This month’s newsletter is short. We’ve written far more about Donald Trump than we care to (and probably far more than you have wanted to read). The markets are up modestly. The economic and political landscapes across the globe remain relatively benign by historical standards. Sure, a surprise upset by Marine Le Pen in the French elections could roil the markets. And there is still the will-they-or-won’t-they Brexit issue. But, the point is, there is no big issue that deserves our attention right now.
We have time to talk a bit about one of the companies we own in our dividend portfolio: United Technologies (UTX). We bought United Technologies last summer during the latter part of the oil-and-gas-led capital spending downturn. The company is a conglomerate that operates four different businesses: (1) a Pratt & Whitney jet engine business; (2) an aerospace systems business; (3) a climate control and security systems business, including the Carrier brand; and (4) an elevator business. Their Otis elevator business is our focus in this newsletter.
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The Otis business accounts for a little under a quarter of the company’s profits. But it’s one of the company’s best businesses. The elevator and escalator industry is an oligopoly with the top five firms controlling about 75% of the market. Profit margins have been rising over the years, and companies now earn approximately a 10% margin on new installations. The real money, however, is on maintenance, with profit margins of 25% to 35%. This creates a virtuous cycle, since the more elevators the company installs the more money it will earn in the long run via service contracts.
There are high barriers to entry in the industry. Since a substantial portion of industry profits are earned from service contracts, a newcomer needs to spend substantial amounts of capital building out a base of installed machines before it has a network dense enough to earn a profit. The proof of how high the barriers to entry are is in how long the companies have been in business. Otis was founded in 1853. Competitors Kone was founded in 1910, and Schindler, in 1874. Check out the Wikipedia list of former elevator companies. You will find a list of about a dozen brands that have been bought by larger companies. Not a bankruptcy among them.
While the industry is stable in terms of competition, it does have a cyclical nature. The new installation business ebbs and flows in line with construction spending as one would expect. This cyclicality is tempered by the regularity of the maintenance portion.
The elevator business is also a growth one. Otis looks set to continue to benefit from long-term population trends. The world’s population is becoming increasingly urbanized. According to the United Nations, 54% of the world’s population lived in urban areas in 2014. By 2050, that number is set to rise to 66%. The trend toward urbanization is most pronounced when looking at “mega-cities” or cities with over 10M people. (Otis might call them prime elevator markets.) In 1990, there were just 10 mega-cities. By 2014, the number had jumped to 24. By 2030, the number is projected to rise to 41.
We look forward to owning United Technologies for many years.
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Article by Ben Strubel, Strubel Investment Management