Description

Otis should survive current covid-19 challenges thanks to a combination of durable customer demand for elevator maintenance and sustainable competitive advantages.  Business margin of safety is more important than supposed valuation margin of safety at a time when many companies’ earnings and therefore net asset values seem unpredictable.  The odds of this spin-off producing a bargain have increased as parent UTX stock halved in the past 5 weeks. Debt is my biggest concern. In more normal times, Otis is a good business, earning high returns on capital (10%+ ROA; meaningless for narrower metrics) and requires no capital to grow due to negative working capital.  

Disclaimer: Please read the first two messages on the thread before continuing.

Introduction

“All I want to know is where I am going to die, so I’ll never go there.”  Charlie Munger

Here we are, each confronting our own mortality, and at the same time trying to figure out which public companies might not make it.  We know the features that we want our businesses to avoid: exposure to sudden stops in customer demand; single source purchasing; operating leverage and high fixed costs as a proportion of sales; financial leverage.  

But can we find the opposite?  Business models that enjoy customer demand resistant to change; the ability to maintain supply during massive supply chain shocks; a flexible cost base?  Apart from some financial leverage, which concerns me, I think Otis has a well designed business model for the current times.

That does not mean the stock will go straight up from here.  But you are all grown ups and knew that anyway.

Will it survive?  

Sales can decline by 35-50% before fixed costs cause operating losses.  I estimate variable costs for elevator OEMs such as raw materials and other production costs for New Equipment (“NE”) to be 21-35% of sales.  When added to 14% operating margins, Otis should still turn a profit this year even if NE and modernization sales (43%+10% of total) collapse.  

Elevator maintenance will continue.  The current health situation is already sad for many people and seems likely to worsen.  I do not mean to gloss over this important human impact. But even at worst case mortality rates currently considered, it will not meaningfully reduce global demand for elevator maintenance.  Almost all existing units will still need to be serviced in future. The supply of labor to provide this service will get hit in the short term. Firstly from sick leave, which will increase the workload on healthy employees, or reduce service frequency.  Secondly from potential government mandated lock-downs, although so far elevator maintenance has mainly been able to continue. After the next few months, the typical elevator technician will need to work, even if he is off sick now. He is male (99.2%: European 2018 data); earns less than $50,000 a year; performs a manual job; and cannot work from home.  One way or another, this market will clear, and ongoing persistent demand for elevator maintenance will be supplied. Even when government policy makers are overwhelmed, the basic rules of economics still operate, as outlined by Adam Smith in 1776 when pestilence was a common threat: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”  

Fixed costs are covered by maintenance revenues (47% of sales) of longer duration than expected covid-19 problems.  The typical service contract globally is about 4 years, so the weighted average duration of the 2 million unit portfolio hopefully gets us to a vaccine or some other kind of solution. Some Otis maintenance contracts last for 10 years, with large installations requiring Otis engineers permanently on site. Footfall changes (more in residential and hospitals, less in hotels and offices) does not necessarily reduce maintenance requirements.  Even if the economy enters a nuclear winter type scenario (OK, that’s an exaggeration) where no new equipment or any modernization happens for the next 10 years Otis has managerial levers to pull. NE and modernization purchasing can be frozen and staff redeployed to manage crisis logistics or to support maintenance staff.  The two sales forces are completely separate since they address different customers (architects and developers buy new equipment; building managers buy service). Taking an axe to the NE cost base should reveal a higher margin (19%+ vs 14% operating margins), consistently profitable maintenance business, half the size from a sales perspective but probably reducing profits by not much more than 20%.  In a non-functioning economy, write-offs and credit losses will increase; but churn will shrink. I don’t find many business models that come close to covering their fixed costs during a sudden stop. 

Further evidence of resilience:   

• Great Depression case study (see Appendix 1 & 2 below)

• Historical consistency in profitability: operating profitably every year since at least 1991.

• Geographic diversification reduces an investor’s dependence on any one crisis management strategy.  A US quoted and domiciled company operating in over 200 countries and territories provides policy diversification that could prove valuable during a crisis that is being managed in different ways across the globe.  

• 40,000 field technicians, and 29,000 other employees, who are used to getting things done, under pressure.  

• An example would be the recent removal and modernization of 68 elevators at the Empire State Building, weighing 26,000 lb apiece, unable to use normal tools due to safety regulations, while dealing with unions and midtown Manhattan traffic, and causing minimal disruption to a functioning office building and major tourist attraction.

• Workforce qualities matter a lot during crisis periods, especially at levels below senior management.  Some well educated, polished professionals turn to jelly when faced with their own doom, no matter how slight the chance.  Other unassuming, unpretentious characters come to the fore thanks to their consistent handling of complex logistical challenges, experience of confronting life’s adversities, or other leadership qualities previously hidden.  The Otis population seems better than average on this count.

• Businesses that survive this next tough period will likely see CEO’s thanking their people as crucial to company performance; the difference will be that this time it will be completely true and many of them will know it. 

Financial leverage is in my opinion a big threat to all equities at the moment.  Anchoring and insufficient adjustment is a human weakness.  It can be deadly during a crisis, when the rule is: adjust or die.

Some investors actively seek out equity that is levered using pre-crisis fixed term debt, so would probably point to the benefits of last month’s $5.3bn unsecured debt issuance, together with significant credit facilities.  Personally I would prefer fresh equity to be raised at the time of the spin to get debt free fast. Since this does not appear likely, the #1 priority for cash flow should be to generate a sufficient buffer to weather some very tough times ahead, the potential for reversals of working capital and non-payments from customers, and to defuse any ticking debt bombs.    

Financial leverage is mainly a generic risk on which preferences differ: we don’t yet know if any debt will be sustainable in the current environment.  Otis has some specific working capital dynamics that we can discuss in Q&A if there is interest.  

Industry

The Elevator and Escalator (“E&E”) industry is dominated by 4 OEMS.  Otis is the founder (1853). There are two family-controlled, publicly traded European companies: Schindler (1874, Switzerland) and Kone (1910, Finland).  ThyssenKrupp’s (1890) Elevator Technologies division was sold last month for €17.2bn by its struggling German conglomerate parent to a private equity consortium who paid 19x EBITDA / 21x EBIT (anyone else feeling nostalgic for February 2020?)  Some Asian companies (Mitsubishi and Fujitec in Japan, Canny in China and Johnson (private) in India) mainly compete regionally, not yet globally. Below that are thousands of small service companies that provide maintenance and repairs, but not the logistically daunting sale and installation of New Equipment.    

Business model

I simplify the OEMs business model to look like a combination of two others:

1. Toll roads in the sky.  The end user elevator rider has limited options for vertical travel within a building.  Once built, a well functioning elevator is the most efficient form of vertical transport, generating genuine economic value to the user on a habitual basis, affording the monopoly provider multiple opportunities for capturing a slice of these economics.  

2. Gillette: sell the customer New Equipment (razor) at low margin and then repetitively sell high margin maintenance (blade).

This is how Otis illustrates it:

If current economic fears materialize, NE and Modernization could collapse and remain extremely low for a year or two.  NE sales are a growth driver, including an embedded maintenance contract for an initial warranty period before the Service salesforce follow up to achieve conversion into their maintenance portfolio.  NE represents $5.6bn or 43% of total $13.1bn sales.  

Service sales of $7.5bn are 57% of total, and comprise Modernization (10%) and Maintenance and Repair (47%).  

The key to understanding the business model’s resilience into a major economic slowdown is that 80% of Otis’ profits are earned in the Service portfolio, generating a 21.4% operating margin vs 7.1% for NE. 

What makes elevator maintenance a good business?

1. High switching costs

A typical service customer is the building owner or manager for a residential apartment building or small office block, responsible for just a few elevators.  (Single elevator unit projects can comprise more than 75% of all Otis customers in some countries). This customer either inherits an existing Otis maintenance contract (average duration 4 years), or a New Equipment unit after the expiry of the initial warranty term during which Otis has been building a relationship and track record with frequent service visits.  Otis’ industry leading conversion rates of 93% (NE into maintenance portfolio) has economic justification, but also plenty of psychological ones.  

Elevator accidents cost lives and can be particularly gruesome.  Video evidence is often widely distributed. Perhaps you are most familiar with the elevator maintenance of your residential building.  You might think that the doorman or janitor plays no role in the choice of who maintains your elevator. But he has subtle incentives to prevent tragedies of tenants he greets daily, is a gate-keeper to the current elevator guy, and often to potential new entrants.  Does he maintain the status quo, or lower the drawbridge for a competitor?

Lower down the severity scale, bad maintenance creates a lot of stress for the building manager from irate tenants.  Most service customers therefore have insufficient cost pressure to justify cutting corners if they are not an expert on elevator maintenance and local elevator regulatory codes.  

The four OEMs therefore maintain about 1 in every 2 elevators, but “because of the types of units and level of maintenance required, these small and independent service providers win a smaller percentage of the service business when measured by value.”  I estimate that upwards of two thirds of the global elevator maintenance market by value is owned by the big four. OEMs can offer highly customized maintenance contracts, tailored and marketed to a customer’s individual preferences, which reduces price comparison.  

So customers often inherit - rather than select - their service provider.  But for those that do choose, barring major mishaps or inflation, high switching costs - often behavioural - prevent churn.

2. Route density: Economies of scale

“That 2 million portfolio though gives us scale, gives us density and gives us reach, and in this business, having that density on routes and in cities is what's critical to our success and it's what drives our profit premium above our nearest competitor.” Otis CEO Judy Marks.

Elevator maintenance is a local business.  It can be illustrated by the reason that the quote “If you want something done, ask a busy person” became a proverb.  The dominant elevator service provider in any locality will typically be the lowest cost producer and most effective maintainer of your elevator.  This competitive advantage reinforces the previous one. Speedy repair matters to a building manager who is measured by tenants every hour that an elevator is down, awaiting the arrival of the technician or spare parts.  So the natural carving up of service territories between the OEMs is more a result of natural economics, than of occasional historical antitrust issues. 

But is this competitive advantage vulnerable to technological change?

3. Possible benefits of digitalization 

Elevators have benefited from applying technologies such as IoT and Big Data to digitalize the Service offering.  Though an obvious development - applying cheaply available technologies from elsewhere to improve elevator monitoring, predictive maintenance and the productivity of elevator technicians - this innovation also contains risk for the OEMs.  Might fewer visits weaken route density economics? Will digitalization investment actually pay off for the companies making the investments, or will efficiency gains and improved service metrics accrue to end users, not the providers?  

Otis claims not.  Firstly, they argue that they will reap latent benefits from a large installed portfolio:

“And in that portfolio where we have 2 million of the 16 million last year, 9 million of that portfolio were held by independent service providers. Over 50% of the installed base is serviced by smaller independent service providers. We're going after that market. We're going after the 3.5 million units that had Otis controllers in them - we have about 1.5 million in our 2 million portfolio - because we'll be able to take fault codes off of those, we'll be able to use that data more effectively than any other service provider.”

Secondly, that innovation will protect its margin from mom & pop service providers:  

“We've changed the mindset from a fairly mechanical product, a robust product but a fairly mechanical product to make it electronic. And beyond all the speed advantages and data advantages that gives us, think of the service advantages that's going to give us. Think of your vehicle that you buy today and the fact that pretty much now you take it back to the OEM because it's got a smart computer in it and that's what's going to be part of IoT offering.” 

Fear of new technologies has served Otis well in the past: 

"When electric elevators were new, and when people were mystified by electricity and a little bit afraid of it, it was not unusual for an Otis man to make a trip of several days to replace a fuse," as the Otis Bulletin recalled in 1948.

And thirdly, Otis are seeing actual evidence of monetization of their digitalization efforts:

“we actually see a higher customer retention rate in the customers that are connected. We're also seeing that our latest eView system in our new equipment installations are creating this 8% to 9% increase in conversion rates from construction into our service portfolio.

At the same time, on average across the region, we're seeing a 19% increase in services revenue per unit for these systems. This technology is a key enabler as we go forward with our Otis ONE technology platform. We think that these systems can continue to provide rich data sets that allow us to better predict system failures and make sure that our customers are realizing data-driven business outcomes.” 

I think the jury is still out.  Elevators were largely unchanged mechanically for about one century.  A lot of innovation is being compressed into about a decade, and we have yet to see how strong the maintenance economics will prove at the new steady state, so margins should be closely monitored.

Spin-off playbook

Management has already given plenty of evidence that Otis should benefit from the usual spin-off playbook.  Increased focus should increase profits. Even large spin-offs like this one from UTX seem to leave a surprising amount of low hanging fruit:

“80% of free cash that we generate is outside the U.S. but most of our capital deployment needs are in the U.S. Interest payments, debt repayments, dividends. And the cost to [repatriate] that cash adds about two to three points to our tax rate...

Offshoring, the debt, placing the debt, where our cash is generated, not only reduces the need for repatriation of cash, but also our interest cost. And taking full benefit of the tax deductions that are available in jurisdictions outside the U.S. that is not something we do today.” 

Capital allocation should be tighter, and I expect higher return.

Do you really need me to spell out why this spin-off might be cheap?  What this special situation lacks in the micro: e.g. complexity or size - two common drivers of cheap spin offs, it makes up for in the macro.  The parent United Technologies has now sold off more in just 5 weeks (56%) than it did in 17 months from the 2007 peak to the March 2009 low. Many of us value investors have never had it so good.  Why doesn’t it feel that way?

Risks

1. Financial leverage from debt and working capital reversals due to collapsing NE demand

2. Digitalization benefits elevator riders more than providers

3. Generic risks of covid-19, including war

Appendix 1: Elevator Maintenance: how Otis survived the Great Depression

“Unemployment in the United States stood at 1.5 million in 1929,​ ​at 5 million a year later, and at 13 million at the end of 1932. A huge new oilfield discovered in eastern Texas destroyed the price of oil. Montana wheat rotted in the fields. In Oregon, sheep were slaughtered on the hoof because farmers could no longer afford to feed or ship them. By 1932 the Red Cross was so stretched that it could afford to give each impoverished family only 75 cents a week, and Herbert Hoover was icily commemorated in the tar paper Hoovervilles that sprang up around big cities, and by the Hoover blankets-newspapers-that their miserable denizens slept under at night. Banks went broke; speakeasies closed; veterans marched on the White House and were dispersed by tanks, guns and tear gas.

Otis did everything it could to protect its multi-talented staff from cutbacks, still hoping for an upswing that would call for their skills again.  Managers pressed salary reductions, shorter work weeks and work-sharing agreements on employees to stave off massive job losses, but the upswing never materialized. Conditions in the country only grew worse.  For a while the company was able to maintain itself with various monumental construction projects taken on before the Crash, but by 1933 even these had come to an end. There was simply no more work. The entire construction business had shrunk 90 percent. Major job losses occurred at Otis in 1935, across the board.

President Van Alstyne was certainly unlucky to come to the job when he did; yet temperamentally, he was just the man to manage seemingly endless decline, rather as Baldwin's exuberant faith had jibed with conditions of seemingly endless growth. Van Alstyne came from the same background as Elisha Otis: as a boy, he had lived and worked on a New York farm, and in 1889, at the age of 17, he took a job in canal construction, as foreman.  "Different lines of engineering" brought him to Sprague, and then to Otis, once Sprague had been absorbed. He was one of the clever young men brought into central operations in the early part of the century. He possessed a kind of old Dutch phlegmatism, and without formal engineering training, he was known for his "unusual capacity for mastering details."

It can be argued that conservatives make the most effective radicals, that when they embrace change under pressure of events, their initial reluctance gives way to the greater determination. Van Alstyne methods were painstaking and innately unshowy, but he managed Otis smoothly through an unprecedented era of contraction and oversaw a dramatic shift in the direction of Otis' business. Van Alstyne learned to recognize the benefits of long-term relationships in the market and to rate the solidity of service revenues over the mercurial satisfactions of pure sales.

The Depression taught him that. Sales slumped in 1930, the year he made his first report to shareholders, and in 1931 revenues fell by almost half. In 1933 the company registered its first book loss, a deficit repeated in 1934, though on a smaller scale. Almost half of Otis' 19,000 employees were laid off in the period, while Otis' common-stock dividends collapsed from $8 a share to 60 cents. Van Alstyne, as a new recruit remembered him, liked to play poker in smoke-filled rooms. He was very steady.”

"About 500 customers with traditionally high repair bills were offered "POG (parts, oil and grease) service, plus major repairs, at a fixed monthly sum." Sometimes, Jackson sweetly said, their costs dropped. But lower repair costs were secondary to the convenience when trouble got dealt with in advance, and the budgeting was simple. Jackson's system, such as it was, appeared to work, and when at last, in 1924, the figures were in place for a wide variety of machines, Maintenance got the go-ahead to launch itself nationwide. By the end of 1925 some 1,407 elevators were under Maintenance contracts in North America."

“…written in 1936 when Maintenance had proved itself at long last, as one of the mainstays of the business in a depression:

“Possibly because more new elevators were being sold than ever before,” he wrote of the year 1929-30, “possibly because of the rapid development of automatic control, possibly because of increased quality of Maintenance - most likely because of all three - Maintenance contracts increased to 9,227 in 1929, and to 10,081 at the close of 1930.”"

"“Then came 1932, perhaps the worst year that real estate activity has ever seen. Maintenance cancellations approximated 1,500.  But over 1,000 new contracts were sold, and the total billing dropped off only 2 percent from the peak! Almost all cancellations affected small machines in small speculative buildings where existing ownership could not survive, while larger buildings with large machines retained or increased their service - more impressed than ever with the desirability or necessity of Otis Maintenance.”

(Cecil) Jackson (who “almost single-handedly launched Otis’ maintenance business”) was alluding to a debate about pricing that had raged in the face of the worst depression anyone had ever known. Full Maintenance sold at a premium, in return for the promise of quality service. In a depression, some argued, prices should drop to stimulate demand. As the 1,500 cancellations of 1932 rolled in, this argument must have gathered strength.  Rival operators, after all, were prepared to take over Otis' maintenance contracts at substantially lower prices. Desperate pricing was in the air.

Jackson's team foresaw another outcome. Lowering prices, they argued, would lower the quality of service If anything, costs should rise, and with them the standards of maintenance. And they were right. When times were hard it was something to be able to say that the elevators ran well. People were prepared to pay for credible maintenance-for at least one link, perhaps, to the good times when the elevator had been commissioned, for some certainty in a crazy world. Meanwhile, many building owners were doing without janitors to save money, and needed someone to keep an eye on the elevator. As for Jackson's Maintainers, they knew they were lucky to have a job at all, and if this did not make them go the extra mile for their clients, Jackson's training served to remind them. He told his people how to sell a deal, and how to answer the more familiar objections to the Maintenance package. But once they were in there, once the job was theirs, he taught them to make a total commitment to quality and reliability, and give the customer what he wanted.

The postscript to Jackson's little history in The Maintainer was illus​trated by a diagrammatic worker striking a test-your-strength machine "a sledgehammer and ringing up the figure 11,347-the number of contracts out, "at least a thousand more than we had at the previous peak.  You can tell a great deal about a product or service by watching how it is affected in adverse times. Any service that can ride though six lean years and come out better than it started – that service had to be good!”"

Appendix 2: Otis Net Sales and Operating Profit during The Great Depression

Differences between 2020 and 1929:

• Maintenance is stronger. Maintenance was only launched Nationwide in 1924, so was still young and undeveloped when the Depression hit.  Then the company thought they were in the razor business. In 2020 it is well understood within the company that they are in the blades business: maintenance generates >20% segment margins; and already represents 80% of peak profits, which will only increase as New Equipment demand drops.   

• More geographically diversified.  The new, centralized International Division was only established in 1934.  Last year, international sales represented 73% of total.

• Residential, not just commercial.  The 1929 US maintenance portfolio would have been primarily commercial.  Residential elevators, especially in Europe, now account for a significant proportion of the current maintenance portfolio.

Appendix 3: The perils of debt

“When William Shannon, the editor of the post-World War II Otis Bulletin, read through young Charles Otis' journals of 1858, he was struck by how close the fledgling business had come to collapse. The journal is a dismal catalogue of bad debts and pressing demands that assailed the Otises, a near-despairing account of Charles' efforts to meet his creditors.  Shannon wondered how the company had survived and came up with an interesting explanation.

"The employees didn't save it. Where would they get the $1,000 apiece (which the firm owed]? The Otis family couldn't save it. Their money was all gone. The real reason the business pulled through, and the reason we have our jobs today," Shannon wrote, "is because Mr. Bashford let Charley Otis have ten tons of coal when he knew the shop couldn’t pay for it. Because Mr. Babbitt advanced $500 when he already was on the hook for a note due eight months before. Because people like Mr. Wooster were willing to risk their money on the ability and honesty of Elisha, Charley, Henry, Billy and the others in the shop." For Shannon, the message was clear: "Today we call that Capitalism, and no one has ever found a better way to do the job."”

Sources 

Otis, Giving Rise to the Modern City (2001) James Goodwin

February 11, 2020 Analyst Meeting

https://files.otis.com/otis/en/us/contentimages/Elevators%2C%20Mod%20Empire%20State.pdf 

The Wealth of Nations (1776) Adam Smith

Header financials are TTM proforma, unadjusted. This write-up is not intended to be investment advice, and expresses opinions only.

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