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Otis Worldwide (NYSE:OTIS) is one of the leading elevator and escalator manufacturing, installation and service companies globally. The company designs, manufactures, sells and installs a wide range of passenger and freight elevators, as well as escalators and moving walkways for residential, commercial and infrastructure projects.

In this article, I present an updated view on Otis post-Q2 earnings. I also assess Otis’s 1H operating performance and present an outlook for 2H 2023 and beyond.

In preview, I believe Otis is currently undervalued with 5-20% potential upside from current prices, and while further economic deterioration could pose risks, the stock presents a favorable risk/reward opportunity. In the short term, I do not expect the stock to take off, while current prices present an interesting entry opportunity. Long term, I believe a combination of organic growth in its core Business, along with its share repurchasing program and continued dividend hikes, makes Otis a top stock for long-term income-seeking investors.

Overview Of Otis

Otis is organized into two segments, New Equipment and Service, which, for the year ended December 31, 2022, contributed 43% and 57% of their net sales, and 17% and 83% of operating profit, respectively. International sales (outside of the US) accounted for 72% of total sales for 2022.

‘New Equipment’ relates to the selling and installation of Otis products in new constructions while Service relates to the maintenance and repair of installed products and the modernization (replacing) of old lifts / escalators / moving walkways in existing buildings. What’s interesting to note is that the operating margins on New Equipment sales are significantly lower than that of its Service business. In 2022, EBIT margins on New Equipment were 6.1%, vs. 22.9% for its Service business. One can argue that the Service EBIT margins are actually diluted by including the Modernization business line in this segment, as modernization involves a significant new product component more akin to the New Equipment segment.

This business model is one of the reasons I am a big fan of this ‘boring’ industry. It is very similar to selling cars. Profits are not made by selling the initial product, but by aftersales services for the next 10+ years. Maintenance contracts tend to be quite sticky with high retention rates. Elevators and escalators are vital urban mobility products and building owners (especially in premium office buildings and global transport hubs like major airports, etc.) are not willing to take the chance of potential safety issues or risk major disruption when breakdowns occur by saving costs on maintenance by going with third parties. At 22.9% EBIT margins, servicing Otis products is a highly profitable business with strong, regular cash flows.

To further enhance profitability of its Service segment, Otis uses their ‘Otis ONE’ platform – an IOT platform designed to continuously monitor equipment health and performance in real time. This allows Otis to do predictive and even at times remote maintenance to reduce their service costs (fewer trips for engineers to go out and fix broken down elevators / escalators), and increased equipment up-time for their customers.

Otis’s geographic coverage is also important to note as it gives some indications as to where their growth will come from going forward. In 2022, New Equipment sales in China represented approximately 1/3 of Otis’s new equipment sales and China represented over half of their global New Equipment unit volume. This shows significant exposure to China, which in the past has been a boon to Otis. However, as China’s property sector is sluggish after recent upheaval in the sector, this to me indicates that Otis will see slowing growth going forward.

2023 Q2 / 1H Interim Results

When looking at the Q2 Interim results, Otis had a strong start to the year.

New Equipment Orders were down compared to 2022 Q2, overall however, backlog increased. Modernization Orders and backlog both did well, and Service revenue saw organic growth of 9.4% YoY, the best performance since the spin-off. The New Equipment performance was mainly driven by growth in Asia-Pacific, while the Americas and China saw a decline. This is a trend I expect to continue into Q3, and the remainder of 2023 as China’s property woes are far from over. Looking at the US commercial property market, I also see continued weakness.

Management gave a revised outlook – increasing its Adjusted EPS from $3.40 – $3.5 to $3.45 – $3.5, and increased their share repurchase plan from $700 million-800 million to ~$800 million. I believe these estimates to be somewhat cautious, as this is the second consecutive quarter management is revising up their Adjusted EPS and share buyback plan. I believe management is expecting to slightly outperform their initial guidance and based on their strong 1H performance want to send a signal to the market that their downside scenario is significantly less likely than expected. Increasing their share buyback target from initially $600 million-800 million now to ~$800 million is in my view affirmation that Otis expects their full-year results to land at the upper range of their initial guidance.

Outlook – 2H 2023 And beyond

Looking ahead at the 2H for 2023 and beyond, I believe for 2023 the outlook for Otis is positive. The same trends reported in 2Q23 are likely to persist – moderate growth in New Equipment and Modernization orders / backlog while adverse mix changes and rising wages and material costs will continue to put pressure on margins.

I expect the Service Outlook to be more positive, and that management’s estimates are largely on point, while potentially conservative. The Service business in general is highly predictable and stable.

Taking a long-term view and looking beyond 1H 2023, I believe the future of Otis’s success will depend on a few key factors:

Recession:

Any recession will naturally significantly impact Otis’s performance going forward, however, with its strong balance sheet and FCF conversion of over 100% of GAAP net income I believe that Otis will be able to weather the potential storm.

Recovery of China’s property sector:

As mentioned above, China is a key growth market for their New Installation business, and as a result will be a major driver for their Service Business. Depending on how quickly the sector recovers from the major shocks of previous years, this will have significant impact on Otis’s growth going forward. Recent government pledges to adapt to “major changes” in the demand-supply dynamics in the property market, announced by the Chinese government in late July have provided a temporary boost in share prices of Chinese property developers, but exactly what shape fiscal or monetary support is unknown. As such significant uncertainty remains.

Wage inflation globally:

As management showed in their previous results announcements, wage inflation remains a major headwind globally. The extent to which wage inflation normalizes in key markets such as the US and EMEA will determine near-term profitability.

In the longer-term, as wages are ever increasing, efforts at driving productivity and other innovation (e.g. the success of ‘UpLift’ – their strategy to improve sustainable long-term performance, and OTIS One to enhance maintenance efficiency and reduce costs, or robotic installation of lifts) will be a major efficiency drivers and ultimately impact how Otis can compete with global rivals.

Otis’s capital allocation strategy:

It is encouraging to see the priority is investing in its existing businesses. This shows that management has confidence in the future of its core holdings. I would include buybacks in this area, as selective buybacks are one way to return cash to shareholders.

Otis’s commitment to sustaining and growing the dividend over time is great for long-term and income seeking investors (more on that below).

However, I believe most important for Otis will be whether it manages to gain New Equipment market share globally, and to what extent they manage to convert these New Equipment customers into Service business customers. While efforts to drive productivity ad rationalizing SG&A expenses are necessary, long-term success depends on portfolio growth, not cost-cutting.

Overall, I am positive about the future of Otis as management has shown themselves to be shareholder friendly and able to execute well on its stated plans. The business has been around for nearly 170 years and managed to modernize itself to stay relevant to how cities and urban life have changed. I believe it will be able to continue this trend through ongoing innovation and targeted investments as it hunts for growth.

Valuation And Shareholder Value

After the 3.6% increase in share price post Q2 earnings release, Otis shares are up c.93.6% since its listing date, and down c. 1.8% down from its all-time high of $92.37 (August 2021). Looking ahead I am positive about future earnings, especially since underlying profit has in 2022 was already above 2019 levels (pre-pandemic) and 2023 is ahead of 2022. As such, I believe a return to all-time high is highly likely, with a near-term valuation range of $95-108, indicating a c. 5-20% upside from current prices.

I arrive at my valuation range by using a DCF approach. Looking at the 1H 2023 net sales growth of 6.6% (taken from their analyst presentation), this is somewhat aggressive and not sustainable for the long run. As such, I am using a more conservative growth estimate of 5.6% to reflect what I believe is reasonable growth considering the economic outlook for the US, the EU, China and Southeast Asia in the coming years. In addition, I am also factoring in the $150 million in savings from ‘UpLift’ over the next 2 years, as well as a slow and gradual reduction of Otis’ effective tax rate which currently sits well above that of their competitors (hence their strategy to reduce the effective tax rate). I am comfortable with these assumptions as I expect Otis will continue to benefit from Volume, Price and Productivity tailwinds, while their wage inflation headwinds are likely to be resolved in the short-medium term through either a soft landing or a recession, as well as further digitalization and productivity enhancements.

By taking a more bullish stance on the recovery of the Chinese property sector and Otis’ success in driving efficiency enhancement as well as winning new projects, I believe the share price can reach $108 in the medium term. There is room for optimism as Otis is benefiting from a strong volume and pricing tailwind especially in its Service business as seen in their Q2 results. Operating profit margins expanded by 50bps, while their Maintenance units grew 4.2% YoY, with growth in all regions. The more scale Otis develops in their Service business, the higher the economies of scale benefits.

That said, if a recession does hit, there will likely be more attractive buying opportunities. While I am a buyer at current levels, I would recommend anyone looking at Otis to start layering in at current prices and buy more aggressively on any weakness (any drop of more than 10%).

Dividend And Share Buybacks

Looking at the dividend and share buybacks, in 2022 Otis repurchased c.$850 million in shares and paid a dividend of $460 million ($1.11 per share / year) up 20.8% from 2021. At the time of writing, it pays a dividend yield of c.1.5% – after having raised its Q2 2023 dividend by 17.2% to $0.39 per share. Otis repurchased $175 million in shares in Q2, and a total of $350 million in 1H – with a commitment to repurchase ~$800 million in 2023. I expect this trend to continue well past 2023 as management has shown a clear commitment to growing shareholder returns.

While 1.6% doesn’t make Otis a high-yield stock, it is higher than the SPY yield of c.1.4% and is not something to scoff at. Otis management has consistently reiterated their commitment to growing the dividend since the spin-off and have increased it by 70% since then. I believe the 1.6% starting yield can present an attractive starting yield that should get long-term income-seeking investors like me excited.

I believe management will likely reward shareholders later this year or early next year with another significant dividend hike and based on their cash payout ratio of >40% I am not worried about any dividend cuts.

Risk and Downsides

Macro risks and downsides include global recession, escalation of geopolitical tensions between the US and China impacting Otis’s operations and holdings in China, and further inflation risks negatively impacting their cost structure (mainly wage inflation outlined above).

Looking at company specific risks however, I believe the critical determinants of Otis’s future performance are as follows:

Successful delivery of ‘Uplift’ – improvement of operating model

To remain competitive in both the New Equipment and Service segments, Otis needs to stay on top of its costs and maintain a lean cost structure. Part of its plan to do so is its new ‘UpLift’ initiative that aims to streamline and optimize processes, accelerate digitalization, leverage scale and efficiency in global supply chain and unlock global synergies. Through this project, Otis aims to unlock c.$150 million in savings in the next 2 years. I believe this is a step in the right direction but is not exhaustive and I expect further updates as well as additional cost savings initiatives going forward.

Continued organic growth of New Equipment projects and conversion to Service Customers

Long-term growth will depend on Otis’s success of winning New Equipment contracts from projects globally, and specifically then converting these projects to Service customers – allowing Otis to generate steady long-term cashflow at significantly higher margins compared to the one-off New Equipment revenue. The extent to which Otis can succeed in winning new projects depends on a combination of cost competitiveness (partly discussed above), as well as continued product innovation and product and service quality. Looking at Otis’s wide-product range and ongoing innovation such as Otis ONE mentioned above, I believe they are well positioned to deliver on this promise. Key performance indicators to monitor will be their New Equipment and Service market shares, as well as keeping an eye on growth relative to competitors. Should Otis grow slower than their competitors and lose market share (especially in Asia) this would be a major red flag.

Debt reduction

Due to recent acquisitions Otis has loaded up on debt. While I am not worried about their current net debt levels (c.$5.6 billion), I do expect their debt to come down materially in the next 18-24 months. Looking at the LTM to June 30, 2022, Otis’s Total Debt / EBITDA was 2.9x, I would like to see this come down to below 1x over time to be more in-line with industry peers. I believe debt reduction is critical for Otis to be able to continue its buyback program and its dividend increases.

Overall, I believe that Otis is well positioned to weather these challenges as management has a strong record of delivering on their plans, and the balance sheet is strong. In addition, I expect its strong and growing Service business portfolio will continue to offer earnings safety and stability while Otis continues its efficiency enhancement and innovation initiatives while the uncertainty surrounding China’s property sector further develops.

Main things that I will be watching out for and that might turn me more bearish on Otis will be drops in market share and increasing debt levels for reasons other than value-creating acquisitions.

Takeaway

Otis is currently trading 1.8% below its all-time high and offers a dividend yield of 1.5%. Since the spin-off in early 2020, the dividend has been increased by 70%.

The business has a strong balance sheet with ample liquidity and offers an interesting entry-level for long-term income-oriented investors. Its 1H 2023 results outperformed the same period in 2022, and I expect the 2H results to beat last year as well.

Challenges remain especially for the China market, as well as for general wage inflation globally. The future of the stock hinges on the success of Otis’s capital allocation strategy and whether it can secure enough New Equipment projects and convert them into Service Business customers.

I believe Otis is currently undervalued, and while further economic deterioration could pose risks, the stock presents a favorable risk/reward opportunity.