The demand for vertical transportation systems such as lifts and escalators is rapidly increasing due to the growing population and increasing industrialization across the globe. As per Research & Markets data, the elevator and escalator market in the U.S. alone is poised to grow by $1.34 billion from 2021 to 2025, driven by a combination of modernization and maintenance-related factors. Increased construction activity in urban areas and high adoption of smart homes should drive this demand as well. One of the largest global players that is bound to benefit from this is Otis Worldwide Corp (OTIS, Financial).
Company overview
Otis Worldwide is one of the global leaders in escalators, elevators and moving walkways. The company has its headquarters in Farmington, Connecticut.
The company installs transportation systems and provides maintenance, repair and renovation for its own products as well as those of its competitors. It reports its operations under two segments – new equipment and service. The new equipment segment deals with the development, manufacture and installation of escalators, elevators and moving walkways. The service segment encompasses all the reports of maintenance, repair and modernization activities. Maintenance and repair accounts for around 80% of the revenue within the service segment, while modernization accounts for the remaining 20%.
Among Otis’ two operation segments, the service segment is more resilient and profitable as its revenues are tied with the installation, which is rock solid even during weak sales periods of new equipment. On the other hand, the new equipment segment is more influenced by economic cycles, mostly the construction cycles. Furthermore, elevator maintenance is legally required in most countries that offer a stable stream of revenues.
Recent financial performance
Otis Worldwide reported a top line of $3.70 billion for the most recent quarterly result for the period ended June 30, 2021, which was a staggering 22.19% growth as compared to the $3.03 billion in revenue reported in the corresponding quarter of 2020. The company beat the analyst consensus estimate of $3.45 billion.
These revenues translated into a gross margin of 29.32% and an operating margin of 15.40%, which were higher than in the same quarter of last year.
Otis reported net income of $326 million, and its adjusted earnings per share (EPS) of 79 cents came in 8 cents above the average Wall Street expectation.
In terms of cash flows, Otis reported $533 million in the form of operating cash flows and spent $17 million in investing activities during the previous quarter, leaving the management with a positive free cash flow.
Service business drives growth
Otis’ service business is its biggest growth driver as its operating margins are three times larger than the new equipment segment. The management’s monetization strategy is based on the service business model. While the company might able to earn small profit margins on elevator installations, it is able to sign long-duration service contracts to monetize the installed base of elevators and escalators.
In fact, the company’s business development team tries to capture the service contracts of competitors like Fuji Electric (TSE:6504, Financial), Mistubishi Electric (MEX:MITS, Financial) and Kone Corp. The strong revenue foreseeability coupled with the fact that lift maintenance is highly regulated in most countries is what makes this segment highly stable. A service contract typically lasts for about four years on average, but Otis has a 90% maintenance contract retention rate, which means it hardly loses any clients.
It was this business that helped Otis weather the Covid-19 storm and the weak equipment sales. This segment also requires a very limited research and development expenditure and is in auto-pilot mode for the company. The company is looking to compete on price in order to gather a larger number of service contracts and drive its top-line growth.
Strong market position
Otis has been a market leader in its space for many years. As per Statista, the company was the largest global player in the elevators and escalators space, followed closely by Schindler (XSWX:SCHN, Financial), Mitsubishi Electric and Kone. The company has the largest installed base in EMEA, giving it a leading position in the modernization market with approximately 20% of the market share. The management has tightened its relationships with its customers to proactively propose a modernization solution and renegotiate service contracts by proposing premium conditions.
Moreover, it claims to provide maximum safety and reliability with less downtime and free connectivity solutions to its customers. Their strategy of rapidly gaining market share from close peers by offering services at a better price and using connectivity solutions are bound to drive future growth. The company should also benefit heavily from emerging markets like India and China which are undergoing heavy urbanization and are bound to have a high demand for vertical transportation systems.
Final thoughts
As we can see in the above chart, Otis’ stock price has nearly doubled in the past 12 months. The management is focused on further improving its operations by focusing on cost optimization, removing operational inefficiencies and gaining market share. I believe this name is a resilient, defensive stock, and its current enterprise-value-to-revenue multiple of 3.13 appears to be reasonable. Even the price-earnings ratio of 34.52 is not too high for Otis in my opinion given the company's growth prospects.
