1.0 IntroductionEvery single day, billions step into an Otis box, press a button, and trust their life with it.In the 1850s, elevators existed. However, the ropes occasionally snapped, leading to casualties.Elisha Otis invented the safety brake and took the marketing one level above. He stood on a platform at a New York’s fair and cut a rope with an axe in front of the crowd. The platform dropped a few inches and stopped.Although we take elevators for granted, their invention and the subsequent innovation to make them safe were crucial for having vertical cities.Today, the company maintains approximately 2.5 million elevators and escalators, including the ones in the Eiffel Tower, Empire State Building, CN Tower, Burj Khalifa, and Petronas Twin Towers.Subscribe now2.0 How does this industry work?An elevator is a 20-year machine living in a 100-year building. For the companies serving this industry, there are 3 revenue-generating streams:New equipment: Installing elevators in a building for the first time. This depends on new construction; it is cyclical, rate-sensitive, and currently dead in China.Maintenance: Core and stable revenue streamModernization: Replacing the core systems (the controller, the hoisting machine, door operators, signalization, etc), while reusing the shaft, rails, and structure. This takes place every 15-25 years, not cyclical, as it depends on the age of the elevators that are already in use.The maintenance contract is comparable to a subscription that the buildings pretty much must have. This is regulated industry, where maintenance and monitoring are a must, and inspections take place.Which is why the razor-and-blade model works. The margin on new equipment and modernization (which I’ll argue is in the same bucket, one-time projects) is quite low. Maintenance is where the high margin is.Otis (and many of its competitors) report revenue into two segments:New equipmentService (which includes maintenance and modernization)It can be argued that modernization fits better in the new equipment segment (as it’s one-time and low margin). At the same time, this grouping is fair if we want to distinguish between cyclical and non-cyclical revenue streams.Below is the Otis revenue split.The new equipment segment generates 34% of the revenue, but generates only 8% of the total operating profit (as the operating margin is only 4%).The service segment, on the other hand, is responsible for 66% of the revenue, but 92% of the operating profit (this segment has a 25% operating margin).3.0 Commodity?A question that I had was, is this a commodity business?Aren’t there many players that basically compete for the same customers and can offer similar prices, eventually ending up in pricing wars?What does the moat look like, if there is one?Elevators aren’t the most complex products today. There are many companies that offer installation and maintenance. However, I’d argue that there is a moat, and it comes in three forms:Trust barrier to entry - If you own a building and you want to install an elevator, I’m quite sure you’d choose the company that has done it millions of times, rather than the one that just started operating. Even if the new entrant offers a slightly lower price, which they cannot afford, because of the second reason:Economies through density - The more units Otis serves in a neighborhood, the more productive each mechanic’s route and time becomes. Compare this to a small company that has a few customers, dispersed throughout the city.Modernization - Lastly, over time, as technology improves, monitoring becomes better, so when the elevators are modernized, Otis can monitor its units in real time and predict failures. This way, the mechanics are even more efficient, as the elevators can be serviced/repaired sooner, which also leads to fewer customer complaints and, ultimately, higher retention.By default, when the words elevators/escalators are mentioned, we connect them to the products that serve humans. However, there’s more than that. On April 14th, Otis launched the heavy-duty elevator range for data centers and mission-critical infrastructure (Link to press release). This is a wild card that isn’t reflected in the company’s numbers, and the market didn’t react to this at all.4.0 Historical Financial PerformanceI do think Otis won’t appear on many screeners as its revenue has grown less than 2% per year.The lower construction activity in China has a significant impact on the revenue coming from new equipment. Although it is low-margin, stock screeners do not distinguish between low- and high-margin revenue. Therefore, Otis is labeled as a low-growth company by default.Under the hood, the picture is different.The fact that the revenue is up despite the lower demand coming from China is an achievement on its own.The total revenue is up “only” 13% since 2018, and the composition of it is what allowed the company to grow its operating profit by 26% over the same period.The new construction, although important for the total elevator base, is cyclical and low margin. So it all comes down to the second segment, services.The modernization component is why the demand in China is expected to bounce back. The construction activity was above normal levels between 2008 and 2015, which is becoming due for modernization very soon. This is low-margin, but it gives Otis the opportunity to land a maintenance contract after that.The maintenance (not new installation) segment is still largely held by independent contractors, and I think it shifts over time to the large companies (driven by economies through density). Which is a great way to move to the next segment.5.0 Capital allocationOtis is not just profitable, but its operating profits are growing, even during Covid. Its capital allocation is rather simple, and doesn’t change much over time.The operating cash flow is being allocated between:BuybacksDividendsAcquiring smaller entities (which helps in achieving economies through density and consolidating the industry)CapexHere’s the capital allocation over the last 12 months:Do I like this? All, except for one. Unfortunately, that is the biggest bar.The management has used ~$4 billion on buybacks in the last 5 years, which led to a 12% reduction in shares outstanding. I do think most of this buyback took place at levels above fair value, which destroyed shareholders’ value.6.0 The most important KPIs (and the 2024 Investor Day presentation)Although there’s always a lot going on under the hood, I think there are only two KPIs to follow.The first one is the modernization backlog and revenue. The backlog continues to grow, and eventually, it should reflect in the revenue.The second one is the company’s ability to upsell the modernization service into a maintenance contract.A red flag would be if the modernization revenue goes up, the backlog gets cleared, and there’s no material increase in the maintenance revenue.In 2024, the management held an Investor Day (link to presentation) that was quite detailed, with its projections on growth, margins, and portfolio growth. Overall, the management delivered on margins, service growth, portfolio growth, tax, and modernization. It missed on new equipment (well, China).7.0 ValuationThe key part of the long-term value of Otis comes down to the expectations on new maintenance contracts and what I labeled a wild card, the demand for their heavy-duty elevator range (targeting data centers and mission-critical infrastructure).I do think they have a very strong brand in the market and will continue to grow their portfolio by ~4%/year. The acquisition strategy makes sense and will benefit them in the long-run too. The combination of the two should lead to higher operating margins (from 15.5% today, to 17.5% over time).Using the above assumptions in a DCF model, the conclusion is that the fair value of Otis is $26.4b ($69/share), not that far from today’s market cap of $27.7b ($72/share).Which brings me back to my comment that the management destroyed shareholders’ value by buying back its own shares at higher prices.I like the business. I think it’s closer to Coca-Cola than to cyclical real estate companies.I don’t own it for two reasons:At today’s price, there’s no upside (except for the wild card or if there’s an unexpected recovery of the construction industry in China).The buyback decisions. In general, I do want to hold shares for a long period of time and be rewarded for that. The capital allocation decisions play a huge role. I am afraid that if/when the share price goes up, the management will continue with the same approach.I’ll keep an eye on the company. The market is irrational in the short run, so there might be a chance I can buy shares at a significant discount.This is NOT investment advice. Everything above is for entertainment, informational, and educational purposes. Do your own due diligence.Subscribe now