Otis Worldwide Corporation (OTIS) Earnings Call Transcript & Summary

All right. Good morning, everybody. Thanks for joining us on day 3 of the Laguna Conference. For those of you who don't know, I'm Josh Pokrzywinski, Morgan Stanley's electrical equipment multi-industry analyst. I'm joined on stage by Judy Marks, CEO of Otis. Judy pleasure to have you, as always, looking forward to the conversation here, maybe even slip in a few puns. You define gravity all over the place. So maybe just...

I'm not wicked.

What's that?

I'm not wicked.

It's fair. We're going to trade this time. I understand. I know you have a few kind of disclaimers you need to read on the front end, but then we'll get into some Q&A here.

Great. Thanks, Josh. Please note, except where otherwise noted, I'll speak to results from continuing operations, excluding restructuring and significant nonrecurring items. A reconciliation can be found in our second quarter earnings presentation on our Investor website. We also remind listeners that today's discussion contains forward-looking statements. Otis' SEC filings provide details on important factors that could cause actual results to differ materially.

Excellent.

Good to go.

Best legal team in the business.

Maybe just start us off with what you're seeing out there. I know you're a road warrior, you're always on the road with customers and visiting all the regions. Anything that's on your mind that you're focused on or you're seeing out there in the macro that we should touch on to get started?

Yes. No, it's great to be back out after a few years of constraints due to COVID and to see really our colleagues performing incredibly well, and I can't thank them enough. But the opportunity to go to job sites, to go to service sites, to be able to see customers and to get that feedback on how we're performing is just as important. 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, which includes the [ mature ] Asia, Japan, Korea, Australia as well as the emerging Asia in Southeast Asia. And as I said, India is just really growing nicely at double digit in terms of the market segment and units. Europe. Europe looks like it's going to be down high single digits this year, but it's kind of a story of 2 parts of what we call Europe, Middle East and Africa. 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 of -- somewhat consumer confidence, especially in multifamily in Germany, in France and in the U.K. So we're calling that one the market segment about down high single. And then as we come home, come to the Americas, Latin America is strong, but North America looks like it's going to be down high single digit. Now both Americas and Europe are coming off really strong few years. And what I'm really thrilled with our team and in terms of how we're performing is our orders have been strong. So we're going in. We ended the quarter with our backlog was up 5% year-over-year and up 3% sequentially. And we always tell folks on our New Equipment to look at our backlog to know how we're performing. China. China has got a range of outcomes. We said the market would be down 10%. That's what we saw quarter 1, quarter 2. And we're really not expecting it to bounce back up in the second half of the year. In China, as we look ahead, the challenge is consumer buying patterns for real estate, as well as just liquidity for the banks to be able to make the loans that are needed for the property developers, both the state-owned enterprises, but more importantly, the private developers. So as we look out at past this year for China, it's pretty much a wide range of outcomes transparently. If it really -- if we see the banks loosening up a little, we think next year as we go in, could be flattish in China. If not, we think it could look like this year and another down 10%. But again, we've got a great backlog. Our outlook, our guide actually, our revenue is up in New Equipment, 3% to 5% this year is what we're guiding. And we've got a strong backlog to take us into next year as well.

Understood. And I do want to kind of keep pulling on that thread in China for a little bit, just because it's so topical for Otis and for the market. Obviously, I think the other thing that you talked about in terms of the property sector sort of tracks with what we've heard elsewhere. In terms of monitoring stimulus conditions and the liquidity profile, are there sort of milestones or I guess periods of time where you would say, okay, here's where we would really want to see some intervention start to say that, that can influence '24? It sounds like we're not quite in that window or the end of that window yet. But over what time frame would you want to see that or expect to see that?

Well, China is our biggest book-and-bill kind of business, book and ship kind of business versus the rest of our business globally for New Equipment. So we saw this morning the reserve requirement ratio went up another -- was cut another 25 bps second time this year. So we'll see what that drives. But it feels to us like we've seen a series of small incremental moves to try and rejuvenate the property markets that really haven't yet made that pivot or made that turn happen. So we look at that. The most positive indicator we've seen is in infrastructure. The infrastructure spend across China is up. We're seeing far larger bids where before a single metro line would get bid for a certain city. Now we're seeing 6 of the lines bundled together. So that is driving volume, and that's our strongest market in China's infrastructure. So infrastructure and industrial segments are the only 2 segments in China that have been up in 2023, both of which are strong for us.

And you sort of touched on it there was a slightly different version of where I want to go with this [ snacks ] is this differentiation between, call it, the volume business and more strategic accounts, which I think have a lot more kind of state-owned enterprise fingerprint on them. How would you distinguish between those at large? It sounds like the infrastructure piece kind of speaks to it, but maybe more broadly on the strategic focus, what's the growth or success that looked like there versus perhaps more of the volume business?

Well, Josh, we put a conscious strategy in place in China as we came out of the spin about 3.5 years ago. We focused on doubling our agent and distributor network. We've done that. We have 2,200 today, and it's really giving us access Tier 1 through Tier 5 cities, but Tier 1 and 2 in China are really the highest growth and the best target for us. The other thing we did is we said we have to move out of this, migrate out of this onesie, twosie volume business into what we call key accounts. Since spin, we have doubled the volume we're getting from key accounts. It's not quite at 50% of our volume for New Equipment, but it's getting closer every day. So the volume still outweighs the key accounts, but it's catching up, and it will surpass it. And that -- those customers, they bought -- they're more predictable and just as important, they convert to Service. And we haven't talked about Service yet. I know we will. But that conversion to Service is what really has allowed us to grow. We now have 350,000 units in our Service portfolio. We're up 75% since spin in China. And you say, well, is there more potential, it's an 8 million installed base. So we're at 4% market share. We've got tons of growth left there and the team, 8 quarters in a row has grown mid- to high teens in Service every quarter in China.

So you anticipated my next question. So if you do distinguish between the key accounts and the volume business, maybe help us understand how that conversion, retention rate looks between the two? I think pretty wide range, but maybe just for folks on the line who may not be aware.

Yes. So our conversion rate in China is our lowest rate anywhere in the world. We came out of spin at about a 40% conversion rate in China. We ended '22 at 48%. We have a stated focus on in the medium term to get to 60%. And when we get to 60% conversion in China that takes Otis, which ended 64% last December, into 70%, which really helps us grow our portfolio significantly, which we've been doing year after year. So the key accounts, there's more stickiness. They like connected units. They like the ability to go to a single service provider. So that really helps us drive our Service business there as well.

Understood. And then you mentioned this a little bit in terms of expanding that capability in smaller tier cities. Where are we in terms of that rollout? You mentioned market share was still low, but is there -- is that an instance of we need more feet on the street? We need to still kind of democratize the footprint? Or is this just we're there and now we need to make the calls, roll the trucks?

Well, I'd tell you, we've spent the last 3 years, making sure we have the feet on the street, both on the sales side to our agents and distributors, but more importantly, you can't get the Service business if you don't have the mechanics in that city. So we've invested in that, and we've grown those service depots and our ability to serve. So now it's about performance. And when we perform, we will continue to get renewals, and that will again add even more to the portfolio.

Understood. And maybe a sense of what the competition looks like today. Obviously, people always going to grind their teeth over these periods of China M2 volatility and what happens at the peaks and troughs. But what does that look like today for New Equipment and Service as you see it?

Well, New Equipment, the top 10 OEMs, of which obviously were one have about 90% of the market. So if you go back 5-plus years, there were hundreds of OEMs, that has consolidated significantly. And most of them, if not all, are public companies that have a responsibility to report and to share their financials publicly. On the Service side, you're talking 75% of those 8 million units are serviced by independent service providers. Now what we're seeing change pretty drastically in China and the rest of the world is those independent service providers, whether it's 75% in China, 55% rest of the world, they just can't put an ecosystem together for a connected offering like our Otis ONE. And so we've been gaining share. As I said, we've been growing our portfolio. Our portfolio now is at 2.2 million units of 20 million across the globe. We have the largest [ single's ] portfolio, which means density, which drives productivity, and with a connected unit and technology really is our differentiator. That's what drives our 80% of our margins come -- profits come from Service. So that's really our Otis ONE connected units. No one wants to come maintain something they don't understand, whether it's a screen in the elevator, advanced electronics, our new electronic safety actuator, safety assembly in Europe, other independents will get near that. So we're going to keep gaining share. I think you know we were fairly stagnant between 2010 and 2018, growing our Service portfolio, and we entered spin just at about 2 million units and growth of 1% a year. I'm really proud of how we performed on conversions, on our retention rate and on our recaptures. And now we're at 2.2 million units and growing and finished the last few quarters, well over 4% portfolio growth, and that's the metric you should watch us on.

Understood. Not to get too deep in the China building [ code ] because no one has this intention [indiscernible]. But I do know there was an important kind of experiment with some remote service pilots that I think would act as a little bit of an opportunity since some of your kind of more fragmented tail of those servicers are sort of remote anyway, even though they're not supposed to be. How do you see that evolving? And is that an opportunity for Otis if that were to change more structurally?

Yes. So safety is paramount in our business. And in China, it's even more so because there was such a rapid increase in cities being urbanization as well as buildings and escalators and elevators going up over the past -- well, basically from 2001. So safety is critical. And because of that, we have regulations in terms of inspections of units to people every 2 weeks through the use of technology. And we've done pilots with the Chinese regulator in well over 30 cities. Through the use of technology, we've been able to automate some of those checklists. We have the ability to do a tremendous amount of remote. It's a matter of are we able to? And we think over time, we will. The amazing part is our China Service margins. I know people think they're really low. They're actually higher than our New Equipment margins in China, and our China New Equipment margins are our best in the world. So our China Service margins are contributing at a really good incremental for our Service business. And again, we're at 350,000 units, up 75% from when we spun and growing group mid- to high teens.

Excellent. I want to pivot over to the modernization side of the portfolio, a lot of strength there recently, not one that gets a lot of discussion, partly due maybe to the low margins, but I want to touch on that as well. But how do you see that market progressing over the medium term. Obviously, you can see the age of the fleet out there. How should we expect that to trend given what you know about the installed base?

Yes. We're really excited about modernization, and it really couldn't come at a better time. So if you -- we talked about the New Equipment market and the fact that maybe it does get flattish because China is down 10% and the rest of the world can't overcome for it or even compensate. But what happens is we have this rapidly escalating high single-digit, at least growth in modernization that's starting globally. So of the 20 million units that are out there, 7 million are in that mod eligible range. They're over 20 years old. And as we look through the end of the decade with China, having their surge between '05 and '15 in construction and getting modernized at a 15-year point, the modernization business is going to grow incredibly. So the question is, how do you address this market because we don't talk about a lot. So we step back at Otis and said, "Hey, we need a strategy." This shouldn't be such a bespoke or custom business, where you go in to see a customer and say, "Your elevator is aging, you need new technology, what would you like to do?" We really took these first few years after spin to execute our strategy. We grew our New Equipment share 2 points in the first couple of years, 0.5 point this year. We've grown our Service portfolio 4%. We've connected 800,000 units in our -- within our digital ecosystem in the Service portfolio. And now we said, let's take everything we learned, all the new products, every innovation, take advantage of our 17 factories and figure out how to make mod more production ready. So we kicked off a fifth strategic imperative as a company. It's the first time I've added one since joining Otis, which is to deliver mod value to our customers and our shareholders. So the modernization market is something that's going to continue high single-digit plus growth rate for as long as we can see it because elevators and escalators are going to continue to age, and they're going to need technology insertions, aesthetic changes. So we've organized to focus on this. We've added executives in each region to run this, and we're going to handle it now out of our factories and really now come up with kits, and be able to handle this. So you will see the mod margin exceeding New Equipment margin over the next year, and it will continue to get better from there. But the secondary benefit is back to we're a service company. Our conversion rates after modernization are in the high 90% everywhere in the world. So it just starts the flywheel over again and starts again. So we'll -- the portfolio is growing because of maintenance, about 4% now. We have a line of sight to 5%. Modernization then we'll add to that. And it just -- it gives us, again, that density and that ability to drive returns and to give us our medium-term guide on EPS growth of about 10% and our ability to drive the cash that we share with our shareholders in terms of our capital allocation.

So all that makes sense, and I can appreciate that introducing standard work into modernization certainly a margin opportunity. What sort of order of magnitude should we think about for that?

Well, I think what you'll see is if you think about our New Equipment segment today being $5 billion to $6 billion, you could see the modernization business over time, getting close to that. And we've had -- the teams responded great across the globe. We have had the last 4 quarters our mod orders have been up double digit. Our backlog is up 14% as of the second half of this year or as we ended June, and you're just going to see that continue. So I would -- it's a subsegment we report in our Service segment, so it's very visible to all of our -- everyone who follows us, and I think it's going to be keen to watch that and to see us turning our focus, our attention and if we've done anything since spin, we've proven when we set our strategy and perform, we deliver.

Understood. You talked a little bit on the last quarter's call about uplift. Clearly, you guys have had a good -- you're chuckling, I feel like there should be a swear jar for elevator-related puns up here. I know I'd contribute heavily to it. Clearly, you guys have had a good run post separation. So what's new about uplift? What was the catalyst to take a deeper look? It seems like you already have a good flywheel going. What's incremental here? What should people keep in mind and monitor?

So I don't think you can ever rest. We have a great flywheel. I think our business model for this industry and how we're executing it is exceptional, but there's always market uncertainty. We've been throwing a lot of headwinds since spin, be it COVID or supply chain commodities were. We've been dealt all of these, and we've executed well through it. But I think it's the responsibility of the leaders in this company, and we've taken it on to say, how do we get to a higher level that's sustainable and drive sustainable growth, profitable growth over time. As we spun, I knew we didn't have the perfect operating model. I mean we were coming out of a conglomerate. We knew what we needed to achieve, but we also had some doubters that said, look at the Service portfolio. Are you really going to grow it more than 1%? Haven't seen that in 10 years. So prove it. So as we spun, we knew we needed to do that. We stepped back earlier this year, again, knowing that we didn't have a truly globalized standard processes, knowing that we could take advantage of our scale even better. We've had a lot of opportunities come our way, and we've yielded on them, but uplift is going to give us that opportunity to have a new operating model streamlined and truly global processes that we use everywhere across all of our branches, all of our back offices and really have the ability to do 2 things: drive out some costs clearly, and we've targeted that at 150 million in terms of through next year. And I think you do this in a time when you're in a position of strength when the company is working well, but it's time to get it prepared for the next many years to come. So we're going to drive out that, and it's going to give us the foundations for our growth and let us be far more customer-centric, eliminate some bureaucracy and get us to an even better performing machine.

Understood. I'd like to pivot over to another big strategic initiative on Otis ONE. Maybe just update us on where we are at on customer penetration today. And then obviously, some of that rollout was just governed by, hey, there are chips in these things and we have the supply chain crunch. Any improvement that you've noticed then sort of target fleet out there that you could share with us?

Yes. So we've targeted -- Otis ONE is our IoT connected offering. We started this years ago, focused on our installed base, but then we made the commitment in our Gen3 product to start incorporating this in our New Equipment. So the actual penetration rate is increasing nicely. We believe we will hit 60% of all of our portfolio to be covered in the medium term. We've got 800,000 of our 2.2 million units, so you know where we stand right now. But again, because it's coming from New Equipment that's getting deployed into the field and then connected immediately through the warranty period as well as we're still installing it in our installed base. We're going to -- each year, we install more and more units, and we're seeing the benefits. I mean you're seeing it in our margin expansion. And our productivity and service. We have real cases, whether it's in Japan or Spain, where we -- the connectivity gives us increased access, better retention rates and in some cases, higher revenues because we're able to charge for more features. If you get a subscription on your display in your elevator, we have the ability to charge that. If we replace a phone line with our system that has voice and data, then we take over what used to be a monthly subscription, someone was paying the landline phone service here in North America that comes to us. So it's driving topline. I would tell you our original intent for it was to drive productivity, but the stickiness we get for it is going to help us in our retention rates.

I guess that would be my next question is, I know it started off as productivity and the retention rate has been sort of a nice ancillary benefit. But are those two becoming more equivalent? Or is this still primarily in terms of how it shows up in your P&L, a productivity feature?

It's still a majority productivity feature. The subscription parts are coming on. We've added -- in the last 6 to 9 months, we've added India, Japan, Korea. So Asia Pac was our last penetration region. China, more than half of our units are connected of that 350,000. So we're seeing -- there, we're seeing productivity. But in Asia Pac, we're seeing more subscriptions, and it's coming up. It's productivity, but to me, it's stickiness. It's that ability -- again, we said 60%, but 60% over the medium term. So if our portfolio is growing 4-plus percent a year, the 2.2 million units will be 2.6 million by about 2026. So it will be 60% of that number. It's a large number. It's great technology. It gives us incredible information. And as these regulatory bodies get more trust in this, we're going to be able to do more remote interventions. Right now, we're stopping the truck rolls because we're not sending someone if the elevators are already up and running. Our Otis line call centers have that same information, our mechanics have that same information, and we're really -- we're seeing the difference. We're seeing it drop through.

Understood. Now we've kind of picked around the edges of and as you mentioned, your Service business, all the different ways you've set up the Service organization over the next several years to succeed even more. But if I think about the stronger New Equipment share, the customer selectivity, so as you said, in places like China, winning the right business, Otis ONE, how should we think about service share over the next 3, 5 years? I know you and I have talked about kind of OEM advantage environment. But what does that look like to you in terms of how that actually shows up in kind of those global markets?

Yes. I think the place to look for it is a few. One is portfolio size, but realize the Service market is probably growing 4% to 5% a year. It's just -- it's simple math, about 900,000 units from new equipment, convert over 20 million units in the installed base. And that even if China flattens or goes -- continues to go negative, this year, we think China, we have about 475,000 of those 900,000 units. So 900,000 goes to 850,000. So it's a couple of basis points. It's not a big -- so the Service business just has this steady growth base of itself, not counting the modernization units coming back in. So I would look at the portfolio when you want to see how we're going to grow share. That's important. And then for us, beyond just the maintenance contracts, which we've done very well on in terms of retention as well as getting price is, I would tell you to focus on really the repair business because that's the ancillary business that we get. We get the annual maintenance contract. But then if there's something down, and we have to either sell aftermarket parts and/or service them and do the repair, we've just seen repair rates continue to be double digit for us. And that's -- we share that on our earnings call. In terms of repair, though, I would tell you, and I get this question a lot with modernization, well, can't people -- isn't it discretionary? Can't they put it off? And the answer is, you can for a few years or for as long as you choose, but that means your elevator is going to break more free...

Yes, no one wants to be in the 40-year-old art deco elevator.

No, no. Not with the circuit board from there either. They all work fine, you're all safe. But think about if you don't -- if you choose, you're running a condominium association and you're putting your reserve away because over half of our portfolio is residential, and we've got your capital plan, and we're working with you. In the interim, if the elevator breaks, you're paying us for repair. So it's -- for us, it's not an end. We get the repair work in the interim.

Understood. Maybe pivoting over to price. Obviously, a lot of inflation, good price discipline and probably a better price yield than you would have expected during that process, although you make your own luck. How is that played out as inflation has moderated. Are you seeing that stick or discipline hold? Anything that you would observe on that positive or negative?

Yes. On the New Equipment side, really pleased with our teams. They've moved from a discount methodology for decades to a price methodology. And we've been able to get price. We would tell you, second quarter, we got low single-digit price, although it varied because China price was negative. The other 3 regions did really well, and they're continuing. We continue to make price increases on New Equipment. We're seeing that come through the backlog now with backlog margin. On Service, like-for-like, we're up 4% last quarter. We have a lot of inflationary clauses in our contracts, especially in the more mature markets, Europe and Americas, they're backward looking. So what we got this year, which was very significant in Europe and then in the Americas, was based on '22 inflation. '23 inflation is still high. So we'll be able to get that in '24. And we've told the teams, we're going to get price, and we have them.

Understood. Obviously, in the Service portfolio, a lot of moving pieces and certainly a lag between orders and installation and then the end of that warranty period, especially in China, where it's a little bit longer. How should we think about the units up for conversion in '24 versus '23. I think maybe you get a little bit of extra help in China given a surge there. But just remind us where we stand on that? Is that an opportunity to grow a little faster or have at least more at bats?

Well, we have more at bat. The first place we got the bat was from the gain share. So we're already with bats in our hand, and we're ready for the pitch because as we gain share, we already have more units, the ability to convert them, and our conversion rate is going up. And so the conversions have the opportunity to drive about another 0.5 point of portfolio growth, and then we measure retention rates. We've got a world-class retention rate, 94%, best in the industry. We think we can get that to 95% pretty much over the medium term, and that will give us another 0.5 point. And then we say, okay, if we do get canceled, we have to recapture a unit. And that's what we challenge the teams to make sure that we have that net gain and all 4 of our regions have been delivering on that. China the most in terms of growth, Asia Pac next, but then even in mature markets in Europe and Americas, we're seeing it.

Understood. I'd like to spend the rest of our time here on capital allocation. You guys are very consistent on the capital allocation, obviously, very shareholder friendly in that regard. But anything you're seeing out there, either in an M&A pipeline or something that's crossing your mind strategically that we should keep in mind here over the next 6, 12 months?

I mean, next 6 to 12 months, we're going to continue our capital allocation model. Our bolt-on strategy is healthy. We've acquired a lot of small independent service providers. We target $50 million to $70 million a year on that. And then the rest goes to dividends, which we just increased again, 70% since spin. So we're pretty proud of continuing to get closer to that 40% ratio, like most industrial -- U.S. and multi-industrials have. And the rest we were turning through share buyback. We're going to do about $800 million this year of share buyback, and again, being capital friendly. We continue to monitor. It is a pretty consolidated industry. We continue to monitor if there's going to be a generational opportunity of potentially another elevator or escalator player available. But that -- we don't know when that will happen or if that will happen, I love our position. We're the leader in the industry. We're driving the right EPS. We're returning the cash to all of you, and we're performing for our customers and for each other. And as we do that, we're prepared to use the balance sheet as we need. Our last debt payment was in '22, about $0.5 billion. We don't think we need to pay down debt anymore. We took care of a recent bond offering. And I think we're managing the balance sheet to the best of our ability.

Understood. Judy, thanks for joining us. It's always a pleasure.

Great. Thanks, Josh.

Thank you.