Otis Stock: Late-Cycle Service-Driven Story Driving It Higher

It’s been a while since I’ve written on Otis Worldwide (NYSE:OTIS), and the shares have outperformed my expectations since then, climbing about 15% and outperforming the broader industrial space by about 10%. Relative to other companies with significant non-residential exposure, Otis has outperformed Allegion (ALLE), KONE (OTCPK:KNYJY), while Johnson Controls (JCI) has kept pace, and late-cycle companies have in general been holding up better as investors increasingly worry about short-cycle trends next year.

I understand the appeal of the Otis story – not only are key markets like multifamily housing likely to be stronger than most in 2023, but the company has a multiyear service growth story that is supported by strong execution in recent years. Valuation already reflects a lot of the positives, though, and I do see a weaker non-residential construction environment as a modest potential negative.

Mixed Results, But Still Delivering On Margins

Third quarter results were a mixed bag for Otis, with weaker than expected results in the equipment business and stronger results in the services segment. On balance that’s fine (and more or less consistent with expectations), but weaker equipment trends are a concern going into next year.

Revenue rose about 1% as reported, missing by 4%, as New Equipment sales declined more than 5%, while Service revenue rose more than 6%. Both missed expectations, with New Equipment missing by about 7% and Service by closer to 2%. New Equipment was dragged down by weaker trends in the Americas region (down 4%) and China (down high-teens), though Europe was stronger (up 7%), while Service was boosted by strong growth in Modernization (up over 10%).

Gross margin declined 60bp to 28.7% on familiar input cost pressures (commodities, wages, et al), but a stronger service mix and improved productivity helped mitigate the pressure on operating earnings. Operating income did fall 4% (and segment income declined 5%), but that was in line with expectations, and margins beat by 50bp, expanding 70bp to 16.3%. By segment, New Equipment profits fell 24% (margin down 80bp to 7.2%), while Service rose 1% (margin up 70bp to 23.9%).

Late-Cycle Is More Popular Now, But The Outlook Is Still Challenging

I believe at least some of Otis’s outperformance over the broader industrial sector can be tied to its late-cycle construction exposure. At this point in the cycle it’s normal to see the market rotate away from short-cycle industrials and search for companies in sectors that serve markets that have more growth left in the tank. Construction is typically one of those sectors/end-markets.

I’ve written before about my concerns about construction next year, and I’ll reiterate some of those points here. First, China is a mess as the company struggles with its zero-COVID policy and significant weakness in its property/construction sector. Europe isn’t looking particularly strong given the pressures and turbulence created by Russia’s war in Ukraine and higher rates. In the U.S., although longer-term metrics like the Dodge Momentum Index are still strong, many banks are reporting weaker demand for commercial real estate loans and more caution from developers/investors in areas like office, retail, and hospitality.

I do think non-residential construction (residential doesn’t really matter for Otis, as multifamily is grouped under non-residential) will be positive next year, but I think it will be weaker than commonly-expected, and that creates some potential headwinds and risks for sentiment. Working in Otis’s favor, I think multifamily is still a good place to be within non-residential, and this is an area of strength for Otis (60% of the Service business is in multifamily).

Orders were down slightly this quarter, and although the New Equipment backlog was up 12% year over year, I think there’s some vulnerability here going into 2023.

I’m less concerned about the Service side of the business. While the pandemic created unprecedented chaos as offices and other facilities closed, that’s not what a typical recession looks like. If the economy does tip over into recession next year, property managers are still going to be operating and maintaining their elevators, and I see ongoing opportunities for Otis to continue to gain share.

Otis has been steadily growing its service business (in market share terms), and I believe increased awareness of the benefits and capabilities of digital-enabled/digital-driven service will drive more market share over time, as small local firms simply won’t be able to compete. Otis still has ample room to increase its service attach rate (it has around 18% to 20% share in equipment, but around 12% to 13% share in service), and both Otis and Kone see service as the more attractive market over the long term given the margins.

The Outlook

I’m still expecting around 4% long-term revenue growth from Otis, with the Service business driving the bulk of that growth. As higher-margin services become a larger part of the mix, I expect improving EBITDA, adjusted operating income, and FCF margins from Otis. If the company can drive Service margins into the 26%-27% rate over the next decade, while maintaining New Equipment margins in the 6% to 8% range, mid-teens FCF margins and high single-digit FCF growth seem attainable.

The Bottom Line

Between discounted free cash flow and margin/return-driven EV/EBITDA, Otis doesn’t end up looking all that cheap to me now. Revenue growth around 4% and FCF growth in excess of 7% would seem to support a long-term annualized total return in the 7% range, while a forward EBITDA multiple of 13.5x would seem fair relative to what the market generally pays for similar margins and returns, but doesn’t support an attractive fair value now.

Given the market’s desire to avoid short-cycle name, Otis’s reliable progress/execution on its growth plans, and the attraction of a growing high-margin service business, I’m not betting against Otis. Some stocks can maintain higher multiples than the current numbers/forward outlook would otherwise suggest is fair, and Otis can certainly be one of those. Still, I’m not inclined to pay up for that now, particularly with what I see as risks to the non-residential construction outlook that may not be fully factored in yet.