Earnings Call Transcript
Otis Worldwide Corp (OTIS)
Earnings Call Transcript - OTIS Q2 2022
Operator, Operator
Good day, and thank you for standing by. Welcome to the Otis Second Quarter 2022 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Michael Rednor, Senior Vice Senior Director of Investor Relations. Please go ahead.
Michael Rednor, Senior Vice President, Investor Relations
Thank you, Michelle. Welcome to Otis' Second Quarter 2022 Earnings Conference Call. On the call with me today are Judy Marks; Rahul Ghai; and Anurag Maheshwari. 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' second 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.
Judith Marks, CEO
Thank you, Mike, and thank you, everyone, for joining us. We hope everyone listening is safe and well. I'd like to welcome Anurag Maheshwari, who is joining us this morning. Anurag is an experienced executive that many of you have worked with in his prior role leading Investor Relations at Harris. More recently, he's been leading our finance team as CFO in the Asia Pacific region. I look forward to my partnership with Anurag in driving growth, operational execution, and value for our customers, colleagues, and shareholders. I want to also take this opportunity to thank Rahul for his leadership and all of his contributions in transitioning Otis to an independent company and in championing our long-term strategy. We wish him well in his future endeavors. Before I get into the results and outlook, on our Q1 call, we noted our growing concerns about the long-term sustainability of our operations in Russia. At that time, we removed Otis' Russian operations from our 2022 outlook and prior year compares. Amidst mounting regulations, we concluded that the best solution for our customers, colleagues, and shareholders was to divest this business, and we recently entered into an agreement to do so. Closing of the transaction is expected imminently. We remain hopeful for a return to peace and stability in the region, and we will continue to contribute to the ongoing relief and humanitarian efforts in Ukraine. This quarter and going forward, Otis' Russia operations and related nonrecurring charges are excluded from our adjusted results, prior year compares, and our outlook. Moving to Q2 highlights on Slide 3. Otis delivered a solid second quarter, closing out a strong first half, especially considering the macro headwinds that we faced. We grew organic sales, expanded margins, and achieved 12% adjusted EPS growth. We had record new equipment bookings and continue to build our maintenance portfolio that was up nearly 3.5% in the quarter. Our Service business continued to deliver this quarter where we grew sales in all lines of business and expanded margins due to favorable pricing and productivity. We generated $326 million in free cash flow, while continuing to return cash to shareholders, completing another $200 million in share repurchases on top of the $200 million completed in Q1. In addition, as expected, Zardoya Otis was delisted in early May. We gained approximately 1 point of new equipment share in the second quarter, driven by high teens new equipment orders growth for Otis in a market that was down mid-single digits globally. New equipment orders in the Americas were particularly strong, up 57%, despite facing a difficult compare in the prior year. In Los Angeles, we're supporting the modernization of Terminal 4 at LAX. Otis was selected to provide 13 Gen 3 elevators, further extending the long-term relationship with the general contractor Hensel Phelps and marking our latest project at LAX. In Paris, Otis was selected to support the construction of the Tour Triangle, a 180-meter high tower that will include office, hospitality, and retail spaces. During the construction phase, an Otis SkyBuild self-climbing elevator will ascend as the floors are built, providing speed and simplified logistics to the building's construction teams. The building is designed to meet several environmental standards that Otis will help support by providing space-saving digitally native solutions like our Gen360 platform, SkyRise double-deck elevators, and Compass 360 destination dispatching. In South China's Greater Bay Area, Otis is supporting several projects to fuel smart city development. In Guangzhou's Canton Fair Complex, we will provide more than 140 SkyRise and Gen 3 elevators as well as escalators for Phase 4 of the Canton Fair complex, including IoT systems that will monitor performance in real time. In Shenzhen, the new China Life Insurance Tower in the Central Business District will be served by 20 Otis SkyRise elevators. In Zhuhai, Otis will provide nearly 90 elevators and escalators for the Ngong Ping Royal Times Square. This project will include Gen 3 elevators equipped with Otis' latest ambience features and digital technologies, serving passengers headed to offices, shopping centers, and hotels. Lastly, in Korea, Otis was selected to provide more than 45 elevators and escalators in the Teachers' Pension tower, a landmark in the financial district of Seoul. This project will include our Compass360 destination dispatching system to seamlessly move tenants between nearly 50 floors. Moving to Slide 4, Q2 results and 2022 outlook. New equipment orders were up 16.5% at constant currency in the second quarter and up 8.5% on a rolling 12-month basis. Organic sales were up 0.4%, and adjusted operating profit margin expanded 20 basis points and was up $16 million at constant currency, driven by strong performance in the service business. Free cash flow conversion was robust at 102% of GAAP net income. Looking ahead to our 2022 outlook, we're revising our full-year outlook and now expect organic sales growth of 2.5% to 3.5%, with net sales in the range of $13.6 million to $13.8 billion. Adjusted operating profit is expected to be in a range of $2.1 billion to $2.2 billion, up $120 million to $150 million, excluding the impacts from foreign exchange. After approximately $145 million in headwinds from foreign exchange translation, adjusted operating profit at actual currency is expected to be up $5 million to down $25 million. Adjusted EPS is expected in a range of $3.17 to $3.21, up 7% to 9% versus the prior year. Lastly, we still expect free cash flow to be robust at about $1.6 billion or approximately 125% conversion of GAAP net income. We will remain disciplined and balanced on capital allocation, advancing our bolt-on M&A strategy where it makes sense and returning cash to shareholders through dividends and share repurchases, which we're now in a position to increase to $700 million versus the $500 million target announced previously. With that, I'll turn it over to Rahul to walk through our Q2 results in more detail.
Rahul Ghai, CFO
Thank you, Judy, and good morning, everyone. Starting with second quarter results on Slide 5. Net sales of $3.5 billion were down 5.8%, primarily due to the broad strengthening of the U.S. dollar. Organic sales were up 40 basis points, the seventh consecutive quarter of growth, driven by Service, which increased over 5%. Adjusted operating profit was down $21 million, excluding the impact of translational foreign exchange; adjusted operating profit was up $16 million at constant currency, drop-through on higher service volume, favorable service pricing and benefit from productivity in both segments was partially offset by the impact of commodity price increases and annual wage inflation. We also continued our unrelenting focus on cost containment. Adjusted SG&A expense was down over $50 million or 90 basis points as a percentage of sales, even with inflationary trends in the economy. Despite the challenging environment, we maintained the investment in the business, and R&D spend and other strategic investments were flat versus the prior year. Adjusted EPS was up 12% or $0.09. A $0.06 headwind from foreign exchange translation was more than offset by strong operational performance, accretion from the Zardoya transaction, continued progress on reducing the tax rate, and the benefit of $400 million in share repurchases completed year-to-date. Moving to Slide 6. New equipment orders in the second quarter were up 16.5% at constant currency. Orders in the Americas were up over 50%, with growth in all verticals on top of nearly 50% growth in Q2 of 2021. Awards, which preceded orders in North America, stayed strong and were up 5 points on a sequential basis. EMEA orders were up 29% with growth in both Europe and the Middle East, and orders in Asia outside of China were up double digits driven by strong growth in South Korea and India, where bookings were more than double last year's volume. Orders in China were down low teens, outperforming the market that we estimate was down about 20%. Strong orders growth contributed to new equipment backlog increasing 6% and 10% at constant currency. Backlog in China was about flat, and backlog in Americas, EMEA, and Asia, outside of China, was up approximately 15%. Globally, pricing on new equipment orders was up low single digits after 5 straight quarters of year-over-year decline. Pricing trends improved year-over-year in all regions, excluding China, where pricing was down low single digits versus the prior year. New Equipment organic sales were down 5% in the quarter, as low single-digit growth in EMEA and high single-digit growth in Asia, excluding China, was more than offset by mid-single-digit decline in the Americas due to a tough compare from the prior year and a low teens decline in China from COVID-related lockdowns. Adjusted operating profit was down $28 million at constant currency, largely from the impact of lower volume and related under absorption. Commodity inflation of $35 million that was in line with prior expectations was mostly mitigated by installation and material productivity and lower SG&A expense. Service segment results on Slide 7. Maintenance portfolio units were up nearly 3.5% from improvements in retention, recapture, and conversion rates with recaptured units more than offsetting cancellations in the quarter. In China, conversion rates continued to improve year-over-year and contributed to the fourth consecutive quarter of high teens portfolio growth. Modernization orders growth accelerated to 9% in the quarter, with growth in all regions, driving backlog growth of 4%. Service organic sales grew for the sixth consecutive quarter, up 5.2%, with growth in all lines of business. Maintenance and repair grew 4.9% as the benefit of strong repair volume and growth in contractual maintenance sales outpaced our unit growth due to improved pricing, which was up about 3% on a like-for-like basis. Modernization sales continued the recovery that started in Q4 of 2021 and were up 6.4% in the quarter with growth in every region. Service profit at constant FX was up $39 million. The benefit from higher volume, favorable pricing, and productivity was partially offset by annual wage increases. Margins were up 50 basis points, the tenth consecutive quarter of margin improvement. Overall, the first half results reflect solid operational execution, with a point of new equipment share gain, the best portfolio growth in a decade, and close to $125 million of cost reduction between productivity and SG&A. These actions helped us manage through the continuing macroeconomic challenges and achieved low single-digit organic sales growth, $50 million of earnings growth at constant FX, and 15.8% adjusted margins, a 30 basis point improvement over the first half of 2021. Margins for the first half are up 140 basis points from pre-COVID levels of comparable periods in 2019. First half free cash flow generation of $800 million, 50% of our guide for the year, enabled us to repay $500 million of debt, raise dividends by 20%, and complete $400 million in share repurchases. With that, let me turn it over to Anurag to walk through the revised 2022 outlook.
Anurag Maheshwari, CFO, Asia Pacific
Thanks, Rahul and Judy, for the kind introduction, and good morning, everyone. I'm excited to be here and look forward to continuing the great work Rahul has done in advancing our long-term strategy, driving operational execution, and creating value for our shareholders. Thank you, Rahul. Let me start on Slide 8 with a recalibrated outlook that incorporates the evolving macroeconomic headwinds combined with our continued focus on things we can control, accelerating service growth, driving productivity, optimizing the tax rate, and reducing our share count. Starting with sales, we are expecting organic sales to be up 2.5% to 3.5%, which is 0.5 point lower than the previous guidance, driven by a reduction in the New Equipment segment partially offset by better expectations for Service. Though new equipment sales are lower, margins remain unchanged, expected to be down 20 to 60 basis points versus the prior year, with the impact of lower volume offset by improved productivity. Service margins are now expected to be up approximately 60 basis points, a 10 basis point decrease from the prior outlook reflecting the mix impact of modernization sales growing faster than the maintenance and repair business. The overall margin outlook remains unchanged versus the prior outlook and is expected to be up approximately 30 basis points to 15.7%. Adjusted EPS is expected to be in the range of $3.17 to $3.21, up 7% to 9% versus the prior year. This high single-digit adjusted EPS growth is driven by strong operational execution, accretion from the Zardoya transaction, progress on reducing our tax rate, and a lower share count at more than $0.42 of headwind from foreign exchange translation and commodity inflation. Our free cash flow guidance for the year remains unchanged at $1.6 billion, and we have increased the 2022 share repurchase target from $500 million to $700 million. Taking a further look at the organic sales outlook on Slide 9. The New Equipment business is projected to be down 0.5% to 1%. This is a 1.5 point decrease from the prior outlook at the midpoint, driven by revised expectation in the Americas and China. While the backlog in the Americas is up by more than 10%, shipments are shifting from 2022 to next year from delayed building construction activity by our customers. As a result, we now expect Americas organic New Equipment sales to be about flat versus up low single digits previously. We expect Asia to be down low single digits from down slightly previously driven by China. Despite our backlog being flattish versus the prior year and up from the end of '21, we now expect Otis China organic sales to be down mid-single digits driven by lower market expectations now expected to be down approximately 10% at the low end of our prior guidance and the impact of lockdowns during Q2 that have moved projects to the right into '23. This has been partially offset by improved outlook in Asia Pacific from the benefit of strong orders growth and momentum in India and South Korea. Outlook on New Equipment organic sales in EMEA remains unchanged and is expected to be up low to mid-single digits in 2022. Turning to Service, we now expect organic sales to be up 5.5% to 6.5%, an improvement of 50 basis points from the prior outlook of 5% to 6%, driven by strong maintenance pricing, robust repair order growth in the second quarter, and incrementally higher confidence to convert a modernization backlog that is up 4%. Moving to Slide 10. We expect adjusted EPS growth of 7% to 9%, a $0.24 increase at the midpoint. The $0.18 or $110 million headwind from commodities is more than offset by the $230 million to $260 million of operational improvement through higher service volume and pricing, productivity in both segments, and other cost containment actions resulting in profit growth of $120 million to $150 million at constant currency. This is $5 million higher than our prior outlook at the midpoint. Accretion from the Zardoya transaction, close to 2 points of tax rate reduction versus last year, and the benefit from $1.4 billion of share repurchases since the spin is more than offsetting the $0.24 or $145 million headwind from the unprecedented strengthening of the U.S. dollar. We have now assumed the euro at EUR 1.01 for the second half of the year, or EUR 1.05 for the full year. Compared to the prior guidance, we are offsetting more than half of the incremental FX headwinds by driving the service business, containing costs, and reducing the tax rate an additional point, now projected to be 26.6% for the year at the midpoint. Overall, this outlook clearly reflects our ability to mitigate the macro challenges and deliver another year of solid organic top line growth, margin expansion, robust free cash, and importantly, strong new equipment backlog and service portfolio growth that positions us well for 2023 and beyond. And with that, I will request Michelle to please open the line for questions.
Operator, Operator
Our first question comes from Jeff Sprague with Vertical Research Partners.
Jeff Sprague, Analyst
Congrats on doing well. First, just on China. Obviously, a lot of headlines of the outlook as you presented, down the single digit for the year-end, market down 10 actually sounds surprisingly okay. I just actually wonder your confidence level on that relative to the backlog conversion and what's happening on the ground, if you could give us a little update there.
Judith Marks, CEO
Sure, Jeff. It's Judy. We are lowering our market growth estimates mainly due to the lockdown impact we experienced in April and May, and we do not anticipate a full market recovery in 2022. We project a decline of about 10% for the market this year, which is at the lower end of our previous range, and this does not incorporate any potential return to growth or stimulus. I feel positive about our business health in China. Our strategy and initiatives are on track, helping us gain market share, as you’ve noticed. We grew faster than the market not just in Q1 but also in the latest quarter. Our new equipment orders were down in the low teens, while the market experienced a 20% decline in the second quarter. We are outperforming the market, which gives me confidence that our strategy is effective. In the second quarter in China, residential, infrastructure, and industrial segments were strong. Higher-tier cities, particularly tiers 1 and 2, performed well for us and the market overall. Our strategy has concentrated on these areas. We have doubled our number of agents and distributors, which is yielding positive results; we now have around 2,250 agents and distributors representing both our products and services, which translates to increased market share in a declining market. We have also focused on our service strategy. As Rahul mentioned, we achieved our fourth consecutive quarter of high teens portfolio growth, and that trend is expected to continue in China. We are striving for balance in China, alongside geographic balance and product mix. China represents about 20% of our global revenue, and as noted in the second quarter, our other business segments in Asia Pacific, Europe, and the Americas have accelerated. We are optimistic about our backlogs around the world and the new equipment orders that will drive our future into 2023. We’re observing China closely like everyone else, but we had a strong Q2 due to Perry and the team after the COVID lockdowns. Our factories are operating at maximum capacity, with the ability to respond if there is a stimulus. All of our service indicators are robust. Globally, including in China, our recaptures for the first quarter have exceeded cancellation rates, and in the second quarter, we continued to exceed cancellation rates. We are effectively managing every KPI, and the team is delivering results.
Rahul Ghai, CFO
To add to that, as mentioned in my prepared remarks, it's important to note that our backlog in China for the second half is roughly flat compared to last year. We saw a decline in orders in the low teens, and sales were also down. Therefore, we enter the second half of the year with a flat backlog. As we update our guidance for the year, we are anticipating a sequential improvement in year-over-year growth. Between the first and second quarters, we experienced a decline of about 9%, and for the full year, we're looking at a decrease in mid-single digits. While the second half is still down, it won't be to the same degree as the first half. Revenue is expected to increase sequentially from the first half to the second half. The conversion process is a bit slower due to the lockdowns, meaning not all projects we anticipated will be completed in 2022, leading to some demand being pushed into 2023. Overall, we anticipate our conversions will drop by high single digits for the year compared to a very strong 2021, but they remain aligned with pre-COVID levels. Conversions have slowed compared to last year but are consistent with where they were before the pandemic. That summarizes our current situation.
Jeff Sprague, Analyst
Sounds great. And then just on the Americas, I mean, these orders really the headline growth itself and then especially versus the comp is just extraordinarily strong I wonder if you could give us a little bit more context on what's going on there, a couple of large lumpy things perhaps but also address kind of the revenue slippage. Is that primarily kind of job site issues with your customers, or you see folks kind of tapping the brakes on economic concerns? Just any additional color there on the Americas should be appreciated.
Judith Marks, CEO
Certainly. I want to acknowledge Jim and the Americas team for their efforts. As you know, order patterns can be inconsistent in all industrial sectors, and particularly in our longer cycle business. However, this quarter was driven by volume for our Americas team. I can't attribute it to any major projects or significant orders; it was simply strong performance. The most notable strength emerged in the residential sector, which we believe is tied to population growth trends. We observed increased residential activity in the South, the Western U.S., and Tier 2 cities. This aligns with what others are reporting, and it's reflected in our order book. Overall, we saw robust performance across all branches, with everyone effectively converting awarded projects into orders. Regarding the transition from 2022 to 2023, we mentioned last quarter that some larger projects were expected to generate revenue in 2023. The main challenge we're encountering is a delay related to general construction labor from contractors, not our own staffing, as we are fully staffed. There has been a slow response due to demand in specific cities, particularly in the South and West. This is causing some delays in our usual cycle time for revenue recognition, but it's certainly forthcoming and should positively impact 2023.
Operator, Operator
And our next question is from the line of Nigel Coe with Wolfe Research.
Nigel Coe, Analyst
And Rahul, I appreciate all your support and help; you've been fantastic. Thank you. I wanted to revisit the discussion about China. The low teens decline was significantly better than we anticipated and also improved compared to some of your competitors. I'm curious how that aligns with your plan. I don't recall if you shared a specific expectation for China, but how did the actual outcomes compare to that plan? More importantly, how did that trend throughout the quarter? I know you were lagging a bit around mid-May. I'm interested to know how that progressed through June and what we've observed in July so far.
Judith Marks, CEO
Yes, it's great to talk to you, Nigel. June was an outstanding month for our team, and the response was remarkable. We achieved record shipment levels from our factories in China during June. Our factories remained operational throughout, given their location in China, which helped us be ready. Both our elevator and escalator manufacturing facilities were prepared, allowing us to produce and ship across different regions in China. The team was well-prepared for that. Overall, June was a strong month, and July's performance is continuing in that direction. While we don’t provide quarterly guidance, our experiences in April and May prompted us to be cautious, but our team was ready for it. We are adjusting our cost structure to align with market conditions. We have done this in the past, and we do not anticipate a sudden drop like we experienced in 2015. We believe that will not happen again, and we will continue to adapt our costs to the market developments we observe.
Nigel Coe, Analyst
Great. And then on the backlog, maybe just give us a little bit of a taste of through a slower macro, maybe a research and what typically happens to your backlog? Do we see cancellations? Do we typically see push outs? What should we expect? And maybe if you can talk about new equipment versus modernization, that would be helpful.
Rahul Ghai, CFO
Yes, Nigel, we are currently observing some project cancellations, which is a normal occurrence. However, we usually receive an advance when we book an order, so our process differs from some other industrial companies that may deal with more significant concerns regarding supply chain issues or multiple orders. In our industry, when we create an elevator or escalator for a specific building, we do not change designs midway through. Although cancellations do happen and projects may get delayed, we are not noticing any significant changes in year-over-year trends, and such cancellations are typically minor for us. The trends remain consistent, and projects do move forward, as mentioned by Judy. We've experienced that in China regarding conversion and also in the Americas as projects are being rescheduled. The construction labor shortage in EMEA and the U.S. has introduced some challenges, and while we are facing supply chain issues, we are tracking them closely. Our projects are not being held back; instead, customers are experiencing delays in their building construction, which is impacting our revenue. However, our backlog has increased by 10% at constant currency, with China remaining flat and other regions combined seeing an approximate 15% increase. This positive trend indicates strong potential for 2023.
Operator, Operator
Our next question comes from the line of Nick Hudson with RBC Capital Markets.
Nicholas Housden, Analyst
The first one is on the tax rate, which was obviously quite a nice tailwind this quarter. It looks like it was down about 5 percentage points quarter-on-quarter. And I know, obviously, you've been saying that you're working to reduce this on a structural level, but I'm just trying to get my head around whether the reduction that we've seen this quarter is completely structural or whether we should expect more normal levels in the next few quarters?
Rahul Ghai, CFO
Yes, Nick. We have made great progress in reducing our tax rate. We lowered our full-year tax rate guidance to approximately 26.5% to 26.6% at the midpoint, which is about a point lower than our previous guidance and approximately 2 points down from where we ended in 2021. This is clearly a strong improvement. In terms of the tax rate for the quarter, there are often timing impacts related to what we are doing and when those are recorded, resulting in fluctuations from quarter to quarter. However, the measures our team is implementing are certainly decreasing our structural tax rate, which is why we reduced our full-year guidance by about 1 point. Now, we are within the medium-term guidance we provided of 25% to 27% on Investor Day, which is a positive development. The progress has been somewhat front-end loaded, and we've achieved more this year than we expected at the start. We are confident we will continue toward the lower end of our guidance, but the pace of progress may not be as rapid moving forward. We will not see a 2-point reduction every year. Although we are now within the range, you can expect some improvement next year, though it won't match the rate we experienced this year.
Nicholas Housden, Analyst
That's great. My second question is on the margin profile of modernization and just how that compares to the Service business as a whole. My gut sense is that it's probably more like new equipment in terms of the profitability there. Any color you could provide would be helpful.
Rahul Ghai, CFO
It's slightly lower than new equipment in our business, as we typically focus on modernization. The appeal of modernization projects is that they allow us to renew service contracts for several years. It's a highly competitive area, and we often take on modernization jobs at lower margins compared to new equipment, but it's still a profitable segment for us. We do make money and maintain decent margins, although they are lower. Additionally, modernization aids in labor absorption. While the margins for this particular line of business may be less than others, it certainly contributes positively to our overall absorption. It's encouraging to see growth in this area, and we're glad to raise our guidance for the year. Last year was challenging for us in modernization due to supply chain issues, but we've managed to overcome those hurdles. This marks our third consecutive quarter of growth in modernization, and we're now increasing our guidance from 6% to 8% for the year, which is fantastic considering the difficulties we faced last year.
Judith Marks, CEO
Yes, Nick, it's Judy. We're very pleased with the progress. Although we mentioned earlier that there were delays, some aspects of the modernization are discretionary. However, every elevator is now about three years older since our spin-off. The market for modernization is growing, and it has the desirable stickiness that supports our follow-on service business, as Rahul mentioned.
Operator, Operator
And our next question comes from the line of Steve Tusa with JPMorgan.
Charles Tusa, Analyst
Rahul, congratulations once again, and thank you for all your assistance over the past few years. Could you confirm the 3% increase in price and service? Should we expect new equipment sales to remain relatively stable?
Judith Marks, CEO
Yes. So service pricing was up 3%. New equipment was actually up low single digits in terms of pricing. So we got price in both segments, Steve.
Charles Tusa, Analyst
Okay. We should assume that most of the commodity challenges are what you're guiding now to be about $108 million to $110 million in year-over-year commodity inflation. What was that number for the quarter?
Rahul Ghai, CFO
The $35 million for the quarter amounts to $70 million for the year, which means $70 million for the first half. You can see that it's around $40 million in the second half compared to the previous year.
Charles Tusa, Analyst
And the vast majority of that is coming in New Equipment, right?
Rahul Ghai, CFO
All of it is coming in New Equipment.
Charles Tusa, Analyst
Yes. Okay. And then one more question for you just on the second half. And anything within the 2 quarters that we should consider from a seasonality perspective? Should we assume a little more catch-up in China in the third quarter and then a bit of a fade on that in the fourth? Or how do we think about the trajectory of EPS just between the third and the fourth?
Anurag Maheshwari, CFO, Asia Pacific
Thank you, Steve. It's Anurag here. Regarding the difference between Q3 and Q4, we anticipate organic growth of about 4% in the second half, with positive contributions from both New Equipment and Service. Last year's Q3 was particularly strong for us, with an organic growth rate of around 8%. In the third quarter, New Equipment is expected to grow in the mid-teens, while growth is expected to slow to low single digits in the fourth quarter. Although we will experience sequential growth in New Equipment in Q3, it will be lower compared to last year's performance. As we move into Q4, we project a return to organic growth, as we will have an easier comparison from last year and also anticipate sequential growth. For Service, we have seen a 5.5% increase in the first half with guidance for 6%, which suggests about 6.5% growth in the second half. We expect service growth to remain consistent between Q3 and Q4. On the profit side, due to the expectations for new equipment, we foresee some year-on-year margin contraction in Q3 due to under absorption. However, in Q4, you should see modest year-on-year margin expansion as organic sales increase. We also anticipate more margin expansion in Service for Q4 compared to Q3 because of the timing of repair work, as we expect greater repair revenue in Q4. Overall, we will see margin expansion in both quarters, but likely more in Q4 than in Q3. When we assess EPS after adjusting for the tax rate, you can expect a small increase in Q3 with the remainder coming in Q4. For the rest of the year, we remain balanced regarding EPS growth across the quarters.
Operator, Operator
And our next question comes from the line of Julian Mitchell with Barclays.
Julian Mitchell, Analyst
And Rahul wish you all the best in the new role. Maybe a first question around the EMEA business, as I don't think that's been touched on too much, but maybe help us understand sort of how comfortable you feel on the service pricing environment in Europe as I know that was a big concern a decade ago when you had a construction downturn there. And also, on the New Equipment side, a mix picture from sort of other companies on what's going on in European construction. Any updates from you on how that's looking in terms of order intake and so forth?
Judith Marks, CEO
Yes, we are very happy with the service pricing trends we have observed consistently in Europe. Most of our service portfolio is concentrated in Western and Southern Europe, with some presence in the Middle East and Africa. However, the majority is in developed Europe, which emphasizes the importance of pricing. The team has done an excellent job in this area, and we have seen growth in our portfolio for two consecutive quarters in the EMEA region, demonstrating the positive momentum from Bernardo and his team. Regarding the market, the core European markets for New Equipment are performing well. This quarter, we recorded a 29.3% increase in orders for New Equipment, with a 12-month rolling average of 5.5%. All indicators point to strong business volume and significant projects, such as those related to the upcoming Olympics in Paris. Currently, the only challenges we face are in Eastern Europe due to the ongoing conflict there. On the construction front, things are stable. As Rahul mentioned in response to a question, labor availability is an ongoing challenge, particularly with some of our installation subcontractors. We are managing labor deployment carefully across different regions and countries within Europe to effectively tackle our larger projects.
Rahul Ghai, CFO
Julian, I’d like to add a few points. Starting with the construction outlook, it’s encouraging to note that while the confidence level has risen slightly, it remains positive. More importantly, the building permits index is currently at its highest level in the past year, which is a good sign as it shows that the permits are holding steady and have increased from the latest report compared to the previous one. Our proposals in the EMEA region are also showing high single-digit growth, indicating that our baseline activity is quite strong. This suggests that we’re not only receiving orders but also experiencing positive trends in the industry and our own activities. Regarding new equipment, we've seen pricing improvements in EMEA for the second consecutive quarter, with an increase in the mid-single digits this quarter, which is better than the previous year’s first quarter. It’s encouraging that we’re achieving better pricing on new equipment orders. As for our service pricing in EMEA, it increased at a low single-digit rate, similar to what we observed in the first quarter. This positive trend in service pricing is contributing to our margin expansion because without it, we wouldn't have been able to grow our margins by 50 basis points in this area. This aspect is crucial for our overall margin growth.
Julian Mitchell, Analyst
That's helpful. And then just my quick follow-up would be, I think you gave some color on the commodity impact this year, which is not really changing from prior. But as we think sort of a little bit further out, maybe. Remind us, I suppose, on the hedging practices on commodities. And also, I suppose, how quickly you think that things like lower steel costs will roll into your COGS? And what degree of tailwind you might benefit from next year looking at sort of steel spot prices today? And again, the speed, just trying to understand the speed at which changes in those prices roll through into your cost of goods sold?
Rahul Ghai, CFO
Yes, that's a great question, Julian. We employ various strategies to secure our prices. We collaborate with our suppliers, either through spot pricing or preferred futures contracts, although we don't always achieve this. We ensure that we lock in rates with our suppliers. Regarding hedging, as we've mentioned before, it can be a bit complicated due to the types of steel we purchase, which don’t always correlate with an index. This sometimes exposes us to mark-to-market accounting risks with our hedges. While we do utilize hedges, their application is limited by the nature of our purchases. Overall, we have locked in about 80% for the year, with nearly 100% locked for Q3. Our spending for Q4 is still somewhat open, but prices are decreasing. Notably, in China, prices fell by 15% in the second quarter and are down approximately 30% year-over-year in Q3, indicating a downward trend. We anticipate a slight single-digit million tailwind for Q4, but given the current volatility in the market, we prefer not to rely on that for projections. Year-over-year, we're seeing significant benefits, with U.S. steel prices down 50% compared to last year. Therefore, we expect to see positive effects in 2023, particularly as we make purchases in Q2, which will have a favorable impact.
Operator, Operator
And our next question comes from the line of Cai von Rumohr with Cowen.
Anurag Maheshwari, CFO, Asia Pacific
Michelle, let's move to the next question.
Operator, Operator
Our next question comes from the line of John Walsh with Credit Suisse.
John Walsh, Analyst
Congratulations, Rahul and Anurag.
Rahul Ghai, CFO
Thanks, John.
John Walsh, Analyst
Maybe just circling back to China. You talked a little bit about internal geographies within China. Just your manufacturing wasn't as impacted by the others due to the Shanghai lockdown. But just curious how you think about the share gains you likely saw in the quarter as it relates to China. Do you think they're sustainable or if it kind of normalizes and maybe only keep a portion of what you gained? Just any thoughts around that?
Judith Marks, CEO
John, our strategy is on track in China, and our team is executing it operationally. And I would tell you with excellence. We have figured out and invested in sales coverage. We've invested in product innovation with our Gen3 offering. We have our factories; some of them are already at industry 4.0. All of these investments and strategies are paying off. We've had share gain now in China for multiple quarters. And we believe it's absolutely sustainable. We think we're at the right price point with the most innovative products with the right customer relationships through our agents and distributors, and it's all coming together and working. So even if the segment declines, we should still be able to gain share.
John Walsh, Analyst
Great. And then you touched on capital allocation, obviously, generating a lot of cash. Just curious as you look at the opportunities, should we think about kind of more service portfolio acquisition, equipment, software, kind of just any color you have there and what we should expect?
Judith Marks, CEO
Our capital allocation strategy allocates about $50 million to $70 million a year for bolt-on M&A. Obviously, the Zardoya transaction was a great opportunity for us at the right time, at the appropriate and fair price. We not only executed it well, but with the squeeze out, we're able to execute it as quickly as possible. We're seeing the benefit of that with the $0.12 EPS gain this year, and there'll be a little more next year. But really, our M&A strategy revolves around adding to our bolt-on Service business. And we've been doing this for years; it gives us in places where we have density and opportunity; we make it accretive no later than year 2. And we have a playbook for doing it. We've got a really good deal book across the globe to continue doing it, and that's what you're going to see from us.
Operator, Operator
And our next question comes from the line of Miguel Borrega with BNP Paribas.
Miguel Borrega, Analyst
The first one, just a follow-up on the order intake, specifically in the Americas, where you said mostly comes from residential and volumes. Can you give us a flavor for timing of delivery? I suppose lead times in residential are shorter. And then can you talk about pricing of these new orders? Do they contribute positively to the backlog margin?
Judith Marks, CEO
Yes, Miguel, you mentioned residential and another term that I didn't quite catch. Could you clarify?
Miguel Borrega, Analyst
Yes, the residential orders in the U.S.
Judith Marks, CEO
Okay, just residential, okay. Yes. So residential in the U.S. is our traditional cycle time. It's kind of in apartment buildings and the like. It's a typical lead time that we have for all of our projects. So we anticipate that that will continue to fill the pipeline, again, with a strong backlog for our Americas group to execute. Rahul, do you want to touch on?
Rahul Ghai, CFO
Yes, it's about 12 months. Judy mentioned that we typically see a 12-month timeframe, and I think these new orders will fall within the same range. Thus, we expect that the orders we're receiving now will likely convert into revenue in the second half of next year. Overall, we're experiencing strong pricing in the Americas, with new Equipment pricing increasing modestly. While it was noted that China’s pricing declined a few points, all other regions, including the Americas, EMEA, and Asia Pacific (excluding China), showed mid-single-digit growth. We have implemented pricing actions in Q3 of last year, resulting in a positive turnaround in both Asia Pacific and EMEA, which was great to observe in the Americas as well. Overall, pricing is slightly improved. In China, although pricing has decreased, it's important to note that commodity prices have dropped 15% in the second quarter and 30% in the third quarter. Therefore, even though New Equipment pricing in China is down, we're seeing reduced prices related to commodity costs.
Miguel Borrega, Analyst
That's great. And then just on labor inflation. Can you give us a flavor for what you've negotiated with your unions, when will that hit? And whether you expect this to be passed both in New Equipment and maintenance?
Judith Marks, CEO
We have several agreements regarding labor negotiations, and the timing varies, especially with work cancellations in Europe. Our labor negotiations in the U.S. have been finalized, resulting in a multi-employer agreement that takes effect on January 1. This is a five-year agreement, which provides us the capability and, importantly, the knowledge to counterbalance this with productivity. While we have raised prices to manage costs, we also need to address wage inflation on the service and installation sides for new equipment. However, we can offset these costs through productivity and anticipate that increases in volume and prices will help mitigate the impact.
Miguel Borrega, Analyst
Great. And then just one quick last question on China. Can you just quantify the lost sales and EBIT from Q2? And whether this will be fully recovered already in Q3?
Rahul Ghai, CFO
Yes, Miguel, I would say that quantifying it is debatable. Overall, sales are down about 12% this quarter, and Q1 was slightly down as well. You could average maybe 6 or 7 points as the factors change. However, I think it's more important to focus on our guidance for the year. We've provided guidance, and we haven't lost sales; it's more about shifting revenue from Q2 to Q3. We should be able to capture most of that, but it depends on project timing. We've mentioned that we expect the market to be softer and conversion rates in China to be slower than last quarter. Conversion rates are indeed slower, causing some demand to shift to the right. Overall, the key point to focus on is our guidance for the year.
Operator, Operator
And our last question comes from the line of Joel Spungin with Berenberg.
Joel Spungin, Analyst
Judy, I was just wondering if I could start by asking you a question on one of the comments you made earlier in answer to another question about why you don't think that what's going on in China is similar to the situation in 2014, 2015. I mean, if I was to play devil's advocate for a second, I would say, well, housing inventory levels are alarmingly high rates as high as 2014, sales of new floor space are on the catering. Why are you more sanguine about the outlook for the Chinese market in the longer run?
Judith Marks, CEO
Yes, I believe there are structural changes ahead that will affect the China property market. However, I don't think it will be as dramatic as it was back then. In our industry, we experienced significant overcapacity, which led to substantial pricing actions that reduced profitability across the board, but we are not observing that now. Currently, about 90% of new equipment fulfillment comes from the top 10 providers, most of which are publicly traded companies, and they seem to be pricing rationally. Otis is in a much stronger competitive position today; we have fewer factories and a superior product offering in terms of innovation. Our sales network is also significantly better, allowing us to align more effectively with a potential gradual slowdown. We are in a much better position to manage this compared to the buildup from 2000 to 2015 followed by a sharp decline. I do believe there will be structural changes over time, but we are well-prepared for them, and I expect our team to perform as they have over the past several quarters, even outpacing our competitors.
Rahul Ghai, CFO
I would like to add a couple of data points to what Judy mentioned. If you look back to 2015 and 2016, residential inventory was at about 3 to 4 months, and it has stabilized around that level. In fact, it has decreased slightly over the last six quarters to approximately 3.5 months of inventory, down from 3.8 in April. Comparing this to 2016 or 2017, I recall it was possibly around 6 to 6.5 months at this same time. So this is a positive sign. If you examine investments, real estate investment is down about 5%, and the space under construction has decreased by about 3%. While conditions are not ideal, they are certainly not at the same declining rates we experienced in 2016 and 2017.
Judith Marks, CEO
One last differentiator to mention, Joel, is that state-owned enterprises are having a much greater influence. This positively affects our relationships, performance, installed base, and customers. We have been proactive in preparing for this trend, and we are ready.
Jeff Sprague, Analyst
That's great. If I could just squeeze another one in very quickly. Just to clarify really with regards to your comments on the North American new equipment market. You're saying that the delays you're seeing are purely, it sounds like a function of issues on the construction side with factors such as labor. You're not seeing people delaying projects because of increased concern about the economic outlook or anything like that.
Judith Marks, CEO
That's correct. It's labor availability in the right market on the job site from all the trades from the people pouring the hoistway with the cement to the general contractors.
Operator, Operator
This concludes today's question-and-answer session. And I would like to turn the conference back over to Judy Marks for any further remarks.
Judith Marks, CEO
Thank you, Michelle. This solid first half demonstrates the strength of our strategy and our ability to execute and adapt to mitigate the significant macroeconomic challenges. We will continue to focus on strong execution to deliver high single-digit adjusted EPS growth in 2022 with continued growth in '23 and beyond. Thank you for joining us today. Everyone, stay safe and well.
Operator, Operator
This concludes today's conference call. Thank you for participating in today's conference call.