Otis Worldwide Q4 2022 Earnings Call Transcript

Presentation

[Operator]

Good morning, and welcome to Otis' Fourth Quarter 2022 Earnings Conference Call. This call is being carried live on the Internet and recorded for replay. Presentation materials are available for download from Otis' website at www.otis.com.

I'll now turn the call over to Michael Rednor, Senior Director of Investor Relations. Please go ahead, sir.

[Michael Rednor, Senior Director, Investor Relations at Otis Worldwide]

Thank you, Norma. Welcome to Otis' Fourth Quarter 2022 Earnings Conference Call. On the call with me today are Judy Marks, Chair, CEO and President; and Anurag Maheshwari, Executive Vice President and CFO.

Please note, except where otherwise noted, the company will speak to results from continuing operations, excluding restructuring and significant nonrecurring items. A reconciliation of these measures can be found in the appendix of the webcast.

We also remind listeners that the presentation contains forward-looking statements, which are subject to risks and uncertainties. Otis' SEC filings, including our Form 10-K and quarterly reports on Form 10-Q, provide details on important factors that could cause actual results to differ materially.

With that, I'd like to turn the call over to Judy.

[Judy Marks, Chair, Chief Executive Officer and President at Otis Worldwide]

Thank you, Mike, and thank you, everyone, for joining us. We hope everyone listening is safe and well.

We're pleased that we ended the year with a strong fourth quarter and solid full year performance in a year characterized by a variety of macro headwinds. We entered 2023 with good momentum as we continue to execute our four strategic pillars: sustaining new equipment growth, accelerating service portfolio growth, advancing digitalization, while focusing and empowering our organization. I am proud of our colleagues around the globe who delivered these results, demonstrating the strategic resiliency of our company as we continue to grow and perform in 2022.

Starting on Slide three. We continue to perform well in New Equipment orders, growing 7% for the full year. In the quarter, orders grew 4%, with particularly strong performance in EMEA and continued solid performance in Asia Pacific. China orders returned to growth with mid-single-digit performance in the quarter. Orders in the Americas were down 4% in the quarter, although the business had a very strong 2022 overall, with orders up almost 18%.

Our New Equipment adjusted backlog at constant currency is up 11% heading into 2023, giving us solid multiyear visibility to grow sales. Organic sales increased 2.5%, driven by service, which grew 6%. We grew our industry-leading maintenance portfolio by 4.1%. It now stands at 2.2 million units, a new milestone for our company. We delivered 7.5% adjusted EPS growth despite $156 million in foreign exchange-related headwinds. We generated $1.45 billion in free cash flow, allowing us to return $1.3 billion of cash to shareholders through dividends and share repurchases.

We continue to win many exciting projects based on our innovation, ability to deliver and the trust customers have in us. For example, in the Americas, Otis was selected to provide our Compass destination dispatch system, along with six SkyRise and two Gen3 elevators for City Center 4 in Surrey, British Columbia. The 23-story building will be built to lead gold standards and extends our more than six-year relationship with Lark Group.

In China, Tianjin Metro has been using Otis equipment since opening in 1984. In November, Otis was selected to provide more than 120 escalators and Gen3 elevators for their new Line 4 Northern Extension. This takes the number of Otis units on the Port City's expanding subway network to more than 1,500. These new elevators will be connected to the Otis ONE loT-based platform, already delivering real-time monitoring and predictive maintenance for the metro system.

In the U.K., we've had a long-standing relationship with Transport for London, including a long-term contract through 2042, to manufacture, install and maintain the escalators and travelators on the busy network. Most recently, we were contracted to provide Battersea station with specialty escalators, specifically designed to run for about 20 hours a day and extend 24 meters in length and 9 meters in rise. We're playing our part to keep the busy network flowing.

Our ESG initiatives continued to progress in 2022, helping to drive stakeholder value alongside our financial priorities. Our manufacturing facility in Florence, South Carolina achieved gold level Total Resource and Use Efficiency, or TRUE certification, recognizing its success in zero waste. With this achievement, Otis has become the first in the elevator industry to have a TRUE-certified facility, helping us towards our goal of having all our factories eligible for zero waste to landfill certification by 2025. We look forward to sharing more about our ESG progress in our second annual ESG report, which is set to be published in the spring.

Moving to Slide four. With strong orders performance in 2022, we were able to achieved approximately 1 point of new equipment share gain, on top of the 2-point increase between 2020 and 2021. For the first quarter since Q4 2021, New Equipment sales returned to growth as we continued the strong growth in EMEA and Asia Pacific that we've experienced all year and were able to overcome supply chain and installation-related challenges, especially in the Americas. These results mitigated the impact of mid-single-digit New Equipment sales decline in China, demonstrating the power of geographic diversification within our business. Notably, we see China on a recovery path as New Equipment sales in the region improved compared to Q3.

Innovation is helping to drive growth across our business. For example, we continue to roll out our digitally-connected elevator platforms, launching Gen3 in India, and expanding the deployment of Gen360 in Europe to the Czech Republic, Poland, Portugal and Slovakia.

The accelerated portfolio growth we saw this year is an essential component of our long-term strategy and top line growth algorithm. We believe the disruption in our industry favors the OEM, and we're demonstrating this as we deploy our Otis ONE loT solution into our New Equipment product offerings and our service portfolio. We continue to work towards our goal of increasing connectivity to approximately 60% of the portfolio, and we're pleased to have connected more than 100,000 additional units this year.

Our service sales force performed well throughout the year, with like-for-like maintenance pricing of 3 points, helping to mitigate labor cost headwinds within the service business. For the third year in a row as an independent company, we delivered adjusted operating profit margin expansion, and we remain well positioned as we enter 2023 with momentum, especially as we execute on New Equipment projects from our backlog.

Now turning to Slide five. In the Americas market in 2022, while North America had a strong year, up better than mid-single digits, Latin America was roughly flat, leading to a market that was up low to mid-single digits. In EMEA, Western Europe performed well, offset by Eastern Europe due to the conflict.

In Asia, the market was down high single-digits. Asia Pacific had a very strong year, up approximately 10% with the performance masked by the downturn in China, which we estimate to be down about 15%. Although market dynamics remain fluid, as we've seen over the past several years, the long-term fundamentals of the industry are well grounded in the service-driven growth model.

In 2023, globally New Equipment markets are expected to be down mid-single digits in units with flattish markets in the Americas and EMEA, and down mid-single digits in Asia, driven by China, where we expect the market to be down 5% to 10%. Asia Pacific should see another year of mid-single-digit or better growth, driven by urbanization in the region and infrastructure investments. The global industry installed base is expected to grow at a similar rate to that of 2022 at about mid-single digits and reach approximately 21 million units.

In the Americas and EMEA, we expect low single-digit growth. And in Asia, we're expecting high single-digit growth driven by China. With this as the industry backdrop for Otis, we expect organic sales growth to be in the range of 4% to 6%, with total sales of $13.8 billion to $14.1 billion, up 1.5% to 4% at actual FX.

By segment, we expect New Equipment will grow 3% to 5% this year, with mid-single-digit growth in the Americas and EMEA and low single-digit growth in Asia. We expect Asia Pacific to grow at least mid-single digits, while we anticipate our China New Equipment business to be about flat for the year. We're expecting a better China market as we get into the second half of 2023 as COVID-related and liquidity constraints in the market should ease on the back of government support.

In the Service segment, we anticipate another year of solid growth, with the business growing 5% to 7%. We expect volume and pricing to drive solid mid-single-digit growth in the maintenance and repair business, with higher growth in our modernization business line. Our modernization orders performed quite well over the past few quarters, and we entered the year with a mod backlog up 7% at constant currency. We expect 7% sales growth at the midpoint, driven by the backlog growth. Adjusted operating profit is expected to be between $2.2 billion and $2.25 billion, up $70 million to $130 million of actual currency or $130 million to $175 million accounting for foreign exchange headwinds. We expect adjusted EPS to be in a range of $3.35 to $3.50, up 6% to 10% or approximately $0.26 at the midpoint versus the prior year.

Finally, we expect free cash flow of $1.5 billion to $1.55 billion between 105% to 115% of GAAP net income. We remain committed to our disciplined and balanced capital allocation strategy and expect to repurchase $600 million to $800 million in shares this year, following the new Board authorized $2 billion repurchase program, in addition to paying our dividends and pursuing our typical bolt-on M&A strategy.

With that, I'll turn it over to Anurag to walk through our 2022 results and 2023 outlook in more detail.

[Anurag Maheshwari, Executive Vice President and Chief Financial Officer at Otis Worldwide]

Thank you, Judy, and good morning, everyone. Starting with fourth quarter results on Slide six. For the fourth quarter, reported sales of $3.4 billion were down 3.6%. Organic sales grew for the ninth consecutive quarter and growth accelerated to 6%, our best performance of the year, with mid-single-digit growth in New Equipment and high single-digit growth in Service. Adjusted operating profit, excluding a $49 million forex headwind, increased $39 million, with constant currency growth in both segments.

Strong service performance, especially on volume and price, was partially offset by commodities and mix headwinds in New Equipment as well as higher corporate costs. Adjusted SG&A expense for the quarter and the year improved 80 basis points as a percentage of sales as we remain vigilant on structural cost reduction and cost containment to help mitigate the macro headwinds we have faced.

At the same time, we are committed to growing the business and R&D and strategic investments as a percent of sales remained about flat. Adjusted EPS grew 4% or $0.03 in the quarter, driven by operational growth of $0.07. This strong operational growth, alongside the accretion from Zardoya and $850 million of share repurchases, more than offset the $0.08 headwind from forex. While the fourth quarter free cash flow conversion was strong at 145%, our full-year free cash flow came in at $1.45 billion or 115% of net income lighter than we had anticipated as we built $65 million of inventory to mitigate supply chain challenges and support backlog conversion going into '23.

Moving to New Equipment performance on Slide 7. Otis New Equipment orders in the quarter increased 4%, with EMEA and Asia Pacific up high-single digits and China orders returning to growth, up mid-single digits, which more than offset a modest decline in the Americas. Overall, with better-than-expected orders growth in the quarter, we finished the year with a New Equipment adjusted backlog up 11% at constant currency, with growth in all regions, including notably in China.

Pricing on New Equipment orders in the quarter increased 3 points, led by the Americas with solid performance in EMEA and APAC. In China, we have been roughly price/cost neutral throughout '22 as commodity inflation peaked [Phonetic] and we continue to drive productivity to offset pricing pressure in the market.

Fourth quarter New Equipment sales of $1.5 billion returned to growth, driven by over 10% both in the Americas, EMEA and Asia Pacific, with EMEA outperforming our prior expectations. China sales declined at a lower rate than what we saw in the middle of the year as the team navigated well through post lockdown COVID outbreaks to execute on the backlog. Overall, strong execution by the team returned to sales growth in the fourth quarter in New Equipment.

Operating profit margins were roughly flat for the quarter. The benefit of higher volume, strong productivity and cost containment nearly mitigated the approximately $25 million in headwinds from commodities and forex.

Now turning to Service segment performance on Slide 8. We saw an acceleration in our portfolio growth to over 4%, with every region adding to the portfolio this year. With another year of excellent high-teens growth in China and low-single digit growth elsewhere, our portfolio now is about 2.2 million units. Globally, our recaptures more than offset our cancellations for the year with conversions as a growth driver.

Additional details on our portfolio growth in 2022 and drivers for future growth can be found in the appendix. Modernization orders were also a highlight, up 13%, with growth in all regions, including some major project bookings in the Americas and Asia Pacific and continued strength from our MOD package offerings. Our modernization backlog is up 7% versus the prior year, giving us good line of sight for growth in '23.

Moving on to Service sales. We delivered another quarter of strong organic sales growth, up almost 7%, with growth in all lines of business. Maintenance pricing, excluding the impact of mix and churn, came in as expected, up about 3 points for the year, contributing approximately 1 point to overall revenue growth. Organic modernization sales grew 8.8%. And similar to last quarter, we saw broad growth across regions, including double-digit growth in both Americas and Asia Pacific.

We finished with our best service margin expansion for the year, up 70 basis points in the quarter. Adjusted operating profit, excluding $42 million of forex headwind, was up $51 million as higher volume, favorable pricing and productivity were partially offset by our annual wage increases. We have now delivered 12 consecutive quarters of service margin expansion, with margins increasing roughly 200 basis points over the past three years.

Slide nine lays out the full year 2022 adjusted EPS bridge. Strong operational execution drove $0.39 of constant currency EPS growth, which mitigated $0.18 in commodity headwinds, leading to operating profit growth of $124 million or $0.21. Through our capital allocation strategy, including the accretion from the Zardoya transaction and share repurchase of $850 million and optimizing our tax rate, we were able to offset $0.26 in forex headwinds. Overall, strong operational performance led to EPS growth of 7.5% or $0.22.

We finished the year with 2022 adjusted tax rate of 26.5%, a 220 basis-point improvement versus '21, which contributed to EPS growth, both in the quarter and for the full year. Overall, the team performed well throughout '22 by executing on the controllables, which helps us to build a strong backlog, grow organic sales, expand margin by 30 basis points and returned $1.3 billion to shareholders.

As we look ahead to 2023, the New Equipment outlook is on Slide 10. Over the past few years, we have delivered strong orders globally from a combination of market growth, our share gain initiatives and incremental pricing actions. This has resulted in a robust multi-year backlog, giving us good line of sight for the next couple of years.

In 2023, we expect New Equipment organic sales to grow between 3% to 5%, with Americas and EMEA up mid-single digits and Asia growing low-single digits. Asia Pacific is expected to be up at least mid-single digits. And though the backlog in China is up 2 points, we expect sales to be about flat, reflecting pressure on the book and ship business from expected market declines in the first half.

We expect New Equipment profit margins to be flat to up 40 basis points. We expect roughly $100 million of tailwinds from volume, pricing, productivity and commodities. This will be partially offset by unfavorable regional and project mix, and some snapback in SG&A expense due to 2022 cost containment actions. We will continue to drive strong productivity on both material and installation and project closeouts as the year progresses to drive outperformance.

Turning to our Service outlook on Slide 11. Starting with sales, we expect another solid year in Service and anticipate organic sales increasing 5% to 7%. Maintenance and repair organic sales are expected to grow 4.5% to 6.5%, driven by maintenance portfolio growth, pricing and low to mid-single-digit repair growth after two strong years of COVID-related recovery. We expect more than 1 point of pricing after adjusting for mix and churn.

For modernization, we anticipate organic sales of mid- to high-single digits as we execute on a solid backlog and drive our book and ship business from new product launches and focus on sales force specialization.

Turning to profit. We expect roughly 50 basis points of margin expansion. Headwinds from annual wage inflation will be more than offset by volume, price and productivity, similar drivers to 2022.

Turning to Slide 12 for the 2023 adjusted EPS bridge. We are expecting $3.35 to $3.50 in adjusted EPS, driven by $0.23 to $0.31 of operating profit growth. We expect to offset $0.09 of forex headwind at the midpoint and a modest increase in interest expense through a lower share count, $0.04 of remaining Zardoya accretion and continued optimization of our tax rate. We plan to complete $600 million to $800 million in share repurchases during the year.

For cadence, we expect strong EPS growth in the second half of the year, while the first half remains roughly flat. We see the bulk of the FX headwind, post lockdown COVID impact in China and a modest supply chain overhang in New Equipment in the first quarter. We anticipate stronger growth sequentially thereafter, including better performance in China in the second half of the year.

Overall, we anticipate Otis organic sales growth of 4% to 6%, with approximately 20 basis points to 30 basis points of margin expansion, leading to 6% to 10% EPS growth. And on cash, we expect to generate $1.5 billion to $1.55 billion in free cash flow in '23, a 110% conversion of GAAP net income at the midpoint.

This outlook demonstrates another year of consistent and solid operational execution, as we continue to mitigate macro challenges and create meaningful shareholder value.

With that, I will request Norma to please open the line for questions.

Questions and Answers

[Operator]

Thank you. [Operator Instructions] Our first question comes from Julian Mitchell from Barclays. Your line is now open.

[Julian Mitchell, Analyst at Barclays]

Hi, good morning, and thanks very much. First off, I suppose I just wanted to dig in a little bit more into the assumptions for how you see the China market starting out the year in terms of orders, after a very good Q4 performance. And maybe just home in a little bit more on the commentary around some of those headwinds in Q1. Should we still expect EPS to be up kind of sequentially in the first quarter?

[Judy Marks, Chair, Chief Executive Officer and President at Otis Worldwide]

Good morning, Julian, it's Judy. Let me start with what we're seeing really on the ground. I would tell you that the Chinese economy is in a state of recovery now. We were really pleased with our team's performance in the fourth quarter, again, with orders being up in New Equipment in what was a challenging quarter with all the lockdowns. It's a fluid situation on the ground between liquidity and the COVID-related absenteeism as we come back from the Chinese New Year. And we're going to watch that closely. But 2022 came in where we expected on the market, down about 15%. We shared we think that was about down 10% in Q4, and came in where we thought between 540,000 and 550,000 units.

Obviously, Q4 saw some abrupt changes with COVID between the lockdowns and then the lifting, which led to the outbreaks. And, what we're monitoring is the liquidity easing, which we're seeing, and where the consumer sentiment and confidence is in terms of the property market.

So as we go through the first few quarters of '23, first of all, we're very encouraged by the government policy and actions to date. We are expecting a better second half. We have a harder compare in the first half, based on what was happening in China first half of '22. But we did see an upped infrastructure market. That was the only segment that was up in '22 in a 15% down market, and we did very well there. Perry and the team just executed really well.

Tier-1 and 2 in China were the least negatively impacted by the down market. And again, you know our strategy there has been very focused on agents and distributors on key accounts, and we've executed that. So,. I'll leave it with I'm feeling good about the health of our business in China. In a down market, in '22, we did well. We were down mid-single digits versus a down 15% market. And in a down 5% to 10% market, we expect to do well as well. So, we gained share last year. Our strategy will enable us to do that, and we're going in with backlog. I'll let Anurag talk to the EPS question.

[Anurag Maheshwari, Executive Vice President and Chief Financial Officer at Otis Worldwide]

Great. Thanks, Judy. Yeah. So Julian, just on the quarter one, let me start with the segments first. From a service perspective, we expect to see performance in line with the full year guidance. The swing factor could be repair with modernization or some mix. But overall, we aren't seeing anything major to call out and expect kind of mid-single-digit growth and margin expansion. It may be not closer to the 50 basis points we're guiding for the year, but still be a good expansion as we run through the year.

The New Equipment is a segment that we do expect some weakness from both a sales and a margin perspective, specifically compared to last year. China has a tough compare as the COVID impact didn't really start until the second quarter. And while we -- as Judy mentioned, we do expect better performance in China as we go through the course of the year. We are expecting it to happen until the second half of the year.

In Americas, the team performed very well in the fourth quarter, but there is still some supply chain inefficiencies and labor shortages, which I expected to clear up in the second or third quarter. So overall, we expect sales on the New Equipment side to be down quarter-over-quarter and year-over-year, and margins to be above flattish with where we ended up in the fourth quarter.

Now, kind of going to the other line items, starting with corporate expenses. Last year, the first half was light because of all the cost containment we did. So, it is going to -- the run rate is going to pick up very similar to what we saw in the fourth quarter. So, there could be a couple of pennies of headwinds over there.

And then on the FX side, we've said about at the midpoint, $55 million of FX headwind. And the bulk of it will come in the first quarter because last year, at this point in time, the euro was EUR1.15. The renminbi was RMB6.35. So though the currencies have improved, there is still a significant headwind. So majority of our FX headwind will come in the first quarter.

So, putting it all together, we do expect EPS to be down a couple of pennies as you know, forex, any New Equipment, corporate will kind of offset the good performance in Service and the Zardoya accretion. So net down a couple of pennies and sequentially also could be down $0.01 or $0.02.

[Julian Mitchell, Analyst at Barclays]

That's extremely helpful. Thanks very much.

[Operator]

Thank you. One moment for our next question. Our next question comes from Steve Tusa with JP Morgan. Your line is now open. Steve, your line is now open. Mr. Tusa, are you on mute?

[Michael Rednor, Senior Director, Investor Relations at Otis Worldwide]

Norma, let's go to the next question. Thank you.

[Operator]

Thank you. One moment for our next question. Our next question comes from Nick Housden with RBC Capital Markets. Your line is now open.

[Nick Housden, Analyst at RBC Capital Markets]

Yes. Hi, everyone. Thanks for taking my question. I'll just ask one. Looking at the outlook and maintenance in particular, you're guiding for 4.5% to 6.5% organic. So just thinking units are increasing over 4% and you seem pretty confident in being able to maintain that kind of level. Pricing is already at 3%, and it's probably going up as you enforce the escalation clauses and you kind of hinted that in the slide. So, 4% volume, 3% pricing. Am I wrong to think that a 5.5% midpoint in the guidance looks a little bit conservative? And is it to do with maybe pricing being a bit more competitive in Asia Pacific, where a lot of the new units are going into? Thanks.

[Judy Marks, Chair, Chief Executive Officer and President at Otis Worldwide]

Let me -- Nick, good afternoon. Let me answer the pricing question, and then I'll let Anurag take you through the walk. Listen, we've been pleased. Like-for-like pricing similar to Q3 was up 3 points in Q4 and was very solid as predicted. Mature markets globally is where we saw really strong service pricing, mid-single digit gains in the Americas, low-single digit in EMEA and Asia Pacific. And as Anurag said in his comments, kind of we've got this -- the margin drivers are really less on price and more on productivity, volume and density in China. But we think 2023 like-for-like should be better than that 3%, and that's really driven by the inflationary clauses we have in the majority of our contracts -- service contracts, especially in Western

Europe and in North America. The Western Europe clauses are backward looking. So, they will reflect 2022 inflation indices, and we are signing those contracts right now. A lot of them in the first quarter. So next quarter, we'll be able to be able to share how we're performing on that. But pricing is healthy. Team deserves a lot of credit. We pivoted from being a discount kind of service pricing company for many years to being able to gain price, especially where it was appropriate and justified.

[Anurag Maheshwari, Executive Vice President and Chief Financial Officer at Otis Worldwide]

Yeah. And just to add to that in terms of the growth for '23. So yeah, you're right that our growth at the midpoint is very similar to where it is in 2022, but the piece is a little bit different. The portfolio growth, as you put together 4%, and what Judy spoke about the pricing, you add 3% then you adjust for churn and mix. We should be up about 6% for '23, which is higher than where we were in '22.

Repair is, as I mentioned in my prepared comments, over the past two or three years, we've been running at a 10% CAGR on the repair business coming out of Cowen. Now typically, the repair business will outgrow the maintenance business because as we continue on our strategy on new repair packages, increasing penetration, but this year, there will just be a little bit of a catch-up from what happened in the past two to three years. And then going forward, it should outpace the maintenance business. So that's why we're saying low- to mid-single digit.

And modernization is pretty - it's around 7%-ish at the midpoint. So those are the pieces which get us to 5.5%. Now clearly, if pricing is a little bit better, repair comes in better and the modernization book and ship, there could be a little bit more over there. But right now, we feel well calibrated at the midpoint of the guidance.

[Nick Housden, Analyst at RBC Capital Markets]

Okay. Great. That's very helpful. Thank you.

[Operator]

Thank you. One moment for our next question. And our next question comes from Gautam Khanna with Cowen. Your line is now open.

[Jack Ayers, Analyst at Cowen & Company]

Hi, guys this is actually Jack on for Gautam today. Thanks for the question. Just a quick question kind of just on your perspective on the end market demand. Kind of back to Judy's comments on the first question, just kind of what you're seeing in the field today maybe by geography and then by end market, maybe kind of parsing resi versus commercial or infrastructure? Just anything there would be helpful.

And then just if you're seeing, any with the slowing global macro backdrop here, if you're kind of seeing any municipalities or other customers sort of defer projects or kind of what you're seeing in '23 so far?

[Judy Marks, Chair, Chief Executive Officer and President at Otis Worldwide]

Sure. Jack, let me try and respond to both parts. Let me start with New Equipment because I'll break this into New Equipment and Service, and I'll actually start with Asia Pacific, where the market, overall, and we're really expecting solid growth due to urbanization and infrastructure growth in Korea, in Southeast Asia and in India. And we're not seeing any slowing in that part of the world. It's really accelerating, and expectation should be for solid growth.

For 2023 in the Americas, we think it's going to be a little worse than the market was in '22. '22 is an incredibly strong market, first half stronger than second half, but as we saw a really strong market. And we're still seeing the Dodge Momentum Index rising on construction. But the Architect Billing Index for the past three months has been under 50, including December at 47.5. So we're watching that carefully.

In EMEA, we think flattish. We're balancing potential headwinds. But I'll tell you, we have seen Europe become far more resilient in terms of the demand, including the residential market in Europe is really strong despite all the challenges consumers are facing. And the Middle East is growing. Middle East, although it's a smaller part of our EMEA, has bounced back nicely. So that end market is going to grow as well.

The good news in China. [Technical Issue] And we're prepared for that because we've got this great backlog at 11% on New Equipment. When I turn to the service business, it's -- the end market is just growing in all regions. It's solid mid-single digit growth, led by Asia, and low-single digit really in the developed markets.

And I just make you recall that the New Equipment market swings really have minimal impact on the Service market. it's going to grow mid-single digit year after year after year. Modernization is up nicely in all regions, and we're ready for that. We're going in with a 7% backlog on MOD. And we expect MOD to continue to, from a demand side, to continue to grow in '23. We have not seen a slowing on projects. We've also not seen the impact of the Inflationary Reduction Act -- of Infrastructure Reduction Act in North America yet. We see that later cycle in terms of airports, metros and other infrastructure. But again, we did see good infrastructure. It was the only positive sector and segment that grew in China in '22.

So, we're feeling good. Our backlog will take us through. Again, we'll watch the book and bill early in the year. But our backlog, we think, is going to take us through on New Equipment and MOD and our Service business is coming in strong, and we're looking forward to '23.

[Jack Ayers, Analyst at Cowen & Company]

Thanks, Judy. Yeah, that's really helpful. And then just one quick one for Anurag really quickly, just on price cost assumptions in '23 and sort of the backlog margin converting here. Just kind of what your assumptions are snapping the line on seeing raw material sort of roll over here in '23? Kind of just high level, how you're kind of thinking about price cost in '23? Thanks.

[Anurag Maheshwari, Executive Vice President and Chief Financial Officer at Otis Worldwide]

Okay. Great. Thanks for the question. So price cost is positive in '23. I mean you can see it from the margin expansion as well, that's happening at the midpoint. So on pricing, if you look at this year, I mean, after a flattish first half, we started seeing pricing going up 3% in the back half. And our backlog is actually up -- our backlog margins are up over 100 basis points. And what we have assumed for next year is about 50 basis points of pricing coming through into the P&L, which is roughly about $30 million-ish. And the reason it's 50 basis points what we have right now is it takes a while for the backlog to convert into revenue, and some of that will come in the later years, but still price positive.

On commodities, we do expect about a $20 million to $30 million tailwind. If we look back over the past two years, we faced about $180 million of commodity headwind, slightly more than $100 million came from Americas and China, and the rest came from Europe and Asia.

In Americas and China, of the $100 million-odd headwind, we're seeing about $30 million, $40 million of that come back as prices of steel have started coming down. And though we are 50% locked, we still see some of it coming down over a year. So clearly, that is very positive. It is actually in EMEA and in Asia Pacific where we're not seeing the tailwinds right now. In Europe, if you look at guide rails, it set up 85% from where it was two years ago. So clearly, there is some headwind over there. And in Asia, we buy a lot from Tier-2 suppliers, and that's not yet come down as well. But overall, we see about a $20 million, $30 million tailwind on commodities. So net-net between price and commodities, it's positive.

[Jack Ayers, Analyst at Cowen & Company]

Thank you.

[Operator]

Thank you. One moment for our next question. And our next question comes from Nigel Coe with Wolfe Research. Your line is now open.

[Nigel Coe, Analyst at Wolfe Research]

Thanks. Good morning, everyone. Thanks for the question. Just wanted to monitor some of the puts and take on margins. And I think you called out mix impacts in New Equipment. So just maybe just double-click on that and just to clarify what sort of the mixed headwinds are. But my real question is really on the investments, I mean you continue to invest. I think it's been very successful on the recaptures and retention initiatives. But maybe just talk about the focus for investment spend going forward.

[Judy Marks, Chair, Chief Executive Officer and President at Otis Worldwide]

Let me start with the investment spend, and then I'll have Anurag talk to the mix. Yeah, we are -- I think you've seen, Nigel, since we became independent, we've been obviously focused on our business, focused on our markets, and we've been extremely focused on investments in our strategy that will yield in terms of innovation. So we've done -- we've continued our investments in our service business, both in making our incredible field professionals more productive and that's yielded the apps that they've been using continue to show incredible promise. Our tune app is up in terms of usage, 70%. In terms of in the field, we've got a lot of our service parts being ordered.

And our sales -- our field professionals using the upgrade app are also being part of our extended sales force and selling repairs. So all that's working well. But the linchpin of our strategy is Otis ONE. It's being connected. It's having that predictive, transparent information available in our ecosystem. And we continued on our investment strategy for Otis ONE, again, where we define on the service side where we're going to install these to get the best yield for both productivity and customer stickiness.

So what we're seeing, we did deploy well over 100,000 units again this year on our trajectory to a 60% coverage of what's becoming a larger portfolio, 2.2 million this year. We said we'll be over 2.5 million units by 2026 in our medium term, and that 60% should be off that 2 point -- that higher number. That's where we're heading. And we're seeing the results of that. We're seeing it on the productivity side, we're running on, arrivals are down. And we're seeing that also on the customer stickiness side in two ways.

One is when we are connected, like our EV product or any connected product, we're getting more in price for service. And then we're getting higher conversion rates and higher retention rates. Our retention rates this year, we were pleased with. They're at 94%. I look forward to the day that we can report a 95% retention rate because that will have significant validity to our service-driven growth strategy.

Conversions were up this year. And I think a lot of that, especially in China, going up to 48% this year where they ended was due to our Gen3 elevators being connected and our Otis ONE units as well. So globally, we're now at a 64% conversion rate. And as China continues on its path to get to 60%, which we think is the target, then, globally, we will be at about 70% conversion. And that is our higher margin conversion.

On the portfolio itself, that it is Otis ONE. It is that connected product that gives us the conviction that we can take the 4.1% portfolio growth even higher. Even though this is what we shared for the medium-term guide at about 4%, we do believe we can get that higher, including in 2023.

So all-in-all, investments in the New Equipment side are continuing. Our R&D spend is there. Our strategic investments are there. We're really pleased with expanding Gen3 and Gen360. On the service side, the Otis ONE value proposition for the customers is working, and we believe it's reflected in our margin expansion as well for our shareholders.

So, Anurag, let me turn it over to you for mix.

[Anurag Maheshwari, Executive Vice President and Chief Financial Officer at Otis Worldwide]

Yes. Thanks. So as you can see, on the investment side, we'll continue to invest and still grow our margins. Last year, we grew about 30 basis points, this year, we're guiding for 20 basis points to 30 basis points. And we'll look for productivity other ways to kind of offset that.

On the mix, it's regional and product project mix. On the regional mix, as you are aware that China New Equipment is a higher-margin market for us. And even last year in '22, the other markets did a little bit better than China. But if you look at '23, we are guiding for China to be flat, whereas Americas, EMEA to be up mid-single digit and Asia mid- to high-single digit. So that adds a little bit of a regional mix impact. But the more bigger mix impact is coming from project mix. And over the past two or three years, and as you've seen us making announcements on, we won a lot of major projects, and part of our share growth strategy has obviously been on the volume as well as looking at different verticals, be it infrastructure, others to grow our major projects.

And the more major projects are -- they definitely come in with very good maintenance business, very high stickiness, very good margin, but they are lower margin than the volume business. So there's a little bit of that impact, a healthy backlog that we have of 11% as we go into '23 and beyond.

[Nigel Coe, Analyst at Wolfe Research]

Makes sense. Thanks for the detail. I guess, a few questions. But did want to ask a question on -- you called out 800,000 connected elevators today. How much of those Otis ONE connectivity? I want to say about half, but clarify that.

[Judy Marks, Chair, Chief Executive Officer and President at Otis Worldwide]

Yeah, I think that's accurate, about half.

[Nigel Coe, Analyst at Wolfe Research]

Yeah. Great. Thanks. Thanks, Judy.

[Operator]

Thank you. One moment for our next question. And our next question comes from the line of Steve Tusa with JP Morgan. Your line is now open.

[Steve Tusa, Analyst at J.P. Morgan]

Hey, good morning. So, I think you called me. I was -- we got some other calls going on this morning, so you overlap. Sorry about that. Can we just get a little bit more info on like attrition or retention? Maybe a little more precision around how much that may have improved year-over-year. Obviously, 1% is a lot. So, there's some nuance there. Maybe just a little more precision on that -- from the 94%.

[Judy Marks, Chair, Chief Executive Officer and President at Otis Worldwide]

Yeah. So, -- yeah, we've got -- there's a chart in the back. And Steve, we've shared that we -- our focus is having a net positive net churn between retention and recaptures. Retention, they're the most important units to us. We get them at the highest margin, and that's where we want to start that individual customer relationship that we hope last decades into modernization and then into it, just for decades.

So it's at 94%. It's about aligned with last -- with '21. I'd say it's pretty close in terms of retention and recapture though, it was up. And you can see that slightly, but it was up healthy, and that was really driven by a few items. Two, I'll call out. One is our sales specialization where we actually have recapture sales reps that, that is all they do. And they focus on the density and capturing the best of the optimal units for Otis, because we have to go in at a lower price than we would at a normal conversion, but we want to make sure that they are accretive.

So, the recapture specialists really, we saw them hit their stride as we went through '22. And the second is Otis ONE. And the capital investment, we continue to make at the data level on connected units and on offering that when we do go recapture that really makes a difference to our customers. I've personally been involved in a few of those sales calls to win some portfolios back. And it really makes a difference. We can show them the visibility they have, their dashboard they're going to have and the whole ecosystem we offer. And so those two combined have really helped, and that's really -- that's been our strategy, and it's what we're going to continue doing.

[Steve Tusa, Analyst at J.P. Morgan]

And then just on the attrition in China. I know it's a growing part of the installed base, but any trends there worth calling out?

[Judy Marks, Chair, Chief Executive Officer and President at Otis Worldwide]

I think it's pretty consistent with '21 is what I would say. We didn't see huge anomalies. Obviously, our portfolio in China, our service portfolio, I think we've shared is a little over 325,000 units. And that's grown. It's our sixth straight quarter of mid- to high-single digit portfolio growth in China. And so we're continuing, recapture, did well there. So, we're continuing to monitor that. But our team -- our service teams in China are continuing against six straight quarters, and we expect because of the growth in that segment, we expect that to be in the teens again for '23.

[Steve Tusa, Analyst at J.P. Morgan]

Great. Thanks a lot.

[Operator]

Thank you. [Operator Instructions] And our next question comes from Miguel Borrega with Exane BNP Paribas. Your line is now open.

[Miguel Borrega, Analyst at Exane BNP Paribas]

Hi, good morning, everyone. I've got a couple of questions. The first one on your margin for New Equipment in China. I know that you don't disclose this. But can you give us some color on how this has evolved over the years? How does your margin compare today versus, for example, pre-COVID levels?

And at the moment, what is the direction of travel for margins on new orders? And then maybe longer term, can you give us a sense why margins in China were keeping much more profitable than, for example, Europe or the U.S.? Thank you.

[Anurag Maheshwari, Executive Vice President and Chief Financial Officer at Otis Worldwide]

Okay. I think there were three questions over there. So let me start with the China New Equipment margin. We don't disclose margin by regions. If you look at China New Equipment, it is slightly higher. It's a good margin business for us. Importantly, if you look at even last year with all the volume decline, the commodities headwinds that we faced, we were still able to mitigate a significant amount of that through productivity. So, the margins of the New Equipment business have actually held quite strong because of the productivity business. And even this year, where we are guiding to our margins to be, we're almost back to 2021 levels. Despite volume being flattish or slightly down, China volume being down 10% and going through a commodity headwinds of about $150 million $80 million.

So clearly, the margins are trending in the right direction. And all I would say is that we're quite happy with the way we've been able to mitigate some of the headwinds to get to where we are right now. Yeah. So that's on the first question regarding where our New Equipment margins are. Backlog is trending up. The backlog margin is trending up. We've had price increases over the past couple of quarters. If you look at where we're exiting this year, in 2021, our backlog margin declined by 1 point. We are above 1 point right now. And where commodities are and where our pricing and new orders and new proposals are going in, that backlog margin should kind of inch up as we move along through the course of the year. We, again, don't give specific guidance on where it would be, but it's encouraging to see the price kind of sticking in the market over there. Yeah. And sorry, what was the third question? I couldn't quite get the question completely. If you could just repeat that, Miguel.

[Miguel Borrega, Analyst at Exane BNP Paribas]

Well, just give us a sense on the spread between margins in China and the Rest of the World. Why shouldn't we see some kind of conversion trending down to more like Europe or the U.S.?

[Judy Marks, Chair, Chief Executive Officer and President at Otis Worldwide]

Mature versus China?

[Anurag Maheshwari, Executive Vice President and Chief Financial Officer at Otis Worldwide]

Yeah, it's still accretive for us in terms of the margins over there where we keep driving productivity. So it will -- the strategy that we're kind of embarking upon the digitalization of productivity, we should see the margins kind of inching up. I mean net-net, on the Service side, we're seeing 50 basis points margin expansion this year, which is on the high end of a medium-term guidance. And obviously, margins will differ by region, by country. But with all the tools we are doing and we see margin expansion across all the regions.

[Miguel Borrega, Analyst at Exane BNP Paribas]

Thank you. And then just one last question on free cash flow conversion. I wanted to get your views, not only on 2023, but also a little bit further away. Where do you see this normalizing? Because 2021 was 128%; 2022, 115%, and now you guide between 105% and 115%. Is this basically China contributing less to working capital? And do you see that improving in 2023 with more financing to real estate developers? Maybe if we can get some of your color what's going on, on the ground in China today? Do you see any improvements there? Thank you very much.

[Anurag Maheshwari, Executive Vice President and Chief Financial Officer at Otis Worldwide]

Yeah. So let me take back, actually, our working capital in China, collection is progressing quite well. If you look at this 2022, we finished about 115% of net income, which was quite good. We had a very strong fourth quarter. We came in a little bit lighter, it was because of the inventory that we built up to make sure that we can support our backlog as we get into 2023. Between receivables and payables, we are pretty much there. So it was more of the inventory build out.

Now, what we're guiding at the midpoint for 2023 is 110% of net income. It's essentially driven by earnings growth with a little bit of a modest offset from capital expenditure as we're embarking on our Otis ONE strategy. So that takes us to 110% net income. And as we move forward, we should grow our cash with earnings. And that's what we've kind of guided towards. And you should see that normalizing around the 110%-ish level.

[Judy Marks, Chair, Chief Executive Officer and President at Otis Worldwide]

Yeah. And Miguel, I'll just let me wrap on that. But I mean this is -- that was our medium-term guide that we gave at the Investor Day in February of last year, and that's what we beat it in '22, and we're staying consistent right now with our guide with the Investor Day.

[Miguel Borrega, Analyst at Exane BNP Paribas]

Thank you.

[Operator]

Thank you. And I'm currently showing no further questions at this time. I'd like to hand the conference back over to Ms. Marks for any closing remarks.

[Judy Marks, Chair, Chief Executive Officer and President at Otis Worldwide]

Well, thank you, Norma. Our success in 2022, our third year in a row of performing for all stakeholders, demonstrates the strategic resiliency of our business and provides us with confidence as we begin a new year. Supported by strong industry dynamics, we remain committed to our strategic pillars in order to deliver for our customers, shareholders, valued communities and the riding public.

We set significant goals for the year ahead, and we look forward to sharing our 2023 success with you. Please stay safe and well. Thank you.

[Operator]

[Operator Closing Remarks]

Participants

Corporate Executives

• Michael Rednor, Senior Director, Investor Relations
• Judy Marks, Chair, Chief Executive Officer and President
• Anurag Maheshwari, Executive Vice President and Chief Financial Officer

Analysts

• Julian Mitchell, Barclays PLC
• Nick Housden, RBC Capital Markets
• Jack Ayers, Cowen & Company
• Nigel Coe, Wolfe Research
• Steve Tusa, J.P. Morgan
• Miguel Borrega, Exane BNP Paribas