Otis' Elevator Maintenance and Modernization Business to Drive Solid Medium-Term Earnings Growth 

Senior Equity Analyst

Grant Slade

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Otis Worldwide is the largest elevator and escalator original equipment manufacturer globally with integrated operations that span manufacturing and installation activities, as well as elevator and escalator servicing for existing installations. Additionally, Otis performs elevator modernization services for elevator systems at the end of a typical 15- to 20-year useful life. Otis estimates the global E&E market was worth about $80 billion in 2021 with Otis commanding an approximate 18% global market share, based on revenue.

Otis operates under an installed-base business model where it monetizes its industry-leading reputation through the growth of the global base of elevators installed over many decades. Profit margins on new elevator sales are modest, with Otis sacrificing profits on new installations for subsequent elevator servicing contracts on the elevators it installs. Elevator service contracts are the industry’s main prize and command significantly higher profit margins than those of new equipment. Otis boasts the industry’s largest elevator service portfolio, with 2.3 million units under maintenance in 2023—about 11% of the total elevator units installed globally.

Otis operates a capital-light model with significant outsourcing of new equipment manufacturing and installation activities and light working capital requirements. This makes for a highly free cash flow-generative business that boasts steadily high returns on invested capital, averaging about 50% over the prior five years. Importantly, its operating model also offers a highly flexible cost structure that protects Otis’ earnings from volatile construction cycles.

Otis’ strategy positions the business to further perpetuate the free cash flow generation potential of its leading existing installed unit base. The strategy seeks to maintain growth in new installations, and accelerate the growth of its service portfolio, while utilizing digital capabilities to enhance the elevator user experience and reduce servicing costs.

Business Strategy & Outlook

We assign Otis a wide moat rating. Otis’ high returns on invested capital result from the confluence of its durable competitive advantages—which include reputational intangible assets, customer switching costs, and a cost advantage in the provision of elevator servicing—and its capital-light business model. An operating model design—which features a relatively flexible cost structure for manufacturing new equipment and installation activities—helps foster strong economic profit throughout the economic cycle. To this end, Otis manufactures only fundamental and/or proprietary components in-house such as elevator motors, electrification systems, and other components that are crucial to the look and feel of its products. Consequently, third-party suppliers manufacture and supply the vast majority of the components used in Otis’ products. The installation of Otis’ products is also outsourced to trusted subcontractors. In turn, Otis’ low fixed-cost orientation of its new equipment business permits it to promptly respond to changes in market conditions, thereby better smoothing earnings and ROICs through otherwise volatile residential and commercial real estate construction cycles.

From a technological standpoint, the elevator industry is mature with the major electromechanical technology used in elevator systems being several decades old. Consequently, new equipment offerings by major elevator OEMs tend to lack significant differentiation. Despite the maturity and relative uniformity of the product category, the new equipment market is dominated by five large elevator OEMs—Otis Worldwide, Schindler Holding, Kone, TK Elevator, and Mitsubishi Electric—which together account for about 70% of the global supply. The stable and dominant market shares and returns of this select group of industry players are the result of brand or reputational-based intangible assets they have built up over multiple decades. Otis and its major OEM peers benefit from a well-developed reputation for product safety, quality, and functionality, and a long-established track record of efficient, smooth, and reliable new equipment installations. The major OEMs also benefit from an established history of delivering novel solutions for customers during a building’s design phase that address individual construction project challenges such as building height, narrowness, or elevator usage patterns. Taken together, these attributes represent key competitive differentiators for Otis when bidding on new property development and infrastructure projects, perpetuating its dominant position.

The Chinese market is instructive of the reputational advantages that the major elevator OEMs possess. Chinese customers remain more price-sensitive than their European or North American counterparts—largely a function of the country’s earlier stage of economic development. This price sensitivity leads to greater competition and fragmentation of the Chinese elevator service market, where the top four OEMs hold a mere 20% of the market—versus 55% in Europe and 70% in North America. Still, the superior reputation held by the top OEMs resonates loudly, with most Chinese property developers maintaining a preference for the major OEMs for new installation projects. As a result, the top-four elevator OEMs command a cumulative 60% market share of the Chinese new equipment market, highlighting the strength of the reputational-based intangible assets that the large integrated OEMs possess.

The reputational intangibles Otis has amassed also deliver a competitive edge that opens access to the lucrative follow-on elevator service market. Here, Otis fully monetizes its long-established track record by converting new installations into its global service and maintenance portfolio. The service and maintenance portfolio generates the lion’s share of Otis’ economic profits, with the service business’ operating margins significantly exceeding that of the new equipment business. We think the durable competitive edge, that its reputation provides in service and maintenance markets is best illustrated by a healthy service contract conversion rate—the proportion of new installations that are converted into a paid maintenance contract—which stood at 62% in 2021.

Upon conversion, meaningful switching costs bind service customers for the long term, despite the typically short-dated nature of service contracts and contractual terms that normally permit price increases to protect servicer profit margins from cost-base inflation. This is a result of the mandatory nature of regular, scheduled elevator servicing—as is uniformly required by relevant occupational health and safety regulations globally—and more generally by the need for reliable and uninterrupted elevator service for the proper functioning of a building. Elevators play a central role in the mobility of tenant personnel of the building and its visitors, creating a significant aversion on the part of building/asset managers and owners to elevator downtime or loss of service. Building and asset managers are loathe to switch servicers given building tenant sensitivity to elevator underperformance and downtime. Fear of the potential for subpar servicing from a new provider—which could in extreme cases result in catastrophic human life outcomes—only adds to service customers’ reluctance to switch servicers. Furthermore, the incentive for a property manager to switch to a new servicer that is offering sharper pricing is limited by the reality that elevator servicing costs are small relative to a building’s total operating costs.

While the servicing market is decidedly more fragmented than the new equipment market— with the top-five OEMs accounting for just 40% of the global elevator service market—meaningful switching costs result in high retention rates for Otis and other major OEMs. Otis’ service customer retention rate stood at 93.5% in 2023. As a result of low customer loss rates, and the OH&S-mandated elevator servicing throughout the year, revenue from the maintenance and service business is remarkably stable through the economic cycle. The elevator service business thereby helps shield Otis’ ROICs from the impact of the more cyclical new equipment side of the business.

We think Otis’ service business also benefits from a cost advantage owing to its superior localized scale and route density of its service portfolio. On their own, the superior unit costs, which its service business enjoys—relative to smaller players that make up the fragmented tail of elevator service and maintenance markets—don’t deliver pricing power to Otis. Still, we think the cost advantage that Otis’ superior route density delivers offers a second line of defense to economic profit generation. 

The cost base of the service and maintenance business is dominated by two major costs—service technician salaries and the leasing, maintenance, and fuel costs of the vehicle fleet used by technicians as they move from one service job to the next. Together, labor and vehicle expenses account for some 70% of the service business’ cost base. The greater the density of a service network—or the number of buildings per square meter that an elevator servicer has under contract—the more fractionalized this cost base becomes and the higher the productivity of the service technicians and vehicle fleet employed by a servicer.

Differences in geographic business mix and variation in disclosure practices make direct comparisons of service costs per installation unit under maintenance of the major OEMs problematic. Still, the relative productivity of an elevator servicer’s workforce (and the vehicle fleet they use to service customers) can be inferred by comparing the average number of elevator units serviced by each field technician. Evidently, the productivity of Otis’ service technicians is industry-leading, with Otis boasting the highest number of elevator units serviced per service technician amongst the four largest integrated elevator OEMs. The superior productivity of its service workforce translates to favorable elevator servicing unit costs, thereby widening Otis’ operating margin relative to its major OEM peers. We think that the cost advantage Otis enjoys is meaningful relative to smaller service competitors that constitute the fragmented tail of the elevator service industry.

Wide

Economic Moat

Otis Worldwide

Otis Worldwide Corp. engages in the manufacture, installation, and provision of escalator and escalator services. It operates through the New Equipment and Service segments. The New Equipment segment designs, manufactures, sells, and installs a wide range of passenger and freight elevators. The Service segment offers maintenance and repair services, and modernization services to upgrade elevators and escalators. The company was founded by Elisha Graves Otis in 1853 and is headquartered in Farmington, CT.

Earnings data Q2 2021

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Earnings data Q2 2024

Otis Worldwide reports strong Q4 performance and outlines growth plans

Otis Worldwide showcased robust performance in Q4 2022, with growth in key metrics and strategic initiatives driving future growth prospects.
Despite challenges from headwinds, the company's strengths in margin expansion, global projects, and ESG efforts position it well for continued success.
With a focus on enhancing productivity, customer relationships, and cash flow conversion, Otis is poised to capitalize on opportunities for sustained growth and profitability.

Otis Worldwide reports strong Q1 results, eyes growth opportunities in Asia

Otis Worldwide's Q1 performance reflects a robust business model with positive growth indicators and strategic capital allocation. While facing regional challenges, the company remains confident in its outlook and aims for sustained profitability and growth.

Otis Worldwide reports strong Q2 performance and eyes growth opportunities in Asia

Otis Worldwide reported a strong Q2 performance with high single-digit organic sales growth, expanded profit margins, and notable EPS growth. The company showcased strength in securing global contracts, emphasizing sustainability, and introducing operational efficiency initiatives.
While facing challenges with new equipment orders and market uncertainties in China, Otis has opportunities to leverage its strong market presence, focus on sustainability, and capitalize on growth in Asia. Initiatives like the UpLift program and mod margin enhancements position the company for future success.
Overall, Otis Worldwide's performance in Q2 reflects resilience and strategic focus, with a strong service segment, robust financial results, and a commitment to sustainability. The company's initiatives and market opportunities present a positive outlook for continued growth and profitability.

Otis Worldwide reports strong Q3 results amidst New Equipment challenges

Otis Worldwide's Q3 performance showcased strength in service segments and organic sales growth, despite challenges in New Equipment orders. The company's focus on key markets like China and initiatives like the Uplift program position it well for future growth.

Otis Worldwide reports robust Q4 performance and eyes modernization growth

Otis Worldwide's Q4 performance showcased strong growth in modernization orders, service sales, and global project wins, underpinned by innovation and sustainability goals.
While facing challenges in backlog volume and competitive markets, Otis remains focused on opportunities for margin growth, ESG initiatives, and market expansion.
The company's 2024 outlook is optimistic, with expectations of continued growth in key financial metrics and a strategic focus on modernization and service segments.

Otis Worldwide reports strong Q1 performance, eyes growth in India

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