Otis Worldwide (OTIS)

As previously mentioned in my 2023 annual letter (link), I initiated a position in Otis Elevator Company last October at $77.2 per share, taking advantage of stock market volatility and the concerns of some investors about the impact of high interest rates on new equipment orders for elevators, escalators and automatic doors (“elevators” hereinafter for short). The stock price has somewhat recovered since then because the problem is temporary and the market usually ends up recognizing it sooner or later, but I believe Otis can still obtain low double-digit compound annual returns for many years, and I will try my best to explain why in this post.

As an investor, there are multiple ways to benefit from megatrends such as the increasing urbanization, growing middle classes and global population, but not all businesses that will benefit from these tailwinds are equally attractive. In my opinion, the elevator business is especially interesting because it is really simple to understand, difficult to disrupt, predictable, recurring, provides a critical service at a very low cost and returns on invested capital are very high (higher than 70% for Otis).

An elevator’s life begins with the construction of a building. Selling a new elevator is, without a doubt, the most cyclical part of the business, the least profitable (in general, EBIT margins are usually around or below 6-7%) and the riskiest (during the installation process, labor and raw materials might experience unforeseen price swings). The new equipment market is a global oligopoly and although the market share of the main OEMs has pretty much remained the same in recent decades, competition and price dynamics can differ greatly depending on location. The behavior of OEMs should be fairly rational (particularly when the vast majority are listed companies), but nothing could be further from the truth. Some OEMs may be willing to take on an unprofitable project because the likelihood that the end customer (not the contractor, but the building’s actual owner) will hire them for subsequent maintenance of that elevator (what they call “conversion rate”) is very high. OEMs will usually carry out maintenance for one to two years after installation, which is the average length of an elevator’s warranty period. After that time, the owner or owners of the building are free to hire any other provider to maintain the elevator. The point is that due to convenience, ignorance or risk aversion, most owners usually stay with the same provider after that initial period.

The maintenance and repair business has extraordinary unit economics, as it has some of the typical traits of a SaaS business: customers pay in advance, gross margins are between 85 and 90% excluding labor costs and EBIT margins are between 20-30% once labor is taken into account. Service is the least capital-intensive part of the business, it produces the most cash flow and is the most stable thanks to the fact that elevator maintenance is mandated by law, regardless of macroeconomic circumstances and whether they are used a lot, a little or never. The EBIT margin for maintenance and repair services may even exceed 35-40% in some geographic areas. Density is essential to achieve very high margins, so some OEMs are more willing to sacrifice their margin on new equipment than others. It also depends on how ambitious their growth strategy is. It is believed that KONE does not disclose the margins of its new equipment division for a good reason.

Elevators are fundamental elements in the infrastructure of any developed society. Unlike several decades ago, no building, whether residential, public or commercial, is built today without elevators. Governments have a responsibility to improve the quality of life of citizens and must pay special attention to those with mobility limitations. Currently, 50% of the world’s population is estimated to live in cities, and by 2050, the world's population is expected to go from nearly 8 billion people to almost 10 billion, with 70% living in cities and the aging population accounting for an even larger percentage of society. Buildings will become increasingly modern and taller, accelerating global demand for elevators. The world's leading elevator manufacturers are century-old businesses because the industry is highly regulated and therefore, barriers to entry are significant. After all, an elevator must provide safe movement for passengers in all types of building (schools, hospitals, airports...)

The question is: why invest in Otis and not KONE or Schindler? I have zero doubts about it, so in this post I will try to explain my reasons in detail.