Description

Executive summary

October 2018 has been an unusually volatile month, increasing the odds of mispriced securities.   Zardoya Otis stock has fallen by 26% increasing its FCF yield to 6.2%. Less risky than most equities, its dominant 25% position in the Spanish elevator maintenance market and local economies of scale in service engineer density mean that 25%+ historic returns on unlevered equity are sustainable into the future.  United Technologies’ 50.1% stake and the founder’s family’s 11.6% continued ownership provide downside protection and a likely valuation floor, as well as securing capital allocation via a 90-100% dividend payout. Any re-kindling of the busted Spanish construction market, or potential M&A involving UTX, would be a bonus.   

Valuation

2018 free cash flow should come in at €168-179 million.  The one adjustment I make is to add back in the royalties paid to Otis (€18.4 million pre-tax last year), since these depress reported earnings by more than would be probable for additional R&D expenses (the royalty depresses operating margins by 2.4%; global peers spend 1.5% of sales on R&D).  I expect that majority shareholder Otis would value the company this way in a transaction.

That makes the current FCF yield 6.02-6.43% compared to a 1.60% 10 year Spanish government yield.   So the market is charging an equity valuation that is merely average on a long-term basis, whereas Spanish discount rates remain far below the long-term average:

Source: https://fred.stlouisfed.org/series/IRLTLT01ESM156N#

Crucial to the thesis is that business quality here is much higher than average, meaning future cash flows to shareholders are more predictable than for an average stock.  

Elevator maintenance: a high quality business

I define a quality business as one that consistently and predictably earns high rates of return on unlevered shareholder capital.

This business has consistently earned 20%+ ROA in the past.

About one third of its entire balance sheet is funded at zero cost by customers and other trade payables.

If strategy and operations hold up, it would be hard to mess this up so that returns on unlevered equity proved anything other than terrific.

Can such a history be reliably predicted to continue?

Yes, because this historical record was the result of dominant regional economies of scale in elevator maintenance, which will continue to be the crucial competitive advantage in future.  

Service engineer density is a sustainable competitive advantage

An elevator is mechanical equipment that requires frequent maintenance by an onsite engineer.  This service is not a discretionary purchase by building managers and owners. In Spain it is decreed by law.  The legal minimum frequency of maintenance visits ranges from every month to every four months, depending on elevator type.  Office elevators, for example, require monthly visits; a residential elevator in an apartment building lower than six floors and less than twenty years old requires a visit every six weeks.    

Spain has the highest elevator penetration per capita of any nation in the world, at around 20 elevators per 1,000 people.  That compares to 2.8 for the US. The elevator market in North America is actually quite small in unit terms when compared to some other geographies, mainly because low to mid-rise residential elevators are under-represented.  Because the North American elevator market is so different to elsewhere, and these differences matter when trying to understand the economics of an elevator maintenance business, it might be useful to read this article on the local geography of elevators: https://www.theatlantic.com/business/archive/2014/10/why-does-spain-have-the-worlds-highest-concentration-of-elevators/381288/

Zarodoya Otis is the dominant service provider in Spain, currently maintaining 287,470 elevators, or about one quarter of the total.  This dominance allows us to consider historical economics predictably sustainable in future, because Zardoya Otis possesses defenses against new entrants.  

Lowest cost producer.  The key to understanding the economics driving the quality of this business is that route density is extremely important in the elevator maintenance business.  

During a typical service visit, an engineer will check the safety features of an elevator system; clean, lubricate and adjust components for performance; note any repairs required; identify any modernization opportunities; and complete a site report.  All these activities create value for the customer, and in some locations might take less than one hour onsite. The determining factor of who becomes the lowest cost producer has traditionally not been onsite productivity, however, but the avoidance of structural waste.  

Wasted engineer time is travelling between sites, or to and from the branch to collect spare parts and consumables; avoiding parking fines in some cramped medieval cities; sitting in a vehicle prior to a scheduled appointment with a building manager; or any of the other periods in a day when the engineer is not specifically working on elevator maintenance.  Reducing such waste, by increasing the number of site visits per day, significantly increases productivity. Higher frequency elevator interaction also assists in accelerating the training period of new engineers, because they see more repair action in a shorter period of time, enabling them to work solo sooner, safer.

For these reasons, the engineer who consistently has the highest route density, wins. I estimate that this company’s engineers make four maintenance visits on average per day.  

But this is not the only sustainable competitive advantage that Zardoya Otis has.    

Brand reputation.  Elevator riders have incentives to scan for fat tail risks.  They care about the safety and quality of their ride, and subconsciously assume that the Otis brand stamped on the elevator maintenance report on the inside of the elevator car should provide them with that.  It is not an irrational assumption, and explains why four long-lived, Western OEMs (Otis, Schindler, Kone and ThyssenKrupp) still dominate the elevator industry despite China’s recent rise. Brand reputation for quality and safety is hard earned in an industry where mechanical failures are infrequent but extremely hazardous or fatal, and when every single one is widely disseminated in the media.  As a trusted elevator brand grows in geographic footprint and longevity, it becomes more valuable, and so its owners acquire incentives to protect it from harm. They do this by training their engineers to higher standards, and by instilling conservatism into their operations.

High switching costs.  Building managers care about safety too, but also about cost.  But in order for a new entrant to convince a building manager to switch from Otis to them, the relevant comparison cost is unknown at the time of quote, and certainly not simply the price of a contract for future maintenance.  Shoddy maintenance would result in unusable elevators during unscheduled repairs. Any tenant forced to walk up stairs during the Spanish summer revolts against the overly-price-conscious building manager. The total cost in terms of rent rebates and potential loss of commercial tenants therefore makes such a cost comparison hard at the point of sale.  These high switching costs favor the incumbent.

For these reasons I think that this business is predictable into the future.

Potential catalyst

United Technologies is expected to complete the strategic review of its conglomerate structure within the next month or two.  It seems that management will only make Otis a standalone publicly traded entity if they conclude there is a high probability of it trading at a richer multiple than it does today:

“The real question is do you get a significant multiple expansion by having separate companies versus the conglomerate or the four businesses of UTC? Tough, tough questions. I would tell you that we’re looking at all of those possibilities.”  UTC CEO Greg Hayes, February 2018

Either way, Otis remains a highly cash generative business with limited opportunities to deploy capital:

“When you have...market-leading positions like we have in elevators, it's hard to think about big, big transactions that would pass antitrust scrutiny today.” Greg Hayes, Q3 2018 earnings call.

Buying the 49.9% of Zardoya Otis that it currently does not own would therefore represent one of the last opportunities for significant capital allocation into its core business.

And this business has not traded this cheaply for at least 20 years.

The 87 year old founder, Javier Zardoya, passed away 4 years ago.  His family’s investment vehicle, Euro Syns, holds 11.6% of outstanding and retains a board seat.  I would imagine that they would be aware of any approach. They last purchased Zardoya Otis stock at €8.37 per share in April 2018.

Other notable shareholders

AKO, respected by some as an investor in “quality” European businesses, bought 2.3% in May 2017, at considerably higher prices.

English Financials

http://www.otis.com/es/es/investor-relations/

http://www.cnmv.es/Portal/AlDia/DetalleIFIAlDia.aspx?nreg=2018115063

Appendix: Growth for free

Elevator maintenance is not Zardoya’s only business.  It also installs new elevators and modernizes existing equipment.  Both could pick up from recent distressed levels. Exports have partially replaced new installations, and been an intelligent use of Spain’s excess capacity during a decade long bust.  Otis’ new product Gen2 has helped recent Zardoya Otis’ modernization business in recent years. But anyone hoping for mean reversion in non-maintenance business should be aware that Spain’s construction boom and the subsequent crash have both been truly epic in scale.

source:

I do not hold a position with the issuer such as employment, directorship, or consultancy. 

Catalyst

(speculative) Otis pays a 50% premium to current market to buy out minorities after becoming a standalone company.