Otis Worldwide Corporation (OTIS) Earnings Call Transcript & Summary

So we're 173-year old business as of last week. And you can imagine, we have very proven reliable processes. We're in the life safety business. It's important that we operate safely but it's also important that we -- that customers count on us. All of you in the room and everyone listening, you count on us for a safe, reliable ride every time you don't think twice, and that's 2.5 billion people every day. We've been on a journey in terms of transformation. We started at spin with needing to set up the company to be an independent public company. We focused on where we needed to enhance processes. We focused on the technologies we needed. We focused on go-to-market. We focused on innovation and product -- and we worked through all of that the first few years after spin, and you saw those results, and we're very proud of those results. And most importantly, we focused on Service portfolio growth because we believe the strength and the size of our Service portfolio is the foundation for Service contracts for maintenance and repair on top of that and then eventually modernization. And we took a company where between 2010 and 2019, the Service portfolio kind of oscillated between 1.9 million to 2 million units -- and we focused on portfolio growth in the early days, the first few years. And we grew at 25%, and we now have 2.5 million units, larger Service portfolio anywhere in the world. Then we said, that's great, but now how do we continue to drive growth top line and margin expansion bottom line. And a few years ago, we said, well, as we look at these 1,400 operating territories. First and foremost, let's take out and centralize the local activities that are not customer-facing, that are more transactional. We called that uplift. You recall, we did a major restructuring on that. So we've removed all of that, handed it, working with a partner, we've centralized all of that. The next step in this transition, and it's not a restructuring, let me be clear, is the Service operating model. We have some of our operating territories that are operating incredibly well. They have best practices to share. But we haven't changed the basic core of how we work end-to-end process from the sale to the field installation to the field service, especially. So this is all in service. So from the time the warranty starts until we provide maintenance, repair and then eventually mid, we haven't changed how we do that in a very long time. So we're going to change the processes, and we're also going to apply technology because this is happening at a very unique inflection point where Agentic AI and generative AI and 1.1 million of our units being connected on Otis ONE and giving us data every day is giving us the ability to make our feel more productive, to improve our quality and also to raise the level of how we work. So it's not a restructuring program, but it's a build after we did uplift so that we can be more customer-centric and we can get leverage on Service margin. This is all about now where do we get the next leverage on Service margin. We can continue to add units -- that will help. We can drive volume on the top line, but now we need to get that leverage in terms of productivity, in terms of how we deliver and how we work. And you're going to be hearing more about the Service operating model. We're going to do it in a very focused way brand and now we are going to start in our high-value countries because not every unit contributes the same way. A unit in an emerging part of Asia is very different contribution than any unit in a mature part of Europe or the Americas. So we're going to start this in the U.S. We're then going to move the Service operating model to a few key high-value countries, you can imagine, Germany, France, Spain, in Europe. And then we're going to -- we'll proliferate it from there. But the yield -- it's all about leverage for us on Service margin. And we think beyond volume growth, this is that second piece that pulls it all together.

As you mentioned, you have some territories that are operating very well, combining strong growth retention and productivity. What separates those best-performing territories from the rest of the network -- and how much margin opportunity is there from simply closing that performance gap?

They're significant. I won't put a quantitative number on it, but there's significant opportunity by raising the lower quartile and getting to where our -- and we have some world-class leaders in these operating territories. Retention rates in the high 90s customer satisfaction, incredible far greater margin contribution and Service margin. What separates them is the ability to do workload planning to do resource allocation to be able to be responsive to customers and to do all of that simultaneously based on the processes they've put in place these best practices. And we have some that are outstanding and the challenge is how do we institutionalize that. And these people are -- they're doing great jobs. We have 1,400 P&Ls that all add up. and they're not all operating at the same level. But when we can get this deployed, especially in these high-value countries, you're going to see the difference on the bottom line.

That's great. I want to drill down a little further on Service margins. The biggest question coming out of Q2 with the margin story of strong organic growth, as we mentioned, but margins declined 170 basis points as mod mix, labor costs and investments weighed on the results there. How should investors separate what was temporary executional costs from structural costs that are required to support a faster Service growth level?

So we had about $50 million of in 2026, we have about $50 million of that it's not investment costs, but was are the decision we made to be able to do much faster backlog conversion, and that drove a lot of the repair and modernization top line volume -- we needed to -- you can't allow backlogs to grow too significantly, especially in repair because the customer has got an elevator down. So we needed to apply higher skills at times in certain countries. We needed to bring subcontractors in for us to be able to convert the backlog. Our mod backlog as we ended the year was at 30%. It's now at 26% with this 24% revenue we had. We needed that ability, and we thought for customer relationships for backlog conversion, that's temporal. We know that, that's temporal in terms of what we need to do. simultaneously, obviously, hiring these mechanics and the skill needed to do repair and modernization is a higher skill discipline than just to do maintenance. Traditionally, we had the luxury of bring everyone in, they start with maintenance and then you continue to grow them and groom them. With our backlogs as high as they are in repair and mod, we needed to use higher skilled labor than we had anticipated. So that all -- that $50 million, that was all fairly temporal in the second half. In terms of modernization though and mix, it is a lower-margin offering for us. than maintenance and repair. But it is worth it. So if you look at right now, we have about a 75-25 split in revenue, maintenance repair being about 75% modernization being about 25%. The modernization markets, our target medium term was to get to about 10%. We're on that trajectory, and then we'll improve from there. But you know our Service margins, we're going to end the year -- the second half will be about a little over 24%. You can imagine that maintenance and repair is much higher margin. The reason we're so excited about modernization is twofold. One is actually the expansive opportunity. But in terms of how it can contribute is we have the volume we're going to get from -- and with that volume, we're going to get the flow-through of profit dollars. So the EBIT is going to come. It will be margin dilutive, but the EBIT is going to come. But just as important is a tremendous number of the modernizations we do are units that are not in this 2.5 million unit Otis Service portfolio. So as we finish those modernizations, as we're in a live building with the customer, they're having us do their work, our conversion on those into our Service portfolio helps us grow the Service portfolio even more. And it overcomes even China conversions, which have slowed down because new equipment slowed down, so to us, modernization is an evergreen opportunity. Again, 9 million units over 20 years old last year, we anticipate it's not really well-kept records in our industry like new equipment. We anticipate a little over 300,000 units got modernized. More than that entered the modernization window last year. So that the opportunity is growing. It's going to continue for years to come. And so the modernization business, again, as we grow scale, it will get even more profitable, but the profit dollars will come and the ability for them to add to our portfolio is like a double benefit.

Before we get to modernization, I just want to ask 1 more on margins. So the $50 million that you said is temporal for the second half of the year. What specifically do you need to see improve in order for that $50 million to truly be temporal unwind into next year?

So we've already hired the mechanics. They're on their journey in terms of their apprenticeships in terms of their learning curve. So in terms of the need to bring in additional surge subcontract to support in the need for us to keep moving labor around whether we're moving China mechanics to Japan or mechanics from Peru to Spain. We've been using our workforce dynamics and subcontractors to be able to help fulfill this while our mechanics are beginning trained. We're comfortable our mechanics are at the right place in the learning curve where we hired them in '24, '25 or now in 26 that will take care of that situation.

Great. So now shifting to modernization. As you mentioned, sales were really strong, grew 24% in Q2, backlog up 26%. And but you're going to moderate growth to the mid-teens you're saying what is -- how sustainable is this level of demand in the 20s? And what would it take for you in terms of investment or whatever else you need to do to support a higher level of growth in the mid-teens you're guiding to for the back half?

We're ready for -- in terms of an investment perspective. We've got the modernization packages standardized around the globe. They're coming across our new equipment lines in terms of manufacturing. So we're getting the the scale in terms of supply chain, in terms of material productivity. And we're seeing the early days of the installation productivity, repetitiveness that will get us that efficiency in terms of how we quoted versus what our final result was. I don't think we stay at 24 every quarter, but I think it will modulate in the 26% up backlog there's a combination of volume odd. So think about an apartment building, a school, something of that nature versus major projects mode. Think about the Empire State building when we did that mod, Willis Tower, large office complexes where -- or airports where you can't stop the flow of people, but you can take down 1 elevator at a time to do a modernization. I was at the last year at the Beijing Metro and for that escalator mod, we were allowed to operate from about midnight to 4 every day. and then we had to leave. So major projects have a little different revenue recognition flow. It looks a lot more like new equipment. But the volume out, we see happening easily at this mid-teens and then major projects is kind of the piece on top. It's a little harder to predict in terms of revenue recognition.

Got it. I want to shift to the new equipment for a second. You saw down only 1% in Q2, 1 of the better results in the last couple of years with backlog growing as well. Is the new equipment market turning a corner and where are you seeing the most strength and weakness on a regional basis?

This quarter, we will -- that minus 1% from second quarter will be positive. First time we can say that since 2023. Any of you who know us know that that's due to the significant decline in China new equipment that's been happening now for about 5 years, a little over 45% decline in the market segment. And we've done everything, whether it's our China transformation or any -- and pivoting more to China Service and modernization to handle that and to really reflect in our business, a different level of business we have now in China that used to be predominantly urbanization new equipment. What we're seeing happening right now in the third quarter, what's overtaking that that overhang from China, and we're just delighted to see it is how our team in North America has done. We've had 8 straight quarters of new equipment growth in the U.S. and Canada, and it's been significant new equipment growth. There's a good 18-month lead time. So if you go 8 quarters, we're now starting to see that not just flow through our factory in Florence, get installed but we're seeing it flow through at much higher volumes to where it's overtaking China. Asia Pacific and Europe still looks strong. China new equipment is now 18% of the group revenue. It was 33% in 2020. So and our business has grown. So you think about we've overcome the China overhang. We're going to inflect positive in third quarter. That's going to continue through the rest of this year and next year. And once China just stabilizes, and we don't have the compare. You all will see how well the other 3 regions have been performing year after year to keep our business growing. I mean our top line, we're going to be up to about $151 billion to $15.4 billion in revenue this year, and that's still with China down in its fifth consecutive year on new equipment. So I think the team has done a great job compensating -- and once China stabilizes, we don't expect new equipment to ever grow there again, that would be a nice surprise. Once it stabilizes, you'll see the strength of Asia Pacific of EMEA and of the Americas and how well they've been doing a new equipment. Still a lot of construction going on in this world.

And as you mentioned, China has been weak, but recent comments have suggested that it's sequentially improving at the very least and perform as expected. What are you seeing on the ground today in China? And what gives you confidence that the market is approaching a more stable level?

I have the privilege of having just gotten back from China 2 weeks ago and met with government officials all the way up through Premier Lead to understand economics, party secretaries, governors, to understand where China is heading, where the priorities are in the 15th 5-year plan and what does that mean to our market and what does that mean to Otis and just as importantly, time on the ground with the team. We understand our markets. So our team has performed incredibly well under challenges we knew we needed to take cost out of new equipment, and we did that through our China transformation last year. But we ended the second quarter with 48% of China revenue being in service. First quarter was 52%. So all of a sudden, what used to be such a predominant new equipment business, we've converted to be Service business and China looks a lot more mature. Where we're seeing growth in China on the Service side, we're still growing our Service portfolio. We spun with about 220,000 units in China in 2020. We're now over 0.5 million. Team has done a great job growing that, which then drives repair. But the biggest CAGR growth is happening in modernization in China. China units tend to modernize at the 15-year mark versus the 20 because of so much usage they get. And in 2024, the Chinese government added a stimulus Originally, it was for white goods, but we got elevators included for older residential elevators, the government pays to modernize their buildings. In '24, it was 80,000 units and 25 is 120,000 units. This year, it's 180,000 units. In the second quarter, our modernization orders in China alone doubled, smaller base but doubled, and we're winning more than our fair share of this modernization stimulus. What I heard while I was in China is going to continue into '27 and we believe beyond potentially beyond just residential to take care of the citizens of China other buildings will be included in the stimulus. This year, we got it added that it wasn't just 1 price point. It's 3 price points depending on the rise, how many floors there are because there's more material -- so the Chinese government is committed to this in the 15th 5-year plan and our Otis team has been performing wonderfully. So China looks more like a mature market to us. It obviously had a hit on our new equipment margin becoming lower because China had the highest new equipment margins, followed by the Americas, but we've been able to make that up.

As investors start to think about looking beyond '26, I'm not asking you to provide guidance, but what should we think of as the major puts and takes that we should be thinking about as we bridge into 2027 in terms of Service volume, margin recovery, new equipment in China.

We are excited. The -- listen, the business model is intact. This is a stable business that has been preparing for higher growth than we've seen in a long time. That's what the investments have been all about. There's investments need to pay off, pricing needs to happen -- we need to see the Service quality continue where it is and continue to improve and that translates directly into retention rate, and we need to execute with excellence. The Service operating model will help us do that we are the leader. We've got a great portfolio. We've got the best people in the industry. And what you'll see on the margin side is some of these temporal issues and investments we made this year not repeating. There is some seasonality, so I'm not going to get into first half versus second half in we'll share that with you when we guide. But we're going to leave the year strong in terms of Service margins. You'll see incremental improvements third quarter and fourth quarter. That's all in our backlog now, so we just need to perform, -- and when you see that strength and we share with you where we're going in 2017, I think you guys are going to see the returns of a high-quality business and a business I've been very proud to lead and will continue to lead into the year.

Great. Well, that's all the time we have. Thank you so much, Judy, and I appreciate the conversation.

Thanks, Brandon.