Content Published Last Week

1. IP Analysis: Otis & Schindler Elevators: Over-Earning on Maintenance?

2. Schindler Elevators & Maintenance Margin Pressure

3. Amazon Retail EMEA Strategy and Profitability

4. Okta, Microsoft E5, & Identity Competition

5. HashiCorp: Terraform Open-Source to Paid

6. Elastic: Customer Perspective

Otis, Schindler, & Maintenance Margin Pressure

Last week, we published one of our favourite interviews of 2022: a Former Regional Manager of both Schindler and Otis Worldwide, with over 40 years of elevator experience, shares insight into how the elevator maintenance business works.

And, more importantly, why he believes the elevator companies are over-earning on maintenance.

We also published our analysis of Otis and Schindler and how margins may evolve given the potential pressure on service margins. We will share a few snippets of the analysis below but the full write-up is for members here.

Otis: Over-Earning on Maintenance?

The elevator business is fairly simple: vendors compete heavily to install new elevators and earn access to higher-margin recurring maintenance revenue. Although maintenance is only ~50% of revenue, it contributes >75% of EBIT for the major vendors.

But what does ‘maintenance’ mean?

How often does the vendor need to visit and ‘maintain’ the elevator?

Historically, the maintenance contracts have been vague; it doesn’t specify the minimum number of visits and specific tasks the vendor needs to complete to receive the maintenance fee. This enabled vendors to get paid without carrying out the required maintenance.

And this is what vendors seem to have been doing.

I was on a job two weeks ago, and the elevator company had only been to the job two times in two years. Right on the first page of your contract, it says preventive maintenance contract. It doesn't say elevator insurance policy. Where is your prevention at? This job that I was talking about where they've only been there twice in two years, I'm talking about twice in two years for maintenance. They had 17 callbacks in two years. So 17 times, the elevator was out of service. - Former Schindler Regional Manager

Weak legacy contract structures mean vendors aren’t properly maintaining its installed base. This inflates margins.

Over the last decade, cancellation rates are down as customers wise up to this trend and begin sending a service RFP to all vendors with more stringent maintenance terms. Increasingly, vendors will have to actually carry out the maintenance. This pressures margins.

The cost of servicing an elevator has two core components: labour and materials. Our estimate of the maintenance cost for a 4-elevator building is as follows:

Source: IP EstimatesSource: IP Estimates

Vendors historically targeted a 45% contribution margin for maintenance.

But now there is a newly reformed Thyseen in town. Now called TK Elevators and under new PE ownership, TK is heavily underpricing competitors to win service contracts.

In the last 10 years, elevator companies' margin expectations have gotten pretty high. They're unwilling to take maintenance at, say, less than 45% margin. Thyssen will take it at a lower margin; they're willing to lower their margins to get the work. - Former Schindler Regional Manager

It’s possible that TK’s owners are aggressively building scale in the business to flip it to public markets over the next few years. However, one interesting data point is that TK seems to have the most advanced predictive maintenance platform:

I think you will see a massive jump in technology from Thyssen with the new ownership group they have…they're focusing on everything I just mentioned; preprogrammed maintenance, security, all the things owners want. Owners want assurance that their equipment will run all the time, so they have predictive callback maintenance that they're building in their MAX system. Don't get me wrong, each company has its version of that, but Thyssen's is much more detailed than the other two. The other two companies built theirs as a bell and whistle to entice the client. I would say that Thyssen’s building theirs to make it functional, and I think it will make the difference. - Former Schindler Regional Manager

Another possibility is that TK is buying maintenance market share in the hope its predictive maintenance platform reduces costs to drive contribution margins back to the industry target of ~45%.

In our analysis, we explore how vendors can combat the pressure of lower-margin new service contracts and TK’s aggressive pricing. What also surprised us is just how frequent out-of-hours callouts really are! We also breakdown how predictive maintenance could eliminate callout costs.

Members can read the full analysis here.

Amazon Retail Strategy and Profitability

The consensus narrative around AMZN is clear: AWS is fantastic and Retail is horrible. And retail is horrible because it's currently not growing or GAAP profitable.

It's estimated that AMZN's Retail GMV is ~$600bn with ~66% from higher-margin 3P revenue. So how can it not be profitable? Walmart, Best Buy, and COST all earn 2-5% EBIT margins at similar or at even smaller scale.

The obvious answers are that AMZN is losing a chunk on 1P retail and has overbuilt its fulfilment network during COVID.

Both factors are likely pressuring retail margins in the short-term. But what seems clear after speaking to many experienced AMZN executives, like the Former Finance Director this week, is that AMZN doesn't see itself as a retailer. It's an infrastructure company.

In terms of strategy, I'd say Amazon isn't really a retailer. Amazon is an infrastructure company. Investing in Amazon is like investing in utilities. That's basically what you're investing in. It just happens to do retail, but the fundamentals of it, it's supply chain, it's the logistics, it's the fulfilment centers, it's the cloud base, it's the distribution systems for content. It's the devices. Again, just ways of basically sending software into people's homes. For me, Amazon is a utility business. In the end, retail is probably not that important to it. - Former Finance Director, AMZN EMEA

Now, this sounds great but it doesn't mean the retail business shouldn't or won't earn its cost of capital. It’s just that AMZN clearly doesn’t aim to earn a profit margin per retail unit. It cares about FCF and where this cash is invested. Let’s also not forget the retail business generates cash without GAAP income; we estimate the negative working cap over the last 20 years has been -3-4% for retail. Retail margins are also understated given the ‘non-AWS’ segment also includes a bunch of cash-burning ‘science projects’. Even if they are losing 1-3% per unit, adding back D&A and NWC, retail is certainly generating cash.

And all this retail FCF is invested in the real prize AMZN is going after: infrastructure. The goal is not being an online Costco. It’s to run the rails of all commerce and cloud computing.

Both of these games require huge scale. If you believe AMZN is playing this game, it’s not a surprise they are not showing profitability. Bears are sceptical given the low growth and declining ROIIC. Bulls believe profit will come with further scale, lower costs, and maintaining the customer experience.

Scale is the fundamental. I think that if you start looking at Amazon's business today, it's probably getting very close to one of the single biggest logistics businesses on the planet. With further moves into last mile logistics, operations, there are ways that you can then leverage all of that third party business; Amazon is now selling logistics services – or large parts of it – which gives you economies of scale on distribution costs and so you can lower the cost of distribution. I think that there's so many ways that, through scale, you can lower your cost of operations - Former Finance Director, AMZN EMEA

And maintaining the best customer experience is crucial to driving more scale through its logistics network. This is why we get stories like this from Jeff:

There was a conversation with the pricing team internally that I know I had when I joined. The pricing team – a bunch of very, very smart guys – had built the pricing tools that could optimize for profit or growth and Jeff got very upset, and said, "Guys, if I ever see that in the company again, you'll be fired". We optimize for customer trust, and I think that that is a fundamental belief in the company that you do not want to lose customer trust - Former Finance Director, AMZN EMEA

AMZN retail is ex-growth and has overbuilt its network. That’s certainly true if you look at the next couple of years. But it’s likely AMZN thinks in decades, not years.

We plan to share our unit economics breakdown in a longer piece soon. Please reach out if you wish to swap notes!

Okta vs Microsoft E5

CISO's have lost confidence in Okta as a product following the recent breaches:

I think my levels of optimism, confidence, based on where they are as a product, and a service, and a customer first organization has suffered a number of significant challenges and those have been primarily brought upon them, because of the breaches back in March or January of this year. For me, as a professional, that has really eroded the confidence in the company, but also the community that I speak in. I share my views with CISOs, pretty much across my community internationally, who echoed the same thing. - Former CISO, Sainsbury's

More worryingly, the functionality bundled within Microsoft's E5 license has caught up with Okta:

It's been a hugely competitive market in the last few years and the products and services that are offered as part of native Microsoft, Azure and AD Implementations have become far more feature rich, and providing capability on par with what Okta do today and so much more, but are included as part of, for example, an E5 license implementation. - Former CISO, Sainsbury's

The existing footprint of MSFT within enterprise stacks makes it far easier to add an E5 license relative to onboarding a new supplier:

I can take a Microsoft E5 in a license and have a lot of core capability included, which I would have to pay effectively an additional premium and albeit, a premium that would be part of my operating expense for SaaS service with the associated implementation costs and running costs, which would be very, very competitive. - Former CISO, Sainsbury's

Hashicorp: Free to Paid

Terraform seems to be a cornerstone product that enables customers to move workloads effectively to the cloud. The question is how well can they monetise the open source platform:

[For Terraform] I would say that most of them will continue with the open source. In terms of the case for the Enterprise or the Terraform Cloud, the only difference in running in the cloud or running in your data center, is environment, in which security is critical. For example, for insurance companies and banks, places where the data is critical – like Inditex as well – you get Sentinel, you get single sign on, you get more control what you're doing it. If you have a company that manages trucks, I don't see the value in buying Terraform Cloud, to be honest. The value is in organizations where security or data or organization management is important. When you we're talking about insurance companies and banks, you want directly go to Terraform Cloud; Terraform Enterprise I will say is better, but I would say that this is the best place for Terraform Cloud, confidentiality of data, data management, single sign on and critical data.

Elastic: Customer Perspective

A current customer and buyer of devops software believes Elastic has a powerful piece of the puzzle that may be difficult to compete with:

for me, they've always been a database engine. They're the most feature rich database engine. They're the best in my opinion. When you look at things like Datadog, that's a product that is trying to abstract away some of those things from you. Splunk and things like that, they're not interested. I could be wrong here but I don't think they're interested in performing as a database. They're interested in providing you your insights as a service, because often the margins are in the insights. I can't imagine a future where technologies like Elastic Search and core database engines aren't the major cornerstone, because those companies always have to approach generality. They always have to be, we have this product, which solves 80% of the market’s problems. - Technology Director at BAI Communications