Description

What do you buy in the week of the biggest stock market sell-off for over a decade? Zardoya Otis now represents a low risk 10% expected return for many years. Although I have submitted this idea once in the past, I hope this counts towards my membership obligation - either in letter or spirit.   Enough has changed due to the Otis upcoming spin-off, and the current covid-19 panic could produce opportunities as well as threats, that a new write-up is warranted.  Here’s why I think this idea is worth your time: 

1. Sufficient threat from covid-19 that an opportunity is being created: 

o   China dominates the Elevator and Escalator industry.  60% of annual New Equipment (NE) demand. 40% of global installed base.  70% of elevator components are estimated to originate from within 60 miles of Shanghai. Nobody in the industry will be treating what is happening as an irrelevance.  

o   Stock down 10% from 2020 highs. Could trade a lot cheaper.

o   Many unknowns for the year ahead.  Competitive advantages mean that what the company probably looks like in 10 years is more clear.  So business resilience is the most likely outcome, for the following reasons:

2. Alternative manufacturing capability to China:

o   The company’s factories are in Madrid and in the somewhat remote (more easily isolatable?) San Sebastian, in the Basque region in the north. Crazy downside scenarios for the industry from covid-19 might at least consider one upside scenario for this company.

o   The company already has a strong delivery track record of elevator exports. 

o   Hong Kong’s International Airport uses elevators manufactured in Spain by Zardoya Otis. A weird anomaly that suggests other opportunities.

o   7,539 elevator units were manufactured and exported from Spain to 76 different countries in 2018 (most recent data available).

3. High margin means a bigger margin of safety.  24% operating margins are the highest in the Elevator and Escalator industry globally, but more importantly should present a better cushion than average for the inevitable supply chain problems and potential employee health problems.

4. No debt.

5. An opportunistic, strategic buyer who could protect your downside and maybe provide some upside. 

The current valuation is a 5.5% free cash yield, which when added to the 1.9% FX hedge benefit for a US investor, creates an acceptable 7.4% current return.  The stock already trades at an 8% price discount to the only purchase that I can find ever made by the vice Chair of Zardoya Otis (“Zardoya”) since he assumed that role in 2009.  Jesus Maria Loizaga Viguri waited all those years until this month - and the week of Otis’s investor presentation ahead of its planned spin-off in April - to pay €7.13 for a couple of hundred thousand dollars worth of stock.  CEO Bernado Calleja Fernandez has been buying in the market as recently as this week, paying €6.70 per share.   

But it is the M&A potential which I previously considered a bonus, or speculative catalyst, that has now in my opinion become tangible enough to analyze.  If in seven years Otis announces a merger with Zardoya at a 35% premium to the prevailing market price (producing €8.90 per share currently, or a 50% premium to original write-up price), this would add an annualized 4.45% to an investor’s return.  This brings current expected returns up to double digits, instead of the somewhat expensive sticker price.

Below I outline why I think this is a rational expectation, using sancho’s earlier question from the thread as a framework (I don’t mean this to be snarky, I just liked the way he framed his pushback):

"Long shot: I dont question the quality or recurring nature of the business, but betting on a UTX takeout sounds like a long shot. Assuming UTX closes COL in the next month or two, and then announces a 3-way breakup, Otis is unlikely to spin off in at least 12 months. Even then, it's unlikely that the new management team will rush to deploy capital. And if they did, why would they focus on a mature market like Spain with little to no strategic value? At a 50% premium, like you claim? Highly unlikely."  October 2018

1.     Q: Assuming UTX closes COL in the next month or two,           Yes

2.     Q: and then announces a 3-way breakup,                                      Yes

3.     Q: Otis is unlikely to spin off in at least 12 months                     16 months

4.     Q: Even then, it's unlikely that the new management team will rush to deploy capital.

The most obvious “rush” deployment scenario would be a stock-for-stock merger.  Arguing against this would be that the Otis management team has a lot going on, not least all the supply chain problems due to covid-19.  But contrary arguments could support a stock-for-stock merger soon after spin: 

Tax and business familiarity reasons might make Otis stock the most attractive – and certainly newest – inducement for the founder’s family to sell their 11% stake.  Furthermore, stock would be safer for Otis than either debt or cash. Debt threatens the credit rating. And slowly accumulating cash risks missing the opportunity created by a valuation differential between Otis and Zardoya at spin.  Minority stubs of global parents often trade at ridiculously high valuations because the market discounts an eventual consolidation. However Zardoya’s stock has been in a 13-year bear market since 2007, driven by the Spain real estate crash, and now implies very low expectations for M&A. 

Sancho’s scepticism therefore seems to be consensus. My variant perception is that the new management team might rush to deploy capital any day after April 2020, and increasingly likely will do so over the next several years.  In my calculation below, I view 7-14 years as the realistic time frame within which a deal gets done.

Issuing cheap € debt would be the other way to lock in the current Zardoya valuation.   Otis is only currently rated in the US so this process will take time. Also it seems less likely since management’s stated preference is to reduce net debt/EBITDA from 2.3x at spin to below 2x.

The longest route would be to pay in cash, using the $1.3 billion offshore cash at spin plus accumulation of the 80% of annual FCF generated outside the US.  So this scenario becomes more probable each year that passes.

“You'll see when we get to our capital allocation model, we've got a 40% dividend ratio and once we delever and repay back some of the debt over the next two years that we've committed to it, $250 million a year, we will then turn to share buybacks and M&A as well.”  CEO Judy Marks, Feb 11, 2020

So even out of the gate, management will deploy into buybacks or strategic M&A $330 (I refer to $ millions from here on) in each of the first two years.  Without any growth in FCF, this increases to $580 annually from 2022, because after that they do not want leverage

This 330/330/580/580/580/etc. deployment, fully 55% of FCF after 2021, will only be to either buybacks or large M&A.  Normal bolt-ons of small service portfolios totalling $50 per year are separate.  These cash flows should be robust from a highly cash generative business model that guides 110-120% FCF conversion for the medium term.  

I expect Otis to conform to the standard spin-off thesis of increased focus and improved capital allocation once the cash cow is loosed from the shackles of a cash-hungry, cyclical aerospace business.  The Board will have a dramatically reduced opportunity set (compared to the old UTX) for how it allocates excess capital. Part of the spin-off thesis relies on increased shareholder scrutiny, which seems alive and well judging by the following direct question on buying out Zardoya Otis.  I don’t recall this ever being asked on a UTX call:

“Nigel Coe - Wolfe Research, Analyst:  So, digging a bit deeper in the weeds here, so non-controlling interest account for a chunk of change. Can you just maybe run through where your major minority interests are? I know Spain and China would be big markets but where else would that be? Is there a path to maybe gaining control?  Maybe a bit more M&A within kind of the Otis brands? And that what kind of cash payouts should be expected from these?

Judy Marks CEO:  So, are you asking where our minority partners are? Okay.

So, you named the two largest ones. And then as we look, we've got several others in the Middle East, Kuwait, UAE, Saudi, and Qatar. And I believe that they all total – you saw in the Form 10 - around $150 million. But Zardoya Otis and our two China JVs are probably 80% of that.

Rahul Ghai CFO: 80%. Yes.

Analyst:  Any path to higher interest, or control of those entities?

CFO:  (author's impression: uncomfortable with the question) Ah…I mean…the question is…I think we are very happy with our JV partners right now…

CEO: Absolutely.”

The rush to deploy capital and defend correct decisions is on, according to the usual spin-off playbook.

5.     Q: And if they did, why would they focus on a mature market like Spain with little to no strategic value?

Mature can be good

The economics of the elevator industry are different from other industrials.  So it would be easy to overlook the beauty of maturity:

“All right. Good morning. I'm Mark Eubanks and I'm responsible for Otis' Europe, Middle East and Africa region. As Judy mentioned, I joined Otis back in April of last year after spending 13 years with Cooper Industries and Eaton, most recently as the president of the electrical products group where I had a chance to meet many of you.

But I'm extremely excited to join Otis and the entire Otis family up here at the front on an exciting and momentous time in our history. What I didn't realize beyond the brand, the market share and the size of the business was how great the business fundamentals were once I landed in Europe.”

The whole elevator and escalator OEM business model focuses on the maturing of new equipment into long lasting, lucrative service contracts.  80% of Otis profits come from its service portfolio compared to just 20% from new equipment (NE) sales. So the money is in maturity. 

Zardoya is consistently more profitable than Otis, with consolidated operating margins of 23.3% vs 14.3%.  This is not just because of a lower proportion of growth-producing, but lower margin (7.1% for Otis) NE sales.  Though Zardoya’s sales do split 65/35 service/NE, whereas Otis splits 57/43. Rather, Zardoya’s much higher overall profitability is because of dominant market share, maintaining 25% of the nation’s total installed base of elevator units, double Otis 12% worldwide’s maintenance market share.

Otis CEO Judy Marks understands how attractive this is, because she boasts of the economics already enjoyed by Otis worldwide: 

“That 2 million portfolio though gives us scale, gives us density and gives us reach, and in this business, having that density on routes and in cities is what's critical to our success and it's what drives our profit premium above our nearest competitor.”

Listen to the Otis Investor Day and you realize that pretty much everything Otis does is focused on increasing scale and route density of the service portfolio.  Yet a 50% block of one of their highest market shares, with the highest profitability, is out there publicly traded and owned by minorities. Why would they not try to own it all?

Spain has plenty of strategic value

1. Digitalization is a key Otis strategy to drive future profits and Otis management demonstrate Spain’s strategic value based on its scale for deploying productivity investments.

“A simple but powerful case study is here in this chart in Spain regarding the increasing adoption of connected systems across our portfolio. In the last three years, we've seen an acceleration rate and certainly in '19 another inflection point of growth on this portfolio.

Across the 250,000 units today, more than 25% of these systems are connected and this continues to grow. It first started with remote diagnostics and simple remote monitoring and then has evolved into an improved customer experience through streaming personal passenger entertainment into the cab.

And our latest connected systems are leveraging cloud connectivity not only to deliver cab personalized content but passenger personalized content as well as leveraging real-time data to increase uptime as well as system liability. Today, across the (EMEA) region, our 275,000 units are really delivering results.

The first as we talked about, improving our customer retention rate, we actually see a higher customer retention rate in the customers that are connected. We're also seeing that our latest eView system in our new equipment installations are creating this 8% to 9% increase in conversion rates from construction into our service portfolio.

At the same time, on average across the region, we're seeing a 19% increase in services revenue per unit for these systems. This technology is a key enabler as we go forward with our Otis ONE technology platform. We think that these systems can continue to provide rich data sets that allow us to better predict system failures and make sure that our customers are realizing data-driven business outcomes.

We also believe that this improve passenger experience not only will be focused on entertainment but also on safety. You'll have a chance to see one of the use cases, our interactive video in cab for entrapped passengers in some of the demos outside.

And then lastly, this technology will allow us to become a key building block in the smart city, smart building infrastructure of the future.”

Mark Eubanks - United Technologies Corporation - Otis, President, EMEA

2.   Spain is strategic to Otis, demonstrated by higher digitalization spend, achieving 25% penetration of units connected vs 20% average Otis worldwide.  They deploy first to highest route densities which pay back quickest.


”You can't just sprinkle it, though, everywhere in the world. You need it in dense areas where you have the routes, where you can gain the productivity and where you can show the value.

So, this isn't just deployed to everyone of the countries that wants it. This is a focused deployment on where their cost pockets are as well as where the density is.”

Judy Marks - United Technologies Corporation - Otis, President and CEO

3.  But Zardoya’s royalty agreement is percent of sales, not margin.  High investment in non-owned markets is sub-optimal.

Focusing on Spain for productivity investments but not following it up at some point with capital deployment to reap the benefits of 100% ownership would make no strategic sense.

Most others are impossible

“You have to marry the best person who will have you.  I’m afraid that’s a rule of life. Things have gotten so difficult in the investment world that we have to get by in life with the best advantage we can get.”  Charlie Munger, 2017

The major OEMs in the elevator and escalator industry enjoy high returns on capital. Managers therefore lust for opportunities to deploy capital within it.  Organic growth is amazingly capital light, however. That is why investors prize these companies so highly. For example, during the biggest recent organic opportunity - the build out of China that saw a 1 million elevator market grow to 6 million units 2006-2019 – the #1 player in that market, Kone, deployed €1.1 billion in capex.  But all that growth generated positive working capital of €1.1 billion in the same period.  Organic growth is therefore not a viable avenue to capital deployment. 

So managers look around for inorganic targets.  But these are typically small independent service providers, who all the OEMs regularly pick up.  It is unlikely that Otis can spend more than its budgeted $50 million a year on these.

Antitrust prevents most large M&A.  Consider the difficulties that Kone is facing with its current attempted acquisition of Thyssen Krupp.

Now look at Otis’ minority partners listed above by Judy Marks.  Not only is Spain one of the biggest, it is also by far the most doable: legal (most other jurisdictions limit foreign ownership) and at an auction-driven price (publicly traded, unlike the others).

Otis is industry royalty: born in 1853, the founder of the industry and still #1.  When you cannot marry anyone else, and don’t want to dilute the royal blood, that Spanish distant relative begins to look even more alluring.

6.     Q: At a 50% premium, like you claim?

Let’s see at spin-off time what valuation differential exists between Zardoya and Otis.  Zardoya might already trade cheaper than where Otis will. If I am right about the M&A probabilities, at some point in the next few years it should trade at a premium.

Financial considerations such as yield differentials and tax (deploying the 80% of Otis FCF generated outside the US to offshore acquisitions should generate a tax saving of 2-3%) strengthen this argument.

But of course I might be wrong.

7.     Q: Highly unlikely.

So discount my analysis by 50%, or give Otis longer (14 years) to reach a consolidation conclusion.  This would mean that the 4.45% of annualized expected return from an Otis takeout reduces to 2.20%:

FCF yield                                  5.50%

Yield diff. for USD investor      1.90%

2034 or 2027 Otis take-out 2.20-4.45%

total expected return   9.60%-11.85% annualized

Catalyst

 A take-out by Otis within 14 years.