Chief Investment Strategist
How did a 171-year old company become a high quality stock in 2024? It all started in 1853 by Elisha Graves Otis with the invention of a safety device that prevented lifts from falling if the hoisting cable broke. In 1857, the first passenger lift was installed in the E.V. Haughwout Building in New York City, making Otis a pioneer in lift technology. The company expanded in the following decades to Europe and South America which in itself was rare for companies in this period of history. In 1903, Otis introduced its first gearless traction lift, a significant advancement in high-rise building technology. Otis is also famous for installing lifts in the Empire State Building in 1931, which was the tallest building in the world at the time.
In the 1960s, the company innovated with the Autotronic lift system, which uses a simple company to manage lift operations more efficiently. Otis ended its life as an independent company in 1976 when United Technologies Corporation (UTC) bought the company. During the 1980s and 1990s the company expanded into Asia and other emerging markets to pursue the new demand for high-rise buildings. In the 2000s, Otis introduced the Gen2 lift which uses a flat polyurethane-coated steel belt instead of traditional steel cables, reducing energy consumption and increasing durability. In 2020, Otis was spun off from UTC as an independent publicly traded company freeing up resources to focus on digitalisation and smart building solutions.
Otis is an incredible complex business to run from a manufacturing and service point of view. But from an investor’s point of view it is a simple business. Otis sells new equipment and it services the installed base of units. New equipment comes with lower margin and more revenue fluctuations just like selling iPhones and printers. The service business is a stable and high-margin business like Apple’s Services segment (digital sales on the iPhone) and ink for printers.
Otis business has three growth drivers, 1) the growth in the portfolio of units installed, 2) modernisation orders (digitalisation etc.), and 3) new equipment orders. The portfolio of installed units will slowly grow so the key to deliver high shareholder value is to constantly optimize the network. The modernisation growth is interesting because many customers would likely want to upgrade old lifts and escalators if they become easier and less costly to maintain. New equipment is a function of market share and growth in high-rise buildings (lifts) and infrastructure (escalators).
Otis’ digitalisation efforts evolve around an entire ecosystem of connectivity under the name Otis ONE™ and Otis indicates that customers opting into Otis ONE increases their retention rate. The services segment maintaining the installed base is also interesting because not only does it come with very high stability in growth rates and margin, it also comes with long service contracts that have inflation adjustments. This is also one of the reasons why Otis’ share price has not been negatively affected by high inflation as we will demonstrate later on. Helmer’s 7 Powers framework, developed by Hamilton Helmer in his book "7 Powers: The Foundations of Business Strategy", provides a structured approach to evaluating a company's strategic positioning. It can help investors understand why a company has a high ROIC and whether it has endurability. Below we analyse Otis in each of the seven powers.
1. Scale Economies – Otis is a global leader in the lift and escalator industry. Its large production volumes and extensive service network enable cost efficiencies and competitive pricing.
2. Network Economies - Otis’s extensive service network creates network economies. As more buildings use Otis lifts and escalators, the value of their service network increases due to greater efficiency in maintenance and quicker response times to service calls.
3. Counter Positioning - Otis has differentiated themselves from competitors through innovation such as integrating Internet of Things (IoT) and artificial intelligence (AI) into their service offerings, creating smart lifts and predictive maintenance systems.
4. Switching Costs - Otis benefits from high switching costs due to the integration of its products into buildings’ infrastructure. Once a lift is installed, replacing it with a competitor’s product would be costly and inconvenient for building owners, ensuring customer retention.
5. Branding - Otis has a powerful brand built over many decades. It is well-known for reliability and innovation in lift technology providing it with a strong competitive edge.
6. Cornered Resource - Otis’s extensive patent portfolio and proprietary technologies in lift systems act as cornered resources. These technological advancements ensure that Otis maintains a competitive advantage that is difficult for new entrants or existing competitors to replicate.
7. Process Power - Otis’s advanced manufacturing processes, coupled with its use of technology for predictive maintenance and service optimization, provide significant process power.
Based on our analysis above Otis has a lot of key quality characteristics and if we look at fundamentals we observe the same making a connection between the strategic analysis and the financial results. Otis has a very high return on invested capital (ROIC) relative to the average weighted cost of capital (WACC). There are some accounting technicalities why Bloomberg has such a high ROIC, but other publicly available measures on ROIC also suggest that Otis has at least a ROIC of around 2.5-3 times the WACC.
It is very clear when you read the investor presentations by Otis that the company is prioritizing efficiency in its business as a way to improve its operating margin. As the chart below shows, the earnings before interest taxes and amortization (EBITA) margin has improved over the past five fiscal years ending the fiscal year at 16.9%. Another key quality characteristic is that the capital expenditures (reinvestments into the business) have not grown over the past six years which is quite impressive given that revenue has grown by $2bn over the same period. In other words, Otis is not a business that requires a lot of capital to be reinvested into the business.
Otis’s main competitors are KONE, Schindler, and Thyssenkrupp Elevator (part of the publicly listed conglomerate Thyssenkrupp AG). Otis has slightly larger annual revenue than KONE and Schindler, but also has a higher EBITA margin and have grown revenue slightly faster in recent years, suggesting Otis is doing something right in terms of its strategy.
In terms of share price performance, Otis has been quite impressive. Since March 2020 the total return (including reinvestment of dividends) has been 110.6% (which is 19.6% annualised) compared to 98.5% for the MSCI World Index. Over the past four years, Otis has delivered 1.4% annualised outperformance which is quite impressive given that the MSCI World Index has been driven by strong performance from sectors such as information technology, health care, and communication services. That an old business from the 19th century selling lifts and escalators can keep up with one of the strongest equity rallies in modern history is an extraordinary testimony to Otis’s shareholder focus.
Opportunities are not present without risks and Otis is exposed to several risk factors. In our 7 powers analysis we highlighted its innovation as a key competitive edge, but given R&D spending is declining in percentage of revenue the company might be sacrificing its long-term edge over short-term improvements in profitability to create shareholder returns.
Competition is fierce in the global lift industry with KONE and Schindler being the main competitors. Price pressures could easily be a long-term outcome. Otis’ new equipment business is vulnerable to the economic cycle which impacts global construction. Supply chains and especially raw material prices have in recent years been a negative for Otis’ financial results and will remain a key risk factor going forward.
Quality companies can be defined in many different ways just like value. MSCI, which is world’s largest equity index provider, has defined it using three fundamental variables return on equity, debt to equity, and earnings variability. This definition makes sense because it can be applied to all companies regardless of which sector they are part of. The definition puts emphasis on profitability relative to the deployed equity, leverage ratio (less debt leverage relative to equity is good), and finally the predictability of the business with less variance in earnings being a good thing. In our past equity research we have also found that the lower earnings variability a company has the higher its valuation becomes, so this is a quality marker.
In our equity research note Top quality companies and how to decode their traits we focused on return on invested capital (ROIC) relative to the cost of capital (WACC) as the key measure to identify quality. Next we explained, that around half of those companies with the highest ROIC see their ROIC falling from the top to outside the top over three years due to competition or changing technologies. This is the quality trap that investors need to avoid. It is about finding enduring quality. The “7 Powers” framework is a good approach to analyse whether a company has enduring characteristics or not. Finally, a company can have a stable spread in ROIC minus WACC with a ROIC not in the absolute top and still be a phenomenal stock for shareholders. All it requires is that the business can invest a lot into the business. Historically, Walmart was exactly such a case.
The interesting thing about researching quality companies is that you cannot put it all into a formula. You must apply discretionary thinking about the business, its products, the company’s strategy, the industry drivers, technologies strengthening or weakening the business, because in the end the big returns about changes in expectations for the company.
The list below highlights our previous analyses of quality companies.
2024: The wasted year
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