Otis Worldwide: Resilient But Upside May Be Limited (NYSE:OTIS)

Investment Thesis

Otis Worldwide (NYSE:OTIS) has been holding up very well in the past year. Unlike the S&P 500 Index which dropped 6.1%, the company rose over 15% during the period. The company is a solid defensive holding as its service segment is highly resilient due to its non-discretionary and recurring nature. The strength is reflected in its latest earnings with organic sales and EPS (earnings per share) both up high single digits despite facing a tough macro backdrop. The guidance also indicates similar growth rates for the coming year. However, the current valuation looks pretty stretched after the recent rally in share price. I think the upside should be limited therefore I rate the company as a hold.

Strong Resilience

Otis Worldwide is a US-based company that manufactures and maintains elevators, escalators, and related equipment. The company is the global leader in the industry and currently maintains over 2.2 million customer units in over 200 countries. I believe Otis should continue to perform well despite facing a volatile macro backdrop, thanks to the resilient nature of its business. While the slowdown of the real estate market may impact new equipment sales, the segment only contributes 42% of total revenue. The remaining 58% is actually generated from service and maintenance.

The service and maintenance segment is very stable as customer spending is non-discretionary due to safety regulations. It is also highly predictable, as it has a recurring nature with a retention rate of 94%. The average contract length for its services is 4 years and comes with inflation adjustments, which allows the company to stay insulated from elevated inflation. Besides, as the company’s new equipment sales continue to increase, its installed base also grows accordingly which further expands the units that require services. The segment is benefiting from urbanization and the modernization of legacy equipment, which should provide tailwinds moving forward.

Solid Earnings

Otis Worldwide announced its fourth-quarter earnings last month and the results are solid. Top-line growth was muted due to currency headwinds but the bottom line continued to edge up.

The company reported revenue of $3.44 billion, down 3.6% YoY (year over year) compared to $3.57 billion. On a constant currency basis, revenue grew by 4.6% while organic sales increased by 6.1%. New equipment revenue was down 6.5% YoY (up 1.6% on constant currency) from $1.56 billion to $1.46 billion. The drop is largely caused by lockdowns in China which reduced demand. Organic sales from the country dropped 4.1%. Service revenue was down 1.4% YoY from $2.01 billion to $1.98 billion (up 6.9% on constant currency). The segment’s organic sales were also up 6.9% and the maintenance portfolio units increased by 4.1% to 2.2 million.

The bottom line improved as the management did a great job of controlling costs and expenses, despite facing inflationary pressure. Costs of sales dipped 2% from $2.53 billion to $2.48 billion, while SG&A (selling, general and administrative) expenses declined 10.9% from $503 million to $448 million, as the company continues to execute cost-cutting initiatives. This resulted in net income growing 5.7% YoY from $281 million to $297 million. The net income margin was 8.6% compared to 7.9%, up 700 basis points YoY. The EPS was $0.71 compared to $0.65, up 9.2% YoY.

The guidance for FY23 was also decent considering the weak economic backdrop. The company expects revenue growth to be 1.5% to 4%, while organic sales are expected to be up 4 to 6%. The adjusted EPS growth is expected to be 6% to 10%, thanks to margin expansion from better pricing.

Investors Takeaway

Otis Worldwide is a great defensive company thanks to its business nature, but the current valuation is a bit stretched which will likely limit its near-term upside. The company is trading at an EV/EBITDA ratio of 17.6x which is elevated on a historical basis. It represents a premium of 6% compared to its historical average of 16.6x. It is also trading above industrial peers like Carrier Global (CARR) which has an EV/EBITDA of 15.2x, or a discount of 15.8%. The company’s high single-digit EPS and organic sales growth are solid in the current environment but probably not enough to support further multiples expansion. Therefore, I believe the company is a hold and investors should be patient and wait for future pullbacks.