Photosomnia/E+ via Getty Images Introduction We review our investment case on Otis Worldwide Corporation (NYSE:OTIS) after the company released Q4 2022 results last Wednesday (February 1). The price of OTIS stock has remained largely unchanged since. We initiated our Buy rating on Otis in July 2020. Shares have gained 54% (including dividends) in less than 3 years, though the share price is currently up less than 4% in the past 12 months: Otis Share Price (Last 1 Year) Source: Google Finance (06-Jan-23). Click to enlarge Our investment case continues to be on track, with Adjusted EPS growing high-single-digit operationally year-on-year in both Q4 and full-year 2022. Including currency but excluding Russia, Adjusted EPS grew 7.5% in 2022. The key Maintenance business grew units by 4.1% and like-for-like pricing by 3% in 2022; Adjusted EBIT margin expanded another 30 bps to 15.7%. Management expects Adjusted EPS to grow by another 6-10% in 2023, even with a contraction in industry New Equipment units. The decline in China is decelerating, supported by new government policies. Otis shares are trading at 25.0x the mid-point of 2023 guided EPS and have a 1.4% Dividend Yield. Our forecasts indicate a total return of 42% (13.3% annualized) by 2025 year-end. Buy. Otis Buy Case Recap Otis is the largest player by sales in the global elevator and escalator industry. We believe Otis and its peers to be high-quality businesses, thanks to the structural growth in demand from urbanization and connected services, recurring Maintenance and Modernization services (which generate most of the profits, except in China), a highly consolidated competitive landscape, and a capital-light manufacturing model that sources components from a network of suppliers. Otis is different from its main competitor KONE (OTCPK:KNYJY) (also Buy-rated) in important ways: Much lower exposure to China (20% of 2021 Net Sales, vs. Kone’s 35%) Lower exposure to New Equipment (45% vs. 53%) More explicit EBIT margin expansion targets Ongoing program to lower its effective tax rate More optimized capital structure, with net debt and buybacks Otis EBIT & Net Sales Breakdown (2021) Source: Otis 10-K filing (2021). Click to enlarge These differences, especially the lower exposure to the slowing Chinese construction market, mean Otis now has much better medium-term earnings growth potential than Kone in our view. Otis targets a 10%+ EPS CAGR in the medium term, as set out at its investor day in February 2022, including: An organic sales CAGR in the low-to-mid single-digits An average Adjusted EBIT margin expansion of 40 bps annually A reduction in effective tax rate from 28.5% in 2021 to 25.0-27.0% Otis Medium-Term Outlook Source: Otis investor day presentation (Feb-22). Click to enlarge Both organic sales growth and EBIT margin expansion are expected to be driven by the Service segment. In addition, Otis aims to return most of the Free Cash Flow (“FCF”) generated to shareholders in dividends and buybacks. Since 2022, the industry has faced rising cost inflation and a slowdown in the construction market in China. We expect Otis to be able to offset cost inflation with price increases and productivity savings, while declines in New Equipment sales in China are being offset by a growing Maintenance business and may be alleviated by new government support. Q4 2022 results show the same dynamics are continuing and our investment case remaining on track. Otis Q4 2022 Results Headlines Otis’ Adjusted EPS again grew high-single-digit operationally year-on-year in both Q4 and full-year 2022, in line with our investment case (where the 10%+ expected growth includes benefits from a falling tax rate and buybacks). In 2022, Adjusted EPS grew around 7% ($0.21) operationally, despite a $0.19 headwind from commodities cost inflation. Including currency, the Zardoya acquisition, a lower tax rate and buybacks, Adjusted EPS grew 7.5%: Otis Adjusted EPS Bridge (2022 vs. Prior Year) Source: Otis results presentation (Q4 2022). Click to enlarge The picture for Q4 2022 is similar, with Adjusted EPS growing nearly 10% ($0.07) operationally and, including the same non-operational factors, growing 4.2% year-on-year. The relatively low Adjusted EPS growth in Q4 was largely due to 1.9% decline in Adjusted EBIT in U.S. dollars, largely due to currency (but offset by lower tax and buybacks); excluding currency, Adjusted EBIT grew by 7.6%: Otis Group P&L (Q4 2022 vs. Prior Year) Source: Otis results release (Q4 2022).NB. Figures exclude Russia from both periods. Click to enlarge All figures quoted here have been adjusted to exclude Russia, which Otis exited as a result of the conflict with Ukraine. Russia was less than 2% of Otis’s sales and Adjusted EBIT in 2021 and, even including the contribution from Russia in 2021 (but not 2022), Adjusted EPS grew 5.5% year-on-year in 2022: Otis Key Financials, Including & Excluding Russia (2022 vs. 2021) Source: Otis results releases.NB. Figures on adjusted basis; percentages impacted by rounding. Click to enlarge Importantly, Otis’s 2022 growth was again driven by the same recurring structural drivers as before. Service Again Driving Earnings Growth The Service business, including the recurring Maintenance business, again drove Otis’s earnings growth. In Q4 2022, even after currency headwinds, Service Adjusted EBIT grew 1.9% year-on-year, while the much smaller New Equipment Adjusted EBIT declined by 5.3%; excluding currency, Service Adjusted EBIT grew 11% and New Equipment Adjusted EBIT grew 4%: Otis Adjusted P&L (Q4 2022 vs. Prior Year) Source: Otis results release (Q4 2022).NB. Some percentages impacted by rounding; Russia excluded from both periods. Click to enlarge Group Adjusted EBIT margin was flat year-on-year in Q4, expanding 70 bps in Services but shrinking 10 bps in New Equipment, a good performance given cost inflation and currency headwinds. Organic Net Sales growth was 6.1% year-on-year as of Q4 2022, including 6.5% in the key Maintenance & Repair business. Maintenance sales growth was driven by a 4.1% growth in the number of units and a 3% growth in like-for-like pricing, offset by a negative mix shift (as lower-price Asia grew at high-single-digits, faster than the rest of the group). Maintenance unit growth was helped by a 94% retention rate and a 64% conversion rate (from New Equipment sales). Maintenance pricing may take a step up in Q1 2023, as contracts often include inflationary clauses (especially in Europe and the Americas) that take effect in Q1 each year, so 2022 increases had not fully reflected the acceleration of inflation during the year after Russia invaded Ukraine on February 24. Modernization sales grew 8.8% organically in Q4, fastest among Otis’s three businesses, with double-digit growth in both Americas and Asia Pacific. This was likely helped by an aging install base (in the U.S.) and the popularity of connected services. Modernization backlog was up 7% year-on-year in constant currency as of Q4. New Equipment sales grew 5.1% organically in Q4, with double-digit growth in both EMEA (up 12.0%) and the Americas (up 10.7%), offset by Asia being “down slightly” (down mid-single-digits in China, but up low-teens in Asia-Pacific). For full-year 2022, the picture is similar, but with lower growth rates as growth was much lower before Q4. (Organic sales growth was 3.1%, 0.4% and 0.8% respectively in Q1-3.) New Equipment sales down 1.7% organically: Otis Adjusted P&L (2022 vs. Prior Year) Source: Otis results release (Q4 2022).NB. Some percentages impacted by rounding; Russia excluded from both periods. Click to enlarge Full-year group Adjusted EBIT margin expanded another 30 bps to 15.7%, including a 50 bps expansion in Service. Otis 2023 Outlook Otis expects Adjusted EPS to grow by another 6-10% in 2023, even with a contraction in New Equipment sales. With Q4 2022 results, Otis released its outlook for 2023 that includes: Organic Net Sales growth of 4-6% Adjusted EBIT growth of $130-175m (implying 6-8% growth) Adjusted EBIT Margin expansion of 20-30 bps Adjusted EPS of $3.35-3.50 (implying 5.5-10% growth) Free Cash Flow of $1.5-1.55bn (implying 7-10.5% growth) Otis 2023 Group Outlook Source: Otis results presentation (Q4 2022). Click to enlarge Among management assumptions is a contraction in industry New Equipment units globally, with units expected to be flat year-on-year in the Americas and EMEA, but to be down mid-single-digits in Asia (including to be down 5-10% in China), all significant decelerations from the industry unit growth seen in 2022 (except in China, where units fell 15%): Otis 2023 New Equipment Unit Growth Assumptions (vs. 2022 Actual) Source: Otis results presentation (Q4 2022). Click to enlarge Otis expects its own New Equipment sales growth to be 3-5% organically in 2023, including mid-single-digit growth in the Americas and Europe, and low-single-digit growth in Asia: Otis 2023Organic Sales Outlook (vs. 2022 Actual) Source: Otis results presentation (Q4 2022). Click to enlarge Otis’s 2023 outlook for New Equipment sales is evidenced by its backlog, where the New Equipment component is up 11% year-on-year (excluding currency). It is helped by Otis’s market share gain (up 1 ppt in 2022) and increased pricing (up 3% globally in 2022, including being price/cost-neutral in China) in the New Equipment market. China Construction Market is Stabilizing The decline in the New Equipment market in China is decelerating, supported by new government policies. This is a positive for Otis, though it is not a crucial part of the investment case. As noted above, industry New Equipment units are only expected to shrink by 5-10% in 2023, compared to 15% in 2022. New Equipment orders in China also returned to growth in Q4, with a “mid-single-digit performance”. Otis CEO Judith Marks also shared a number of positive observations about on the earnings call: “The Chinese economy is in a state of recovery now … It’s a fluid situation on the ground between liquidity and the COVID-related absenteeism as we come back from the Chinese New Year … As we go through the first few quarters of 2023, first of all, we’re very encouraged by the government policy and actions to-date.” Kone, Otis’s main competitor with the #1 market share in China, has forecasted a slightly worse industry decline (“somewhat over 10%”) but likewise highlights the potential benefit from government support measures. As Kone CEO Henrik Ehrnrooth said on their Q4 earnings call: “We have seen a lot of policy announcements to improve the situation for developers to enable them to refinance themselves, to get financing, to be able to drive the whole property sector forward. So those have clearly created much more optimism and, therefore, there are encouraging signs for the market.” We believe the China New Equipment market should stabilize in 2023 and resuming growing in 2024. Valuation – Are Otis Shares Overvalued? At $84.73, with respect to 2022, Otis shares are trading at a 26.4x P/E and a 3.6% FCF Yield. However, this likely understates actual earnings as the figures are not pro forma adjusted for the Otis Zardoya buyout in Q2: Otis Earnings, Cashflows & Valuation (2020-23E) Source: Otis company filings. Click to enlarge Relative to the mid-point of the 2023 outlook, the P/E is 25.0x, and the FCF Yield is likely to be nearly 4%, as FCF (management definition) is expected to be $80m higher at mid-point but dividends to non-controlling interests should be much lower after the Zardoya buyout. (They were only $11m in Q4, down 56% year-on-year.) Otis pays a dividend of $0.29 per share (raised 21% in April 2022), or $1.16 annualized, implying a 1.4% Dividend Yield. Management targets a Payout Ratio of 35-40% (relative to GAAP Net Income, but this is similar to Adjusted). Share buybacks are now expected to be $600-800m in 2023, equivalent to 2% of the current market capitalization at mid-point, slightly lower than the $850m carried out in 2022. Net Financial Debt was $5.58bn at 2022 year-end, or 2.4x EBITDA, likely at the high end of management appetite. Management had described “just over 2x” as “a good number” at the investor day in February 2022, but the ratio has likely worsened with the stronger dollar – 72% ($4.81bn out of $6.67bn) of Otis’s long-term debt is dollar-denominated. Otis Stock Forecasts We reduce our 2023 forecast and 2025 valuation multiple slightly, but keep other assumptions unchanged. We now assume: 2023 EPS of $3.43 (mid-point of $3.35-3.50 outlook) (was $3.53) From 2024, Net Income growth of 8.0% (unchanged) From 2023, share count to fall by 2.0% each year (unchanged) From 2023, dividends to be based on a Payout Ratio of 35% 2025 year-end P/E multiple of 28.0x (was 29.0x) Our new 2025 EPS estimate of $4.16 is 3% lower than before ($4.29): Otis Illustrative Return Forecasts Source: Librarian Capital estimates. Click to enlarge With shares at $84.73, we expect an exit price of $116 and a total return of 42% (13.3% annualized) by 2025 year-end. Is Otis Stock A Buy? Conclusion We reiterate our Buy rating on Otis Worldwide Corporation stock. 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.
