Otis Worldwide Corporation (OTIS) Earnings Call Transcript & Summary

Ladies and gentlemen, thank you for standing by and welcome to the Otis Worldwide Corporation investor webcast hosted by Barclays. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, Julian Mitchell. Thank you. Please go ahead.

Thank you very much, Brandy, and thanks, everyone, for joining. It's my great pleasure to have on today's call from Otis, Judy Marks, President and CEO; and Rahul Ghai, CFO. It's been a very busy time at the company in light of the spin occurring only a few months ago and, of course, compounded by the macro backdrop of COVID-19. So we thank Judy and Rahul for making this time available to us. In terms of format, Judy will kick off with a couple of minutes of introduction. The call overall, we're expecting to last around 45 minutes. Please feel free to e-mail me your questions to ask anonymously at julian.mitchell@barclays.com or send me a question directly via the webcast screen. So with that, I'll hand over right now to Judy.

Thanks, Julian. Starting with our opening statement, please note, except where otherwise noted, the company will speak to results from continuing operations, excluding restructuring and other significant items. The company will also refer to adjusted results where adjustments were made as though Otis was a stand-alone company in Q1 2020 and the prior year. A reconciliation of these measures can be found on the company's website. We also remind listeners that this discussion contains forward-looking statements, which are subject to risks and uncertainties. Otis' SEC filings, including its registration statement on Form 10 and its Form 10-Qs, provide details on important factors that could cause actual results to differ materially. It's great to be with you this morning, Julian. And let me just start with probably the most important element that we are, at Otis, executing on our long-term strategy. We're creating value for both our customers and shareholders, which will drive sustainable growth over the midterm. Through the cycle, we're investing, and we intend to continue to lead our industry and thought leadership in diversity, equity and inclusion and in EPS growth. Our Q2 results were solid and stronger than expected, especially due to COVID in both the Americas and in EMEA. We were encouraged by recovery trends in China, and all of this highlights our resilient service business. Our free cash flow of $628 million in the second quarter, a 280% conversion with strong working capital performance drives a strong liquidity position, with $1.9 billion of cash balance and $1.5 billion of our undrawn revolving credit facility. This, in addition to our performance through the first half, gave us the belief and the conviction to improve our outlook across the board for the fiscal year 2020. We improved our sales outlook, our operating profit, with EPS improvement, free cash flow improvement and also gave us the confidence through the free cash flow to improve our planned debt repayment of an additional $100 million this year to $350 million. We'll share during this conversation, I'm sure, the recovery trends we've been seeing in July and August. But overall, we're seeing small improvement right around what we were expecting and in line with how we built our guidance. And finally, we continue to define who Otis is and who we intend to be with the actions we're taking, whether it's thought leadership with a study we recently commissioned with Purdue University about elevator airflow during times of COVID and other challenges or what we're doing in terms of diversity, equity and inclusion by joining the Paradigm for Parity Coalition and by, most importantly, visibly, putting into place actions for our commitment to change in terms of how we're going to lead Otis into our future. With that, let me turn it over to you, Julian, for questions.

Thank you very much, Judy. So maybe the first question would be, you've spun out of UTC 5 to 6 months ago. Maybe help us understand how you're finding the experience as a stand-alone public company. What's being done differently now relative to the prior existence within UTC? And perhaps there's an addendum to that. When you compare yourselves with other corporates, who are you benchmarking against? What are the key metrics that you're tracking?

Sure. Let me start with really what the experience has been like. I think we've -- we were preparing for this since late 2018, and we really use 2019 as a proof year for us, to be ready to become an independent company, to hold ourselves accountable and to deliver the results we knew we needed to both the UTC investors but more importantly to ourselves. And every quarter, we showed consistent improvement in 2019. We had our operating profit up $100 million in constant currency and had earnings growth, again, in both our new equipment and our service sectors. As we came into '20 and getting ready for the April 3 spin, we had very solid performance in the first quarter and, again, solid performance in the second quarter as well. We had improving overall company margins. We had profit expansion of 70 basis points for the first half of '20 versus the first half of '19 despite a 4% organic decline in sales, which was due to COVID impacts and/or lack of access to job sites and, again, reflecting the resiliency of our business. We continue to invest in the company. So while we put cost containment activities in place, we continue to invest and really advance our innovation muscle. But what's really changed and what I think everyone in Otis can feel is everything matters, whether it's little things that matter that we can then accelerate at scale, whether it's every quarter meeting our commitments for our investors, we no longer have cover from our parent. And most importantly, I think the biggest pivot we've made is to becoming a growth company again. And to do that, we had to change our metrics. We had to change our incentives, and we did all of that to not just focus on the near term but to focus on becoming a competitive growth company, especially against our peers, both our elevator peers and then more challenging against some of our industrial peers. So we focus on what matters, of productivity of our service business where we have 33,000 field professionals, again, providing essential service, working on our material productivity every quarter, and we're very pleased with the progress we've made there. And then really ensuring our SG&A is what's needed, whether we were a public company or just to operate the business and rationalizing everywhere to gain efficiencies across the board. So again, it's focus, it's taking care of the little things and it's making sure that whenever we put something out there for our customers or our shareholders, we meet our commitments. Who we look at? We really do compare ourselves to 2 different sets of benchmarks. One, the elevator and escalator industry, which is its own vertical. And so we constantly compare ourselves there in as many metrics as are visible. As you know, we're the only U.S. and SEC-governed public elevator and escalator company, so the metrics are always not identical. And then we really are focused on key industrials who also have service businesses so that we can benchmark ourselves in terms of other short-cycle businesses. Even though we're not short cycle, our ability to take trends to invest, to have digital acceleration, we need to hold ourselves accountable to that as well.

And you'd mentioned a brief comment around current demand trends. Maybe if you could just expand on those a little bit in terms of what you're seeing on Service versus New Equipment. And also on the New Equipment side, your orders were down about 7% in Q2 organically. Do you think that sort of rate is a good placeholder for the second half in terms of new equipment orders?

Let me touch on both of your questions there. Obviously, we do run our business in 2 business segments: Service and New Equipment, each with different rates of margin and each with different skill sets at times. Our Service business continues really to be resilient. We were deemed to be an essential business throughout COVID. And I think you saw that we had 170 basis points of margin expansion even in Q2 for our Service business. So it's continued to be resilient. On the New Equipment side, we are experiencing some of the macro headwinds that many people have seen that's really making the new equipment environment more challenging. Again, that's construction sites, job site availability. And you see that year-to-date in our sales and orders number. On the New Equipment side, we do expect to see recovery in the second half of the year, and we are seeing new equipment job sites becoming more open across the globe. Through the end of August, we're closer to 95% open, and that is a global number. There's still a few areas in regions in the world like India where we're just under probably 60%. A lot of that due to mobility, government restrictions and some of the migrant labor not being able to be addressed. But we do see recovery in the second half on the New Equipment side. And we also believe the Service business is going to see some improvement. We're down 10% at constant currency year-to-date on New Equipment, and we see the full year playing out mid- to high single-digit. So that clearly implies a recovery in the second half. And if you're trying to kind of watch us Q3 versus Q4 from a cadence perspective, Q3 should be better than Q2 and then Q4 should sequentially improve over Q3 on New Equipment. On the Service side, we expect some of our repair volumes that were impacted just due to access to buildings in the first half to improve into the second half. I'd say that growth rates are somewhat smaller because our maintenance and repair business, the majority of that part of our Service segment is contractual maintenance. So the dollar improvements there will be smaller in the second half of the year. Orders is what we are watching very closely. This is going to be an indicator for us on 2021 because of the strength of our backlog. The second half of 2020, our revenues will be performed from that backlog. And the market segment is down in terms of new equipment this year. And when we looked at this pre-COVID, so back about February, we don't yet have an idea how much the market has shrunk, but we think it's down high single digits. And that's why, for us, it's important that we continue to gain share in every market we're in. Against that backdrop, we're up about 1% a share year-to-date. And we think that shows our strategies are working. So with mid- to high-teens share currently, we think we have the opportunity in every market, even in a challenging down segment, to continue to gain share. We've added sales force. We've got some -- to get better coverage. We've added new products in terms of our Gen2 Prime, and we've added innovative new health solutions to also help.

And the -- you mentioned the new equipment side and the market being down high single digits year-to-date. China remains the biggest OE market globally. What can you tell us about what you're seeing there in terms of, I suppose, demand trends? Any step-up in consolidation among local service providers or OEMs? And also what your strategy is in China? How you -- how good do you feel about the share gains in that market?

China -- so let me talk to all 3 of those. Let's first talk to consolidation. We are not seeing significant consolidation at this point in China. The top 10 OEMs now have over 90% of the new equipment share. So that, over the past few years, has naturally happened, and so we don't see additional new equipment consolidation happening and actually fairly minimal consolidation amongst the ISPs. Our China business really bounced back nicely in Q2, strong performance. We are continuing to see those trends in Q3, and we think we'll be about that level of run rate for the rest of the year. We had over 100 basis points of share gain in China, double-digit unit gains in Q2. But we are seeing more price competition in China, especially in the infrastructure market, but pretty much across the board. Most companies after Q1, which is when China was decelerating in their V and coming back in Q2 and accelerating, people were trying to gain volume, and we saw some price pressures, and we had some booked margin pressures ourselves in Q2 in China, which we'll have to find productivity offsets for when that hits us. Now it's in the bookings, it will hit us from a revenue perspective out in '21. On service side in China, we are continuing to invest in our business. It will eventually overtake EMEA in a few years as the largest service market. And we know we need to grow there. We need to grow size, scale and density like we have in the rest of the world. But we now have the ability to invest in that and make a difference as a stand-alone company. And we are continuing to do that right now as we go into the second half. A lot of folks think that Service profitability is lower, and it is right now in China than the rest of the world, but the margins are still good and higher than the New Equipment margins. So all growth in China is margin accretive, and we will continue to grow there.

And you did touch on pricing within China a couple of times. Your peers' comments back at the Q2 earnings also caused some investor concerns around pricing conditions perhaps in the European service business as well. Maybe help us understand what's happening in European service pricing right now. And as you look out, is the broad assumption that pricing trends globally in the elevator industry will get worse because customers are under a lot of pressure in terms of occupancy rates and rental incomes and so forth? Or do you think that the pricing you're seeing now, this is sort of the low point perhaps as you look out?

Let me start with the fact that pricing is going to follow macroeconomic trends. We know that we've got the backlog, and in a long-cycle business, we have the ability to make sure that we can achieve cost reductions and productivity. And let me give Rahul a chance to answer the pricing pressure we're seeing and bring my partner on the line here.

Yes. Thanks, Judy. So Julian, I think on the service pricing, I think we mentioned that our -- outside of the temporary price concession, the environment has been stable. We've got a little bit of price in Q1, and we achieved a similar level of year-over-year price increase in Q2. So other than the pricing concessions, the service pricing globally has been stable. And the pricing concessions are limited to the hospitality and the retail segment that makes up less than 10% of our portfolio. And if you go back historically, what we saw even back in 2019, we saw a good price increase, including about a couple of points of price increase in Europe. So it's been stable. Obviously, we are watching that very, very carefully. But the good news is that our productivity initiatives on the service side continues to deliver. And our hours per unit, which we track very closely, were down 4% between 2016 and 2019. The calls for elevator that we make are down about 3% over the last couple of years. So all these metrics that drive productivity continue to head in the right direction. And that helped us gain about 90 basis points of margin in Service in the first half. So yes, pricing is important, productivity is important, and we are managing those dials very, very carefully. So on the New Equipment side, I think we spent a lot of time on the Q2 earnings call on this topic, but our message has been very consistent right since Investor Day. Listen, we're going to drive material productivity. That's about 3 points on a material spend of about $2.3 billion, $2.4 billion. And we didn't build any of that into our margin outlook over the medium term. And what we said was that this material productivity will offset any pricing pressures that we -- that may manifest in the market. So it's not that I think our commentary was any different than what our peers said and we said, listen, our booked margins are down about 70 basis points. All we're trying to say is, listen, we understand that there could be pricing pressures in the market. We're going to be focusing on what we can control and just continue to deliver on our margin expansion strategy for the company overall. So that's been the message right since Investor Day for us.

And are you seeing -- there's been this notion on that service side, the bigger digital push, digitization of elevator service is perhaps making service attrition rates lower and the customers stickier for the established OEMs who have the budget to invest in digital. Are you seeing that play out? Or do you also start to see new competitors emerging with that digital background, smaller companies like WeMaintain and so forth that we get asked questions about? So I just wondered how you saw competition changing as digitization of the industry rises.

Yes. We absolutely have evidence that units become stickier in terms of retention rates. We've got the industry-leading retention rates at about 93% already, but that still leaves opportunity for us, again, to convert new equipment customers as well as to retain even more service customers. We've been connecting units for over 30 years, originally during -- via with phone lines, but we've got a tremendous amount of experience. And what's even more important with those units is it gives us access to a data link to understand the performance from Otis controllers of how elevators are operating different sets, different generations so that we can draw conclusions and start doing predictive maintenance and proactive maintenance. And then when we do, Julian, have digital products, whether it's our eView product, which is becoming more pervasive, especially in EMEA, our Compass destination dispatch product. Wherever we have digital products, our retention rates are higher, significantly higher than our overall 93% global retention rate. So any type of connectivity, be it Internet of Things, which is our Otis ONE offering, again, our Compass destination dispatch, eView, our customers are seeing value and they stay with us longer because they know we'll continue to give value enhancements. Our widespread deployment of Otis ONE and IoT devices is going to take this another step further. And we believe this is going to differentiate our service offerings versus the ISPs. It's going to make us more productive on the units we maintain through actions like remote monitoring. And we're seeing the acceptance of that more and more, especially in light of COVID. But there's also very basic blocking and tackling based on the fact that we'll know a unit is running on arrival and not need to dispatch one of our field professionals, eliminating unnecessary visits and most importantly, for our customers, increasing uptime for the unit because once our mechanic does come via the IoT data on the mechanics app, they're going to be able to put the unit back in service faster, fault isolate it quicker and come with the correct part. So it's a reduction in overall labor hours for us. As our mechanics use their knowledge and have the parts needed, customers are happier with uptime, and we've seen that this does improve stickiness, as we call it, which drives retention rates. The OEMs are going to have an advantage. I can only speak to Otis' advantage. We are investing. We are going to have another 100,000 units connected to our Otis ONE network by the end of the year, primarily in Europe, China and North America. And we are rolling those out as we speak, a little softer in the first half. More driven by COVID than anything else, but our ramp rates are up, and we're investing capital. It's a significant capital investment that we think will drive service returns in terms of both productivity, customer satisfaction and, ultimately, retention.

And on the other point, Julian, in terms of third-party applications, the third-party IoT applications, all we can say is that the OEMs will have an advantage over the third-party solutions. And the reason for that is the OEMs can talk directly to the controller of the elevator. And that means that we can get all the event logs, the operations history of the unit as long as -- and any faults with very, very detailed information. Instantaneous operating parameters, what's the unit status, what's the load, what's the speed, all of that, right? For any non-Otis unit that we connect, we have to rely on external sensors. And that, obviously, the level of information we get through external sensors is at a much, much lower level than what we get from talking to the controller directly. So the OEM solutions, whether it's an Otis solution or some of our peer group solutions, when they talk to their own units is going to be far superior. And that's the -- and that is going to drive better end product for the customer and drive higher productivity for the companies that are maintaining the unit. So that's the benefit that we see. And we see that with our own solution. I think our peers are probably going to see the same. So our take on this is that the OEMs will come out ahead of -- as units connect digitally for all the reasons that Judy just mentioned in terms of retention. The only other point I want to add is one of the things that we have been connecting elevators for a long time. And in Spain now, where about 1/3 of our units are connected, up from maybe 10% back in 2016, our cancellation rates that were already very low are 1/3 of what they -- on the connected units are 1/3 of what they are on nonconnected units. So you can see that that's a live example that we see within our company, and Spain has one of our highest connected rate of portfolio. So there is a distinct advantage from connectivity.

Understood. So yes, it does look like the customers are definitely appreciating the benefit of that service push. How about on the Otis side of things in terms of the costs to serve on the aftermarket? Do you see further scope for maintenance and installation hours, for example, per unit to keep coming down?

We have opportunity here. We have developed a suite of applications and put this technology really in the hands of our field professionals. And it allows them to be more productive and we think actually to be more satisfied because they have the ability to successfully service customers in a timely manner. So we've developed this suite of applications. It's not been deployed fully yet across the globe, so there's opportunity in terms of reach, in terms of new countries, and we have more and more coming on every month. And then there's also the ability for absorption of these applications and expansion and penetration and adoption in the countries where these already are. One of the apps we call Tune, and it's an app that allows the field professional to either put their iPhone on the floor of an elevator or on the rail or step of an escalator, and it gives them readings on -- immediately on -- well, near real-time on noise, on vibration and on -- or is the elevator or escalator intolerance for service or what needs to -- what's recommended to be done. So we've doubled our usage of the Tune app year-to-date, but it's still only in half the countries that we provide servicing. So there's lots of opportunity there, again, improved time for field isolation and, again, technology in the hands of our field professionals. And then IoT, in addition to the apps, these global apps, IoT is going to give us that reduced -- fewer visits, lower time per visit. And our IoT deployment, as we said, is underway with 100,000 units being added later this year. So there's opportunity, and our field professionals really are our strength. They are the ones who come up with additional opportunities, and we've motivated them. One of the apps we call Upgrade that lets them real-time sell repairs to a customer because they are the trusted face of Otis to that customer, and that has continued to increase. Obviously, some COVID challenges with lesser repairs in Q2, but we are seeing repairs now and job sites available for repairs also being in the kind of 95% level, which is encouraging for the second half of the year and what we've planned for in our outlook.

And the other thing, Julian, is even Judy spoke about the reduction in the number of visits we need to make, the time per visit, but in addition to that, we're also actually seeing the ability to perform maintenance remotely. For example, in China, the technicians, they have about 30 to 35 checkpoints that need to complete within a visit. Our Otis ONE solution now can complete about half the required checkpoints remotely. So that basically means that when we show up for a regularly scheduled maintenance was that, that reduces the amount of time that we need to spend or we can have fewer people for that maintenance visit. So that helps now. We need to work with the jurisdictions in China that we can conduct the maintenance visit or piece of the maintenance visit remotely. But the fact is that this thing is going to be -- it's going to reduce the number of visits. It's going to reduce the time per visit, but also help us with just performing maintenance remotely and putting some of these service elevators back in use remotely. So this is going to definitely turbocharge all the productivity that we have been seeing.

Yes. And what's so meaningful is that 70% of our service or aftermarket costs are labor. So that's why we have focused on service transformation, both with the apps and now with IoT and with really soliciting the best from our field workforce.

And I think you'd mentioned that 100,000 new connections this year -- in the second half of this year. Is there any kind of medium-term context you could give about what rate of that new connections we should see in the medium term? Or what share of the Otis installed base, let's say, might have those types of connections in 3 or 4 years' time?