Otis Worldwide Corporation (OTIS) Earnings Call Transcript & Summary

Good afternoon, everyone. Thank you for joining us for the afternoon sessions here for Virtual Laguna. I'm Josh Pokrzywinski, the firm's U.S. electrical equipment and multi-industry analyst. Joining me for the last of track 1 for today. Great story coming with Otis. I have the C-suite here, Judy Marks, President and CEO; Rahul Ghai, CFO. Folks, thanks for taking the time here. Just before we jump in, I do need to read a quick disclaimer, and then I'll hand it over to Judy, so she can read her quick disclaimer and then we can get onto affairs. But please note that this webcast is for Morgan Stanley's clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see Morgan Stanley's research disclosure website at morganstanley.com/researchdisclosures. [Operator Instructions] With that, again, Judy, Rahul, thank you for joining us. I guess just to kick things off, Judy, if you wouldn't mind just giving us kind of a lay of the land and any opening comments you'd want us to take away.

Great. Thanks, Josh. Rahul and I are as excited to be here with you. Let me just read my disclosure. Please note, except or 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. Well, thanks again for having us join you, and this is certainly an exciting year for Otis faced with opportunities, faced with challenges. And I just couldn't be more proud of how our team has performed. As we've come through the first half, I think the most important takeaway we have is how resilient our service business continues to be even in the face of COVID. It was efficient. Our teams performed. We had productivity, and we really did provide essential services globally and kept the world moving despite other distractions. As you look at how we came through the first half, Josh, we were down 4% organically on the top line, but we still had 70 basis points of margin expansion as we focused on cost, as we focused on productivity and as we delivered services effectively and efficiently. That's what gives us real confidence and allowed us at our second quarter earnings to improve our outlook for the year. We took up our outlook on sales, on EBIT and on cash flow as well as EPS. And the cash flow story in the second quarter was very strong and helped us really now have $1.9 billion of cash balance after generating $628 million of free cash flow, 280% of net income, which just again justifies what a strong cash flow business Otis is. So we took up our guidance and EPS. We took it up on free cash flow, and it also gave us the flexibility to delever. And so part of our capital allocation model has been focused on returning value to our shareholders while honoring our commitments, our commitments to the rating agencies. And so we're actually going to pay down more debt in 2020 than we had originally planned. That allows us to pay the remainder in early '21 and accelerating the '21 potential for a share repurchase plan. So we're excited about the business. This is a long cycle life safety business. Our backlog is strong at $16.3 billion. We ended the second half, again, with backlog improving. Our New Equipment business, as I look at it, really gives us the 12- to 18-month range of backlog to where we really feel we've got a good sense on price. We've got a good sense on where things are going for '21. Obviously, price will be driven more by the market, but we know how to drive productivity and drive costs. So again, it's an exciting time for us. It was just early April. We spun to our independence and really looking forward to having this discussion.

Excellent. Well, appreciate you taking the time and for some of that -- for some of those opening remarks. I guess just to pick up the thread on backlog there, as you mentioned it, we've had a lot of folks with nonresidential exposure talk today. And I think the investor sentiment is probably that the sky is falling, but the feedback from companies is not nearly as dire, not really dire at all. You mentioned backlog growth entering the second half. And I know that pricing kind of plays a role as well. So any observations that you would make on the new equipment side, what you're seeing in the marketplace that we are heading for -- if we are heading for a deeper nonresi downturn and how that's playing out competitively on price or any other kind of observations that would be relevant to that line of thinking.

Yes. And I always start by putting context in. Our service business is 57% of our revenue and 80% of our profit, and that's tremendously resilient. And we build off of that. On the new equipment side, again, and we shared this at our second quarter earnings, more than 50% of our business is residential globally. The nonresi impact is primarily felt here in North America. But as we look at our end markets, hospitality and retail is about 10%. Even office is a little over 10%. So we've got a nice blend. Our product fits in every one of our end markets. So we don't have this unique product portfolio, so our manufacturing and our ability to install is not inhibiting. What we've been challenged by in new equipment to date is really job site access in terms of our revenue. But on the pricing side, before the second quarter -- and pricing is lumpy -- I'm sorry, orders are lumpy, but before the second quarter, we had experienced 5 to 6 straight quarters of price. And throughout 2019, we're already at $100 million of earnings growth. We had -- every one of those quarters, we were able to get price in every one of our regions. China goes back 6 quarters. Normally, we'd look at the second quarter and say it's not a trend because we did -- our backlog margins were down about 70 basis points. But in light of the macroeconomic headwinds we're seeing, we're really taking pause and making sure we understand what's in our backlog, how do we finish '20, and most importantly, how do we perform in '21. I want to talk about backlog conversion for a minute, and then I'll turn it over to Rahul if he has anything to add. But we have converted less backlog this year because of lack of access to job sites as well as other intermediate challenges, where crews who potentially test positive, we have to release the crews. We haven't been as efficient as we could be globally. Next year, our intent is to go in at -- continue this year to try and build backlog. But even if we go in flat, we have the ability to convert more backlog. We're not a book-and-ship business. In our new equipment market, we're long-cycled, 12 to 18 months. So we know what to do. Any of the orders we took in, in the second quarter, we have the ability, through material productivity and other cost controls, to be able to make sure that, that price impact doesn't see the bottom line. So we're excited about '21 and we think that, there, we have the ability to control those costs. And we'll handle price as it comes up. We'll handle it with productivity, and we'll handle it before it actually hits the factory and then before it gets installed.

And then I guess on that...

So Judy, I think...

Please. Please, Rahul.

Yes. So Josh, I think Judy hit on a really important point for us, which is backlog conversion. So as she said, there were a lot of disruptions this year both in accessing the job sites and even in the factory side, factories are -- our factories are open today, but we've had periods where they've been shut because of supply chain issues or because of somebody contracting COVID within our factory. So we've gone through those disruptions. But if our backlog is flat by the time we end this year, we should be able to accelerate a backlog conversion into next year, and that reduces our volume-related headwind that we experienced this year. So that, I think, is a critical component for us. That having full access to job sites, factories working normally, supply chain performing the way they should, we should be able to accelerate our backlog conversion. That's the big tailwind for us getting into next year with everything that we've seen this year. So that's one. I think the second point that you made on the macroeconomic environment, everything that we are reading today is that the construction industry should snap back after a fairly sharp decline this year. So if you can navigate next year by just accelerating our backlog conversion, then our backlog coffers start rebuilding for '22 and '21 and that helps us navigate this multiyear span with next year managing through accelerated backlog conversion and then '22, working off the growth that we will hopefully see in backlog next year. So that's what we're kind of focused on right now to drive continued earnings momentum.

Got it. That's helpful. And is there any way to size how much of that extra backlog conversion you can pull into '21? Or maybe said differently, the disruption in '20 that goes away and allows you to get after that backlog better.

Yes. I think typically, what we see is about 2/3 of our New Equipment revenue comes from backlog, right? And our backlog is around $6.5-ish billion, so -- the New Equipment backlog. So that's the way to size it. And this year, it's down. So we're not able to get to the 66%. And our goal is not only to get back to the 2/3 level that we saw in 2019, but even go beyond that. So we've got room to maybe affect that by a few points. So that's what we're going to work on. Work that $6.5-ish billion of backlog and just continuing to drive new equipment growth from that backlog next year.

Got it. That's helpful. And then I guess just one market that everyone pays pretty close attention to and will soon be the biggest elevator market in the world in China. Any observations there on the competitive landscape, how pricing trends have laid out there? And then I guess, there are also some new property rules that went into effect. And I know you guys have like your -- I've got a mislabel, like some elevator trade show symposium, you can tell that I wasn't in attendance, in the past month or so. So any observations that came out of that as well would be helpful.

Yes. The China market is back. It's snapped back really strong in Q2 versus Q1. All 4 of the segments we compete in, in China, residential, commercial, office and infrastructure, we had share gain in all 4 of those in the second quarter. So our China business is doing well. And it will be -- the segment itself in China will be down a little this year because of the first quarter, but we had predicted it would be a down segment, which is why we went after getting share. In terms of price, as I said earlier, we've seen 6 straight quarters of price that we're coming off of in China. And so our booked margin in China for Q2 was flattish. But we are seeing competition there, especially on some of the infrastructure bids, but we have great share on infrastructure, and we're going to continue especially as airports, rail and metros continue to grow, which they are in China, we expect to continue to yield there. We're going to continue to be competitive. If you go back to 2015 on the new equipment side, the top 10 OEMs really had 70% market share. As we exited 2019, that was down to -- it was up to 90% market share. So we don't see irrational pricing in China. All 10 are basically public companies, the majority of them now. And so we're seeing rational pricing and a little smaller segment, and we're going to gain share and we're going to continue to gain share.

Does that...

And Josh...

Please Rahul, go ahead.

Josh, yes. Just to add to Judy's point on share gain. I think China has been a huge success for us going all the way back to 2015. Between 2015 and 2019, we gained maybe 1.5% of a share overall. But what we've also seen, what we've done this year is we've added about 500 channel partners in China. And that has allowed us to increase our coverage of the China market by about 10 points roughly. And so that's the part of the self-help story about Otis that is so critical, not just for China but globally. So the fact that Judy mentioned a couple of points -- a couple of times that we've gained about 100 basis points of share in the first half of the year. And that's coming from steps like this that we've taken in China, where we've added 500 channel partners on a base of about 1,100. And this has happened since the end of last year and primarily, since we spun from UTC. So that's the part that we were an under-managed, under-invested asset under UTC, and this -- becoming an independent company allows us to drive all the things that are critical for us. And globally, we focused on a few things around gaining share, which is increasing our sales coverage, making sure our sales performance of our salespeople is up to mark, introducing new products. And all that, that all contributes to the self-help that Otis can do even if the end markets kind of stay challenged. That's what we are focused on internally in terms of driving the top line growth.

And then I guess on that significant increase in channel partners, because it's not a small number, where did that opportunity come from? Were these people waiting in the wings that should have been attacked already? Was that kind of new development that was maybe a little less obvious? Was it taken from competitors? Maybe just kind of touch on how you were able to amass that base so quickly.

Yes. It's a little bit of all of them. I mean we've expanded our reach now in the Tier 5 and Tier 6 cities that before we just hadn't been able to address. It was a much more lengthy process as part of the portfolio company. We've streamlined the process where we now have great distribution in terms of these agents and distributors. The other area we really focused on is enhancing relationships with the key developers. We call them key accounts. They've continued to consolidate and continue to be major players in China. There's a twofold benefit for us. One is the volume on the new equipment side. But the second, these large companies want a business partner to be their national service partner for these units. So we get better conversion rates, better retention rates and more predictability.

Is that something that's a bit more of a global trend? And I think maybe a good segue into some of the digital initiatives, as these products become smarter, the ISPs just don't really seem like they have the capability to participate in it, and they still have the majority of the market. I mean how do you see that shift happening? Especially you mentioned larger customers want that national presence and that sophistication, it seems like there's a lot of wood to chop there.

There's so much opportunity. In our world, once you're connected, the connected elevator, it just defines an ecosystem where you can drive tremendous value-add for your customers and productivity for Otis. And so we look to that, whether that's connections through IoT, through -- again, through all of the Otis portfolio that has been manufactured, whether it's in our service portfolio or not. If there's an Otis controller and an elevator, we have unique access to the brains, the fault codes, the traffic management, really understanding that the flow of the elevator and what's happening with it. Independently, that's interesting for one elevator. But when you think of the data like we have and are able to create and the data analytics we can do, it lets us be far more predictive, far more transparent and share that information with our customers. When we connect, Josh, whether it's through our destination dispatch system we call Compass, whether that's through having a screen inside a cab, whether that's through an IoT sensor, our ability to attract a customer goes up, our ability to convert that customer from just buying and having our units installed to a service contract goes up significantly. And then our ability to retain that customer goes up. I'll just give you one example. In Spain, where we have about 250,000 unit portfolio, over 1/3 of units are connected via IoT devices and our -- both our conversion rate and our retention rate instead of our national -- our global retention rate of 93% is in the high 90s, 98%, 99%. The customer gets value. They can see if they're elevator's up and running, they can see it if they're doing a campus or a building manager, we get value and productivity, and we get the knock-on important value and stickiness and retention.

And presumably, price is not as much of a discussion at the table when there's a connect development.

It's that value proposition that really does have the customer wanting to do business with you for the long-term.

And then I guess the other side of some of the digital strategy here would be on new equipment, completely different scenario but using some different selling tools. You mentioned some of the opportunities in China, really being a little bit outside of that. But where have you seen some of the biggest opportunities or success on kind of the new equipment side and digital initiatives there?