Otis: Down 10% Since July; China & Macro Fears Overstated
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Otis: Down 10% Since July; China & Macro Fears Overstated
Company Update (OTIS US) (Buy)
Highlights
New Equipment market is down, but earnings are driven by Services
China is less than 20% of Otis; Maintenance sales there grow strongly
Large backlog means that Otis New Equipment sales are still growing
Shares are at 25.3x 2022 EPS; 2023 outlook is for ~10% EPS growth
At $81.70, we see a 66% total return (17.2% p.a.) by end of 2026. Buy
Introduction
We review our Otis investment case after shares have fallen more than 10% since the end of July, and following an appearance by CEO Judith Marks at an investor conference last week (September 14):
Otis Share Price (Last 1 Year)
Source: Google Finance (20-Sep-23).
We have followed Otis (including as part of United Technologies) for more than 5 years, and first published our research on Otis online with a Buy rating in July 2020. Since then Otis shares have gained nearly 51% (including dividends).
We believe Otis shares are attractive. Investors may fear the market decline in New Equipment orders, which are expected to shrink by 10% in China this year, as well as by high-single-digits in both EMEA and Americas. The rising U.S. dollar is also a headwind. However, Otis profits are mainly driven by Maintenance and Modernization sales, which tend to grow regardless of macro and are up high-single-digits organically in H1. Even in New Equipment, a strong backlog means Otis sales are expected to grow 3-5% organically in 2023. China is less than 20% of the group and, within this, New Equipment sales are helped by a focus on large projects and market share gains, while Maintenance units continue to grow at mid-teens. Overall, management expects 2023 Adjusted EPS growth to be around 10% in U.S. dollars and we believe this will be achieved. At $81.70, Otis shares are at 25.3x 2022 EPS. Our forecasts indicate a total return of 66% (17.2% annualized) by 2026 year-end. Buy.
(For a recap of our investment case, see our April article.)
New Equipment Orders Down in Multiple Regions
We believe the recent weakness in Otis shares is most likely due to investor fears around the market decline in New Equipment orders, notably in China but also in Northern Europe and North America. During Q2 2023, Kone observed a 5-10% decline (in units) in China, as well as >10% declines in North America and EMEA (after interest rate hikes):
New Equipment Market By Region (Q2 2023)
Source: Kone results presentation (Q2 2023).
This picture of declines was changed when Otis CEO Judith Marks spoke at the Morgan Stanley Annual Laguna Conference on September 14, with industry declines this year (in units) expected to be 10% in China, as well as high-single-digits in both EMEA (driven by Northern Europe) and Americas (driven by North America):
“As we look around the world and the market today, our strongest market is actually Asia Pacific. We're seeing really strong growth in new equipment there, double-digit in India, but really kind of mid-single digit the rest of Asia Pacific …
Europe looks like it's going to be down high-single-digits this year … Middle East is up. Southern Europe looks really strong in terms of Italy and Spain. But we really are seeing the impact of interest rates and somewhat consumer confidence, especially in multifamily in Germany, in France and in the UK …
Americas, Latin America is strong, but North America looks like it's going to be down high single-digit …
China has got a range of outcomes. We said the market would be down 10%. That's what we saw quarter one, quarter two. And we're really not expecting it to bounce back up in the second half of the year.”
The picture in China may not improve in 2024, with Marks expecting “a wide range of outcomes” depending on the government’s policy response, including potentially another year of 10% decline unless bank lending is loosened.
Currency Also a Headwind
The rising U.S. dollar is also a headwind for Otis. Since July 31, the U.S. dollar has risen by about 3% against both the Euro (21% of 2022 sales) and the Chinese Yuan (19%).
Otis Earnings Are Driven by Services
Lower New Equipment sales will only have a modest impact on Otis, whose profits are 82% driven by Maintenance and Modernization sales (based on segment Adjusted EBIT as of 2022), which tend to grow regardless of macro.
Even with currency headwinds, Otis Service revenues have continued to grow in U.S. dollars in recent quarters, which have also helped Adjusted EBIT maintain its sequential growth in dollars:
Otis Sales By Type & Adjusted EBIT By Quarter (Since 2021)
Source: Otis company filings.
Organically, Service sales grew by 7.9% year-on-year in H1, including by 8.0% in Maintenance & Repair and by 7.1% in Modernization. Maintenance sales growth was backed by a 4.2% year-on-year growth in the number of units in both Q1 and Q2, driven by a 94% retention rate and a 64% conversion rate (as of December 2022).
There are powerful structural drivers that will ensure Services revenues continue to grow. In Maintenance, the rising penetration of connected services has added to Otis’s advantage, with CEO Judith Marks declaring that:
“Independent service providers … they just can't put an ecosystem together for a connected offering like our Otis ONE.”
Similarly, in Repairs and Modernization, demand will continue to rise as the current install base continues to age, including the large number of elevators installed during the construction boom in China in 2005-15.
New Equipment Sales Still Growing
Notwithstanding the market decline in New Equipment orders, Otis’s own New Equipment sales grew in H1 and are expected to grow for the full year, helped by a strong backlog.
In H1, Otis New Equipment sales grew 4.9% organically, and showed positive growth in all regions. Even in Asia, double-digit growth in Asia Pacific (led by India) more than offset a low-single-digit decline in China:
Otis New Equipment Sales Organic Growth (H1 2023)
Source: Otis results presentation (Q2 2023).
For full-year 2023, management outlook is for New Equipment sales to show a 3-5% organic growth, again with positive growth in all three regions (low-single-digits in Asia, mid-single-digits in Americas and EMEA).
The resilience in Otis’s New Equipment sales is helped by its strong backlog, which has continued to grow in 2023 year-to-date despite a 4.0% decline in new orders:
Otis New Equipment Back Log & Orders (H1 2023)
Source: Otis results presentation (Q2 2023).
Note not all New Equipment sales are of the same margin, and New Equipment margin is much higher in China. So, despite the higher sales, New Equipment Adjusted EBIT in fact fell by 8.7% year-on-year in H1 2023.
China Macro is Marginal to Otis
While headwinds in the property sector in China, we expect the impact on Otis to be limited for a number of reasons.
China was only 19% ($2,573m) of Otis sales in 2022 and, given China was described as one third of New Equipment (“NE”) sales, China NE sales was only 14% of Otis sales. While NE sales in China are higher-margin than those in other markets, they are still lower-margin than Service sales there. So, even if we were to assume non-China NE sales to be zero-margin and China NE to have the same margin as Services, China NE would still be less than 20% of group profits.
Otis Sales – China vs. Non-China (2022)
Source: Otis company filings & Librarian Capital estimates.
Otis’s China NE business is also less affected than the market because of its focus on large projects in Infrastructure and Industrial, the only two subsectors that grew in H1 2023. This means Otis NE orders have declined less than the market, for example by 5% vs. the market’s 10% decline in Q2 2023.
This outperformance against the market means Otis has gained market share overall in China. Management has also improved their capabilities in China, including in their agent distributor network and key account coverage, and these are likely to have generated market share gains in individual subsectors too, though no actual data has been disclosed.
Otis’s China business has also continued to benefit from a strong growth in Maintenance sales, with Q2 2023 being the 8th consecutive quarter where the number of Maintenance units has grown by mid-to-high-teens year-on-year. As mentioned Service sales have higher margins than NE sales.
So, overall, we believe macro headwinds in China would only have a limited impact on Otis earnings.
10% EPS Growth in 2023 Outlook
Management’s full-year outlook, revised upwards slightly at Q2 results, include a 2023 Adjusted EPS growth of around 10% in U.S. dollars, from $3.17 in 2022 to $3.45-3.50:
Otis 2023 Group Outlook (Updated)
Source: Otis results presentation (Q2 2023).
Adjusted EPS was $1.72 in H1 2023, up 6.2% year-on-year and already about half of the guided full-year figure.
We believe this full-year 2023 outlook will be achieved.
Otis Valuation
At $81.70, with respect to 2022, Otis shares have a 25.3x P/E and a 3.7% FCF Yield. This somewhat understates actual earnings as the 2022 figures are not pro forma adjusted for the Otis Zardoya buyout in Q2:
Otis Earnings, Cashflows & Valuation (2020-22)
Source: Otis company filings.
Relative to the mid-point of the latest 2023 outlook above, the P/E is 23.5x and the FCF Yield is 4.5%.
Otis pays a dividend of $0.34 per quarter ($1.36 annualized), last raised in April this year by 17%. The current dividend implies a Dividend Yield of 1.7%. (Management targets a Payout Ratio of 35-40% relative to GAAP Net Income.)
Share repurchases are expected to be $800m in 2023, equivalent to 2.4% of the current market capitalization.
Otis Stock Forecasts
We raised our 2023 EPS forecast slightly and extend our forecasts to 2026. Our assumptions now include:
2023 EPS of $3.48 (mid-point of $3.45-3.50 outlook) (was $3.45)
From 2024, Net Income growth of 8.0% (unchanged)
Share count to fall by 2.0% each year (unchanged)
From 2024, a Dividend Payout Ratio of 37.5% (unchanged)
2026 year-end P/E multiple of 28.0x (unchanged)
Our new 2025 EPS estimate of $4.22 is 1% higher than before ($4.19); our 2026 EPS forecast is $4.65:
Otis Illustrative Return Forecasts
Source: Librarian Capital estimates.
With shares at $81.70, we expect an exit price of $130 and a total return of 66% (17.2% annualized) by 2026 year-end.
We reiterate our Buy rating on Otis.
Ends
Stocks mentioned: OTIS 0.00%↑We are long Otis.
Disclaimer: This article consists of personal opinions, based on information believed to be correct at the time of writing, but not guaranteed. We undertake no responsibility in updating content in this article. Nothing published here should be taken as financial advice.