 107% of 2019 NE revenues, and the majority of the order book is typically converted into sales within a year, OTIS booking a break-even year seems implausible.

Regarding potential supply chain disruptions, Kone commentary suggests no issues so far, and the OTIS prospectus notes “Components and systems necessary to effectively complete our New Equipment projects, as well as to satisfy our maintenance and repair obligations, are often available from two or more sources within the industry.” (“Raw Materials,” p. 73).

Forex

In the current environment, forex is an especially important factor to consider. OTIS hedging policy aims to minimize price volatility on committed purchases and sales (Form 10, page 88). As such, forex risk should be translation risk in the long term: will non-US revenues sustainably get impaired through forex, while OTIS debts are denominated in USD?

Disclosure: I am/we are long OTIS. 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.




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