Otis: An Industrial Capital-Light Business Generating Enormous FCF

Otis Worldwide (NYSE:OTIS) represents a company with a resilient and cash-generating business model. The company is a global leader in the elevator and escalator manufacturing industry. Its IPO in 2020 made it a stand-alone company and, since then, the stock has successfully appreciated supported by improving financials and by multiple expansion.

Why Otis is a compounder

Otis checks all the characteristics that make me consider it as a long-term compounder.

It is part of an oligopoly shared mainly with KONE (OTCPK:KNYJY) and Schindler (OTC:SHLRF). When smaller regional players come forth, Otis and its peers usually end up buying them out to defend their market-leading position.

Otis’ revenue stream has two main sources: new equipment sales and services (modernization and maintenance). The latter is Otis’ golden goose. In fact, both modernization and maintenance are high-margin businesses and generate recurring revenue. Elevators and escalators have a long life cycle which can last 15-20 years. During this period, they need to be serviced and maintained. Here is where Otis’ big chunk of profits comes from. After a while, this equipment needs to be updated and modernized. This is another high-margin revenue stream which Otis benefits from. So, to make things easy to understand, the real goal for Otis is, yes, to drive sales, but, most importantly, to retain its customers and service them.

To understand and visualize even better my point, please take a look at the following slide, taken from Otis’ earnings presentation. New Equipment generated only $89 million in operating profits, while Service reached and breached the $500 million barrier.

Thanks to this business model, Otis offers a high level of predictability, with more than half of its revenues coming from services. This gives the company a high operating leverage. As a consequence, its profitability stands out as excellent, with an incredible 54.4% return on total capital. This is why Otis earns an A+ in Profitability from Seeking Alpha Quant Ratings.

In terms of growth, the company grows its top line at a 3%-6% pace, but its EPS grow at about twice the speed. Being a cash-generating machine, the company has been paying a dividend since May 2020, right after its IPO, and it has increased it at a 30% CAGR for the past three years. In the meantime, its payout ratio remains a safe 37%. Currently, the company yields 1.52% which needs to be summed up with ongoing buybacks the company is doing. In 2023, Otis returned $1.35 billion to its shareholders, $800 million of which were distributed through share repurchases. The balance sheet is not endangered by this capital allocation. It sports $1.3 billion in cash while carrying a total debt of $7.2 billion, most of it coming from UTC. Considering Otis’ EBITDA of $566 million, we would think the balance sheet is too leveraged. But Otis only had to pay $41 million in interest expenses in the past fiscal year. Considering its pre-tax earnings of $477 million, we have a company whose earning power amply covers its obligations.

Last, but not least, I may surprise many by saying Otis is a capital-light business. Although being an industrial, it spent on capex only $42 million during FY23. Considering its cash from operations was almost $600 million, we understand why this company is set to generate enormous flows of free cash for years to come.

Otis Q4 Earnings

Otis recently reported its Q4 earnings. This means we can also have an overview of the whole fiscal year that just went by together with a first forecast for 2024.

Let’s take a look at the main highlights Otis reported for the quarter:

• Net sales were up 5.3% to $3.62 billion. Organic sales growth was 3.8%
• Operating profit margin improved by 10 bps to 14.4%
• FCF grew $125 million YoY, or 29%.
• EPS of $0.79 beat expectations and were up 11.3% YoY
• New Equipment sales were almost flat, improving by just 0.3% YoY to $1.47 billion, meaning volumes were overall lower but prices increased. However, New Equipment orders increased by 3% YoY.
• Service sales improved 8.9% YoY to $2.15 billion

Zooming out to consider the whole fiscal year we have the following picture:

• Net sales up 3.8%, with organic sales up 5.6%.
• Operating profit margin improved by 50 bps to 15.4%
• FCF was up by $44 million and reached $1.49 billion
• EPS of $3.39, up 14.5% YoY
• New Equipment sales were up 1.2% YoY, while orders were down 4% YoY
• Service sales increased by 7.4% to $8.4 billion. The maintenance portfolio grew by 4.2% and currently has 2.3 million units globally.

Overall, we see a company where the weaker performance of new equipment didn’t jeopardize the whole report thanks to service performance. Most of the weakness we see in new sales comes from China, where new orders and deliveries are down compared to the past. However, Otis is not exposed to China as its main competitor Kone. This is helping the North American company weather better than Kone cooling the housing market in China.

The most important fact I saw reported by Otis was its service business growth. Modernization is seeing growing demand, combined with maintenance and repair. This is highlighted by the column chart below, where Otis’ remaining performance obligations are visualized.

Valuation

Overall, I judge Otis’ report as positive: in a market where home construction across the world has slowed down, although new sales volumes are decreasing, the company is able to grow its top and bottom lines thanks to its services.

Now, having seen Otis is a company worthy of being part of a portfolio built around high-quality dividend growers, we can ask ourselves one last question: at what price should we buy the stock?

According to Seeking Alpha Valuation Grade, Otis scores a D- which means its valuation is seen as a bit demanding. After all, the stock trades at a fwd PE of 23.7, a fwd EV/EBITDA of 16.2, and a fwd P/FCF of 19.8. And yet, the company also trades and an earnings yield of 4.2% and a FCF yield of 4.5% which suddenly makes it look a bit cheaper than what at first may have appeared.

I ran a discounted cash flow model with the recent financials Otis reported. I assumed an FCF growth rate of 5% for the next 5 years and a perpetual growth rate of 2%. I discounted the cash flows by 6%, considering Otis to deserve a premium.

Here is the result: Otis’ target price is $90.70. The stock now trades at $91.

Usually, I don’t like rating stocks with a hold. It sounds as if I am not committing. However, I think a hold rating is currently appropriate for Otis. No doubt the company is a high-quality one. But we can’t overlook how, in just three months, the stock has raced from $75 to $91, a 21% run-up. This has caused the valuation to become more aligned with the intrinsic value of the company. But, at the same time, it has reduced the margin of safety we should always try to have in case of sudden volatility or negative news.

Currently, I am neither adding to my position nor selling out of it. I will just let it compound nicely, keeping a bit of cash aside to take advantage of any dip that may occur.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.