Otis Worldwide Corporation (OTIS) Earnings Call Transcript & Summary

Good morning. I'm Josh Pokrzywinski, Morgan Stanley's electrical equipment and multi-industry analyst. Thanks for joining us for day 2 of our Laguna Conference virtual for this year, hopefully, on the beach for next year. Joining me for our next fireside is President and CEO of Otis, Judy Marks. Judy, thanks for joining us this morning. Before we dive in here, I do have a quick reminder for folks that for any questions about our research disclosures, please visit Morgan Stanley's website at morganstanley.com/researchdisclosures. And for all other questions, please reach out to your Morgan Stanley salesperson. Judy, thanks for joining us. I know you have your own disclosures before we dive in, so I'll let you get through those, and then we'll hop right to it.

Great. Thanks. Great to be with you, Josh. Please note, except for otherwise noted, the company will speak to results from continuing operations, excluding restructuring and significant nonrecurring items. The company will also refer to adjusted results, where adjustments were made as though Otis was a stand-alone company in the current period and prior year. A reconciliation of these measures can be found in the Appendix of our earnings presentations. We also remind listeners that this discussion contains forward-looking statements, which are subject to risks and uncertainties. Otis' SEC filings, including our Form 10-K and quarterly reports on Form 10-Q, provide details on important factors that could cause actual results to differ materially. Ready to go, Josh.

Awesome. Let's get right to it. So you've had a busy 1.5 years here, both within Otis and the macro environment at large. So maybe just kick us off here, starting off with what have been kind of the biggest changes since Otis has been a stand-alone company? What are you most excited about? What do you feel like could still be going better?

Thanks, Josh. It's been a fascinating year. I really do want to thank our 69,000 colleagues because with them, together, we have executed our strategy. We've driven focus. We've driven innovation. Think about our new equipment business where we set out to gain share, and we've done that about 1.5 points of share this year, driving it through everything from sales coverage to innovation and new products. We've introduced our Gen3 and our Gen360 connected products. And we're really excited about where that's going to take us, our passengers and our customers. Our service portfolio, remember, service is 60% of our revenue, 80% of our profit has grown 3% last quarter after 1% in '19 and 2% in '20. And we believe that we've got continued reach there throughout the globe. And we've seen strong growth throughout the globe in terms of demand. We've done a great job managing capital for ourselves and driving free cash flow to about -- we're out looking 120% this year. And we've been able to drive our capital management strategy. A year early, we finished paying down our debt that we thought was appropriate, raised our dividend 20% and also now have started and are driving about $750 million of share buybacks this year, a year ahead of schedule. So stellar performance for our [indiscernible] really good performance for our investors. And I think through a global pandemic and spinning to be an independent company, we've added that focus, that intensity and that excitement about growth. In terms of opportunities, there are lots of opportunities. We talked about Otis as a company of 1,400 branches doing business in 200 countries and territories, where we just have great opportunity to get to more consistent offerings in both our installations, our product deployments and most importantly, in our service offerings. So we're excited by where IoT is going to take us, and our Otis ONE offering is going to get -- take us to the next level. But that consistent application, consistent performance will really give us those enduring customers that we so value. So we're excited, lots ahead, 15 months in. I'd like to say every elevator is now 15 months older, and is a great opportunity for us for repair and modernization as well.

Excellent. So I think as you and I were talking about before we started here, kind of supply chain is the word of the day. And certainly the biggest opportunity for -- or challenge for folks at the moment. Kind of wrapping in the price/cost environment, broader supply chain, how do we think about the biggest opportunities, the biggest focus for you now? And then any kind of -- the way the headwinds have evolved over the last, call it, a couple of months as things have been more acute?

Sure. And I'll just ask the audience to keep in context. We are a long-cycle industrial and really more so a long-cycle business -- services business. But when we think about where the headwinds are in terms of supply chain, it really hits our new equipment business far more. So if you think about -- and let's look at kind of the different input costs, we -- of about $2.5 million we spend on material, $300 million of that is raw materials, which 75% to 80% is steel. So steel is our big purchase, steel is our indicator, and we're watching the futures really carefully. We've done a really good job on our supply chain in general. But steel, we came into the year thinking, between all the headwinds we were seeing in raw materials and commodities, we have about a $20 million to $25 million headwind. We increased that after first quarter earnings and really came out of second quarter earnings now feeling confident. It's going to be about a $75 million to $80 million headwind for us for the year for that $300 million that we purchased. We've got really good line of sight to that as we kind of wrap up fourth quarter. Everything is in our backlog that we're going to execute on. We've gotten our buys ahead. So we really have a good sense that $75 million to $80 million is that pressure point for us that we're seeing. When we look at the other $2 billion that flows through our factories, we've got -- we showed last year, we can drive 3% material productivity. We did it again in the first quarter of this year, and we look to that to offset any increases we might see on that $2 million that flows through our -- $2 billion that flows through our factories, excuse me. So we're going to offset this in a variety of ways, and we've included this in our most recent outlook, that $75 million to $80 million. We have made price increases, started earlier in the year in select markets. We're now doing that in all markets. We're focusing on material productivity and the things we control. And we're also focusing on installation productivity, because on any given day, there are about 10,000 installations happening for Otis with our customers. So we bring all those 3 together, and again, think about this in the new market, new equipment segment, with all that in, we're still going to outlook 90 basis points of margin expansion in new equipment this year. So we're controlling what we need. Our supply chain teams are on this. We're watching Asia right now. That's where we have our ocean freight challenge, although it's because we manufacture locally throughout the globe and source locally, it's a pretty small number for us. But obviously, we're watching what's going on with some of the recurrence of COVID in some of the more mature markets, Japan, Korea, et cetera. But we've got good line of sight for this year. Challenges will probably roll in the first half of '22, but then the pricing will take -- that price/cost mix will shift and second half of '22 should be strong.

Excellent. So just, I guess, a follow-up on that '22 comment. We can all look at things like spot rates and track those kind of charts, but I think in the real world between hedges and contracts and purchase agreements that it takes time for everything to roll in. Does the environment, in terms of kind of the acuteness of this inflation, get worse before it gets better just as a function of time and kind of rolling in some of those lagged increases?

Yes. So our issue is not a lag. If you look at the $75 million to $80 million, we would -- because of what we had locked in, that would split 25% first half of this year, 75% second half of this year. So the compares will get easier second half of next year as well. But we're doing all of those elements. I just would remind you that when you think about that $75 million to $80 million, it's -- we're talking we need 1 point to 1.25 points of price to offset that. That to us is very achievable. We have raised our prices globally. Different levels in different markets. We're seeing some of that stick. It just takes time to progress through from bid, to award, to then when we execute our backlog. But I'll tell you, the team is doing a great job even with those price increases. You look at what we've achieved through the first half of the year, our organic sales in new equipment is up almost 25%. Our orders are up 21%, 9.4% on a 12-month roll because we know there's some choppiness there. So we know what's in our backlog. Our backlog margins are -- we finished second quarter, it was down 0.5 point. We know what we need to do to execute from the time something hits our books until we actually deliver it, and our team has been doing that really well.

Excellent. So maybe pivoting over to the demand side. And I think most folks would describe the demand environment is pretty frothy right now on a global basis. Maybe one outlier is some slowing in some China property markets, but maybe walk through your perception of your major regions and anything that you think is differentiated for Otis perhaps versus the market.

Yes. So demand is very real and very attractive. As we entered this year, we did not expect that the demand signal and the end markets to be as positive, especially in China and North America. China, we came in thinking it was going to be about a mid-single digit segment market. We saw high single digits. And we're continuing to see good strength in China in the end markets, and we're gaining share there. We had a record quarter in China, in orders second quarter record for us ever in Otis' history in the mid-teens growth. So we were really pleased with that. And I'd tell you, North America, especially the U.S., is the other really positive story. We thought it was going to be slightly up as we came in the year. We're seeing mid-single digits and just really strong orders demand, some strong residential demand. We're seeing commercial demand as well as industrial. And it's really driving the construction markets and our order backlog in North America. EMEA, we thought it's going to [indiscernible]. It's proving out to be that. Asia Pac, ex-China about mid-single digit, even though it's a tale of 2 Asias, the COVID impact hit kind of India and Southeast Asia early. Now it's in Australia, Japan, Korea. But with vaccination rates, we think it will still be mid-single digit in the new equipment market as we exit the year. Service business, very resilient. Our maintenance business has always been strong. It is the resiliency. It's that subscription business that has gotten us through -- really through this global pandemic as we knew it would. People always need this contractual maintenance. What we've really been excited to see in the first 2 quarters of this year is the repair business, it's up in both quarters. We're seeing that demand signal, and that's driven by usage. So great ancillary effect. And now the modernization business, which we knew would come back because so much of it is discretionary. We knew it wasn't going to -- it would be delay, not disruption, 17% orders growth in modernization in the second quarter, and that's going to convert to sales. And we see modernization, as I said, every elevator aged during the pandemic. We see the modernization business in and of itself growing, and then starting our maintenance business all over for, hopefully, these long-standing continued relationships with our customers. So we're optimistic about the end markets. All indications are positive. Obviously, a little pause, watching what's happening in Asia right now, especially the mature Asia. 1 month, maybe 2 months ago, we would have seen the acceleration continue. But we think, again, with vaccination rates, that will come back as we enter the latter part of this year.

Excellent. So just sticking with China here for a second, between any kind of customer behavior change with 3 red lines or any regulatory impact, or just a market with kind of the recent surge in COVID, anything that feels transitory or disrupted or kind of atypical versus where you would have seen it a couple of months ago? You just mentioned you would have expected kind of before some of this last bout, a bigger acceleration. But would the market maybe answer that question differently than Otis? And is there anything that you can point to specifically that would say, here's where we've seen some disruption, policy or otherwise?

Yes. So let me break China into 3 pieces: no equipment market and how we're doing the service market and then the liquidity situation and the 3 red lines. As I said, the new equipment market is high single-digit growth. And China is the largest market in the globe. Almost 600,000 of the 900,000, 950,000 of the segment in new equipment is in China, and it's still growing. And even if it were to flatten over the next few years, we're gaining share a lot through excellent execution of our strategy. We've increased our agents and distributors. What has Otis done differently? We've increased our agents and distributors. We've added almost 1,000. So we're now up to 2,150 agents and distributors in China. It gives us better reach, better relationships with the key developers and better coverage. And we've also added internal sales coverage to help with that. So we again gained 1.5 points -- or sorry, it grew orders, gain share in China and really pleased with our work there. On the service side, if you think that there's about 18 million, 18.5 million units in the globe, China has now purchased 6 million of those installed units. And we have, like other OEMs, lower share in China than anywhere else. 75% of the China market is serviced by ISPs. But that was in a more electromechanical elevator world, not in a collective -- connected elevator world. So with our addition of Otis ONE, with our ability to basically to have information on a real-time basis on the performance of these elevators, with our agents and distributor relationships, we have really turned to a growth mode, not only in new equipment, but in service in China. And we've taken our portfolio growth, our service portfolio there. We've taken it. Last year, we grew it high single-digits. We ended the second quarter in the mid-teens, and there's room for more growth there. That's the single largest growth in China, and we're going to stay focused on it. We've added service branches. We've made run rate investments so that we have better coverage. And we've proven country after country when we have density, we can perform better. And the reason I always bring everybody back to service is it's 80% of our profit generation and it's not as volatile as a lot of the new equipment resi versus non-resi discussions. And then finally, on liquidity, kudos to our China team. If you look at our free cash flow, first half of this year versus first half of last year, almost double. DSO is down. Working capital is down. We are controlling what we can control. And we -- even in China, but across the globe, the beauty of our customer base is we have this incredible diversity where no single customer has a significant percentage of Otis' business. So we're watching the key developers carefully, but we're also managing the liquidity situation. We get paid advances. But we're making sure we're going to get paid for services rendered. And in the situation where we see people veering off of that, we focus more on collections, and we pull in some of the new business we're going to do. So we're managing on an account-by-account basis. The 3 red lines have been around for a few years. We think it's a healthy part of the development business, but the developers are continuing and growth is continuing in China.

Excellent. So you touched on service there a few times. And I know in kind of that opening period, you mentioned that some of the more discretionary parts on modernization are starting to come back after a bit of a lag. So how do you think about the outlook there on the maintenance and modernization side? I mean have we sort of worked through that pent-up demand that we've created over the past year, 1.5 years? And sort of how would you size what's remaining? Baseball analogy, number of innings or however works best for you.

Yes. So there's still pent-up demand. We are awaiting decisions, and decisions by condominium associations throughout the globe who either haven't had an opportunity to meet or now are really trying to understand, do they need an upgraded -- an updated proposal from us to be able to understand 1.5 years later, what more do they need? The segment itself is growing. Over 5 million units are over 20 years old. And whether they -- whether you need to upgrade an office building for aesthetics because the office building next to you is new construction, so you want to be able to retain and attract new tenants, we're getting a lot of those requests. But it's really in that residential sector that we see so many of these small to midsize modernizations that are really the bread and butter of our modernization business, and there is pent-up demand there. The good news is we're ready. I talked about the colleagues -- our field colleagues and thanked them earlier. We kept every one of them part of Otis over this whole pandemic. We wanted them to be with us. We wanted to make sure they were safe, but then we also wanted to make sure they were ready when we accelerated out. And modernization, again, with the orders being up 17% in the second quarter, we're going to continue to see that crescendo. We're ready for it. We've got the kits. We've got the personnel. We are not running into the same labor challenges as many of the other late industrials. A large part of our labor base is represented, which means we have multiyear agreements. So we're not even seeing that part of inflation hit us either. So we're in a really good time to be able to optimize and to drive that modernization. And you're going to see that as we report over the next few quarters pick up nicely.

Got it. And maybe kind of compare that versus the competitive environment. Obviously, ISPs play a big role in the elevator industry at large. How do you see that evolving? You mentioned that because a good amount of that technician force is represented that maybe the labor inflation or availability is less of an issue. Is that more or less acute for the independents? Are they struggling more in this environment? Maybe just speak to share kind of how do you see that whole relationship and dynamic playing out?

Yes. So ISPs have about over 50% of the service market in general, but over 75% in China, which is why we stay so focused on portfolio growth globally, but laser-focused in China because that's the largest opportunity. The biggest challenge ISPs -- and where we're going to take share from ISPs is by having a more connected offering, a more predictive offering that gives more value to our customers, especially as elevators become more digital, more connected and more electronic and more challenging to maintain than the 160-some year-old industry that has been fairly mechanical, electromechanical to date. So we are becoming more productive. You've seen that in our margin expansion on our service business. 110 basis points last year or since 2019. We're going to do another 30 to 40 basis points of margin expansion in our service business in our outlook this year, that's through the combination of really starting to surge on Otis ONE and giving our IoT offering with this transparency, with this ability to be -- to have remote diagnostics to be able to understand and have our technicians be more prepared as they as they go and fix an elevator or most importantly, not even roll a truck because we can see that it's back and operational when a call comes into our Otis line. Between that, between our apps that we have and just all the incredible information available to our field professionals on Yammer, between them, sharing all that information on all of our portfolio, our products or the OEM products we maintain, I think the ISPs -- we're going to become more productive in places like China because of that, and we've seen about 10% to 15% productivity already from Otis ONE. We're going to become more cost competitive, which will then let us bring units back on our portfolio, which will then give us the density and that enduring portfolio in terms of retention. We -- our retention rate in China is a little over 40% now in terms of attrition, in terms of when we -- 40% once we move off of warranty when they become part of our service business. Everywhere else in the globe, it's closer to 90%. We've got a midterm objective to get that closer to 60% in China as well as continuing to increase it, obviously, albeit on a smaller number, everywhere else in the world. So we are going to take share back from the ISPs again, through a combination of route density, IoT, productivity of our field mechanics and then just all the innovative products that we're starting to off on the new equipment side are going to that stickiness, whether it's our dispatch -- Compass dispatch solution, whether it's infotainment in the cab, we see increased attachment rates whenever we have something connected. In Spain, it's been significant, anywhere we've deployed this in the world, and we continue to see that taking hold and our Gen3 offering and Gen360 offerings are going to allow us to accelerate that as well.

Got it. So you mentioned Otis ONE several times in that. Maybe kind of walk us through the opportunity? And how that rollout has progressed? And any kind of tipping point that we're reaching relative to the development that went into it versus kind of the leverage you're getting on that from those deployments today?

Yes. We're starting to see the leverage already. We've shared that we have about 540,000 connected units as we left last year. That's a combination of a lot of our legacy units because we've had connected units for multiple decades plus the 100,000 Otis ONE systems we deployed in 2020. We're going to deploy about that same amount this year. That 540,000 is about 25% of our portfolio. And in the medium term, we're going to cover 60% of our portfolio. And what's really exciting about Otis ONE is beyond the productivity and what we're seeing, so from that 100,000 units we deployed last year, we think we're seeing a point of productivity, about $10 million to $15 million this year alone. But we believe so much in the connected elevator. We're including it in Gen3. It's part of -- it's native in our Gen360. We're now shipping units out of our factories in China, in North America that are already prepopulated with our Otis ONE offering. So we don't really need to go out to existing sites to install that. So you're going to see this compound and the impact of the compound with our portfolio rates going up, and you'll see it in our margin expansion in our service business. But really, the transparency gives customers the ability for them to know the heartbeat of the elevator that it's working. And then we -- just as we think about Otis ONE, for us, it's not just a data offering, that's what we put out last year. But now you think about adding data and voice and then data, voice and multimedia in so many markets. And in voice, it's voice over IP. And every elevator by code has a phone line in it right now. So we're going to take that phone line. We're going to handle it voice over IP. That's going to give us increased revenue per unit. We've seen that revenue go up almost 10% to 20% in markets where we offer that. And then on the multimedia side, we're going to see it as well. So I tell people, our service business, especially our maintenance business is a subscription. Now you're going to put a subscription on top of a subscription when people now buy from us in terms of their multimedia, their flexibility they have for infotainment and the voice that they're going to get in the cab.

How would you kind of characterize that competitively? Because it seems like the real arms race here is sort of the OEMs versus the ISPs who sort of naturally don't have that same moat. Does this become something that's essentially table stakes? And how would you differentiate Otis' offerings maybe versus some others in terms of where you've been focused?

Yes. I can't talk to what the competition is doing. I can tell you with our data, data and voice and now data, voice and multimedia solution, and they're all visible. Different levels of availability in different parts of the globe because we have to work through codes and standards, but that's going to be our differentiator. Again, it's this transparent information for everyone simultaneously to be able to see is the elevator running so that we have the ability -- if it's not, what floor did it stop on because it's connected to our controller. So we know the brains of the elevator, and we can send the mechanic at the right time with the right equipment to fix the elevator. More importantly, we take 30 years of data and all the data we're gathering now from Otis ONE. And we've got a data lake that allows us to really be prognostic. It will be the next step, right? So we'll be able to say, boy, this door operator, after about 15,000 usage or pick a number, that's a hypothetical, we should do some preventive maintenance to it. So the next time you're out on a maintenance call at this customer, do that so that you never run into the issue and you don't even need to repair, but more importantly, customers and passengers don't have downtime nor do they get entrapped. That's the goal to make the ride even more seamless and autonomous than it is today. And that's the downtime. And so yes, it is -- that is table stakes. We think our technology will help us. But again, with over 50% of all the installed units now being maintained by ISPs, that's the market we're going after.

Got it. So I have a number of questions here on the portal, and I won't be able to get to all of them, although we've touched on several. One that has come up here several times on China is on the services side. So can you talk at all about the conversion rate to service and how you've seen kind of the services market there develop? You spent some time on the new, but anything on kind of the other side of the coin there?

Yes. So China will surpass Europe at some point. It will cross over shortly to be the largest installed base in the world. About 6 million units today. Our share is fairly small, mid-single digits. And we're not unique because if 75% is ISPs, the other 25% is the OEM group. In the past, we really did focus, everyone did, on new equipment at Otis. We really didn't invest in such a large geography in advance to put out service depots as well as to have those agent and distributor networks, which help us in service as well to drive that conversion rate. I go back, and this was public with UTC when I joined, we were in the mid-20s. That conversion rate, we've gotten it now past 40%. And as I said, in the midterm, we think 60% is achievable. We're going to do that through driving density. We're going to do that through these conversions and attachments as some people call them, driving that laid up. And we're going to do that through recapturing other -- our units. Getting those Otis units back into our portfolio. I'd like to tell people, an elevator, view it as a fixture and a pretty firm fixture in a building. When you know where every elevator is, we can understand where it would fit in, in a route, how it will be accretive. And in China, we're really doing that. And again, the portfolio -- the proof of it is mid-teens growth.

Excellent. Well, I see we're out of time here, Judy. I appreciate the time, as always. Hope to do it again next year on the beach. But thanks for joining us, and be well in the meantime.

Great. Thanks, Josh.