Trane Technologies plc (TT) Earnings Call Transcript & Summary

Mike, I don't hear anybody from Google Meet.

[ Adrian ], if you were still there? [ Adrian ] from Google Meet.

I see we're live without a countdown. Awesome. Good afternoon, and welcome back, everybody, to day 2 of the Morgan Stanley Laguna Conference. Thanks for bearing with us there on 30 seconds of dead air. I'm Josh Pokrzywinski from multi-industry analyst. With me from Trane Technologies is Chairman and CEO, Mike Lamach; and CFO, Chris Kuehn. Before we get started, guys, I just need to read a quick disclaimer. Please note that this webcast is from Morgan Stanley's clients and appropriate Morgan Stanley employees only. This webcast is not for members of the press. If you are a member of the press, please disconnect and reach out separately. For important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to Morgan Stanley sales representative. Chris, Mike, thanks for joining us. Always a pleasure. Shame we can't do it in person. But glad to have you all the same.

Yes, Josh. Thanks. Great to be with you in a virtual Laguna. The logistics are great. Thanks for doing that. It's worked -- other than that short 30-second hitch there, it's been great. So thank you. I want to say first, though, our thoughts and prayers are to all the people on the call, family and friends, affected by the fires out in the West Coast and certainly anybody down in the Gulf states here with the hurricanes. We -- you folks don't need another 1, 2 punch, and it looks like we got one here. I also wanted to step back for a minute from COVID and the pandemic and tell you that the energy and optimism and excitement that we had around the rationale and reasons to split the company and become Trane Technologies are intact. We think the sustainability story is strong that reducing the energy intensity of the world through the spaces that we're involved in, where HVAC typically is 40 or more percent of the energy demand in the building and where greenhouse gas emission reduction is so important because 25% of greenhouse gas emissions will be met from HVAC systems by the year 2030. And that is certainly, when you couple that with Thermo King, where 10% of the world's food loss and greenhouse gas emissions occur somewhere in the cold chain, these are opportunities for us to grow faster than the market, do good in the world and do great for shareholders. The thing we didn't predict back in March 2 was the impact we would have from COVID in its early innings, but I would likely say that there's probably a third leg in that sustainability stool, which is around healthy environments, healthy spaces. And we're, today, we're very busy with assessments and helping customers through the crisis, I do think that our perception is going to change going forward. And for people to return to work and feel good about returning back to spaces, there's lots we can do and certainty and surety that we can provide, and our customers are asking us for that. The timing of the RMT was outstanding. And certainly, from a balance sheet perspective, liquidity perspective and the fact that we think we had a business model advantage, a field advantage and a technical advantage, we talk about playing aggressive offense, and that's what we're talking about doing here in this downturn and coming out even stronger. And so Josh, with that, ready to take on questions you might have.

Yes, absolutely. So I think just kind of bridging off of some of the items that you mentioned there, Mike, on the reopening front. Obviously, a lot of activity, like you said, we didn't expect in March, and some of that surprising to the upside. I think 2 elements stand out. First, that emphasis on indoor air quality and all of the unintended consequences at the building level for what that means for efficiency is probably one; and then the other, the impact of people staying at home and probably having a stronger residential season than you would otherwise expect relative to employment or GDP. But on the commercial reopening first, just since it's a bigger business for you, as folks are starting to return to work, present company excluded where we might be the only ones in the office, the -- are those conversations live with some sets of urgency saying, "Look, we want these folks to be able to come in January 1, and we need to start specking things now?" Or is it still kind of floating around there in the ether rather than being hard quote?

No, it's absolutely live. It's urgent. And if you think about any good reopening plan, I mean, think about a school district, where we live here in Charlotte, there's a large district, Charlotte-Mecklenburg Schools that is not open for in-person education, and they're using the time to go do assessments inside their buildings now to get ready. So whether you're open and have taken some action or you're reopening and planning, the actions to be taken, there's some urgency. When we look across this too, what's unique is it's a global urgency. Anybody on the planet is thinking about the same thing these days, whether you're a small restaurant owner, a major university or an office building, thinking about reopening, you have the same questions. And Josh, for us, as best we can tell, we would have something in the probably low couple of billion square feet of space where our equipment is located in a world where you've probably got low tens of billions of square feet of space, all going through the same challenge. So I think about this really is something that has got urgency now. But in some cases, it's going to take a long time probably to address permanently. And I think codes and standards will ultimately change to strengthen and shore this up and provide more surety into the future. I think this is one of these once in a lifetime, certainly once in a generation experiences that will change the way that people think about preparedness and readiness as it relates to spaces, and we're going to see some permanent change here with codes and standards going forward.

And one thing that kind of struck me about your business model and maybe commercial HVAC at large is that we've gone from this pull model where someone says, "Hey, my stuff is broken and gosh, it's hot in here," to you guys being able to beat down doors and say, "You guys are spending way more money than you need to, and let us go down into your basement and do some math." That appears to be a bigger driver of the business, certainly the way you guys have talked about it for the past few years. I would imagine that this is kind of another entry point into a customer to say, "Let's have a conversation that ultimately goes somewhere else." Is that how these have gone where it starts out with indoor air quality, but you end up with something that's a little bit more fruitful?

Yes, Josh, interestingly for us, it's always been selling total cost of ownership and driving demand. The bulk of our business really isn't responding to quotes and bids. It's actually doing retrofits and services. And so we've always had a bit more of a -- we're creating the demand. Now certainly, we also respond to customer demand, and you have to play in both worlds there, but the majority of our business would have been more proactive on our part. And then conversely, too, where we're typically approaching customers with offers, the inbound from customers, again, the sense of urgency, "Can you help us sort out what we've got, what do we need to do, how do we address the issues," is also different, right? I mean where the inbound traffic is pretty amazing around the interest. Again, every building that's going to occupy, whether it's students or tenants or retail shoppers, is looking to have the same sort of certainty or surety when people enter their space that something has been done. Tenants want to know what's been done. Occupants want to know that the space is safe. And so these things are all front and center on customers' minds today. So this is keeping us busy. I mentioned as the jump-off point for the last conference call we did last earnings call that really was thousands of proposals that we're seeing here, and this is the sort of demand that I think is going to continue. And I think it is HVAC industry-wide, certainly. Our advantage, I think, has been a systems approach to everything that we do. So it's analyzing every unique customer. We tend to get involved more with the large applied systems, which is where the sophistication of customers and the density and the population of people's occupants is greater. And that's where we're focused our attention certainly right now.

And then, I guess, focusing on applied kind of brings up certain slices of the market, things like large office buildings, where potentially, there's a bit more to worry about than just occupancy. You're also saying, gosh, maybe as a landlord, I'm not going to have very many tenants over the next few years and people reconsider space. Are you hearing that side of the equation where people are worried about the new construction environment or work from home longer term that is acting as friction to invest in their existing space?

Yes. If you think about our business, first of all, in North America, between 50% service and 50% equipment or systems, of the systems and equipment business, about half of that is institutional, which tends to lend itself toward applied systems. Outside the U.S., we're about 90% applied systems, again, dealing with more complex solutions. And in these markets, every situation, every customer is a bit unique in terms of what the building was built for, what the occupants require, what systems are involved. And so the solutions, they are quite different. The commercial side of the commercial business breaks down into about 12 different markets, in the U.S. at least. And there we see demand with data centers, with warehouses and that sort of thing, serving e-commerce. But of course, you see the flip side of that, which is going to be restaurants and retail and national accounts and kind of big box on the flip side of that. We -- about 10 years ago, flipped the mix over really to data centers from retail, thinking at that time that e-commerce will be more of the trend. And of course, warehouses became an important market following e-commerce. So we're much more weighted there. In the middle, though, you've got markets like commercial buildings, Class A buildings and offices. And here, we've heard everything from the Amazons of the world taking on more space to people thinking they're not going to come back to the space and everything in the middle. We've done our own primary research here with about 400 of our own customers and about 400 of our competitors' customers just to make sure we had a strong sense of the market. And there's really multiple scenarios that we're tracking. One scenario in an office building that we are looking at would be you're not coming back with the same capacity and density that you would have had in your space, your office building you're sitting in today, Josh. But the people back are spacing. And because the building is running and because indoor air quality almost always puts a tax on energy efficiency and on the energy bill, there's a need to both address the IAQ, the energy consumption, which has increased for fewer people spaced out throughout the existing space. That's probably the baseline that we're going to see, but it will evolve over time. I think as people become more comfortable with the standards in place and the assurances that they would have entering a space that the space is safe.

Got it. And then understanding that it's a smaller part of the business, but you guys are certainly exposed to newer construction, and I think that's been a pretty decent up cycle here for the past several years kind of post GFC. Is your baseline right now also assuming that we have a few years of softness? And is that something that, in your mind, is overcome by the replacement piece?

Well, I think in retail and in big box, absolutely, that's the case, and probably restaurants and that sort of business, but I think data centers, I think warehouses. I actually think K-12 schools, which largely can be kind of a unitary business, we'll see resurgence as they do asset planning, school boards get behind, making sure that they've actually renovated under new IAQ standards and upfitted systems and buildings. So it will take a while to play that all the way out, but I think there'll be enough markets growing in 2021 as it relates to IAQ. So early to tell. And clearly, there's going to be markets that are not going to come back for some time, but it's going to be a mix.

Got it. And then I guess just on the policy side, I think here in the U.S., some Biden proposals had 4 million buildings, which is not terribly well-defined in terms of what's going to happen and what that looks like. But some legislation with more teeth in Europe that's coming up. Just based on your own experience with past legislation and the offering today, is that something that's going to be kind of a traceable significant benefit for Trane? Or is that like a nice to have, and then ultimately, it still comes down to paybacks and regulations end up being a bit of a side show?

Well, listen, Europe is a great example. And where the EU, there's been regulations around the codes that don't allow you to replace a fossil-fueled boiler with another boiler created a whole $1 billion market segment, which didn't exist, and we didn't play in. Now we play in that with some of the 4 pipe applied systems that we put into the market. Those systems, the old systems, you put a unit of energy in, you got 0.6 units of heat back out. Now you put a unit of energy in and you get 7 to 8 units of energy back out, 7 to 8x the output because there's a cooling and heating load that happens in some of these larger buildings. The total efficiency in the building is 300% to 400% more than the fossil fuel boiler. Now we're in a $1 billion market. We arguably have the best technology in the market; didn't exist before. You're going to find us behind any proposal by any administration that lowers the energy intensity of spaces that lowers greenhouse gas emissions; and thirdly, now improves into air quality and standards for buildings. And so it doesn't matter who the administration is, you'll always find us on that side of the equation, publicly advocating, privately advocating to drive those standards and to sit on those code and standard bodies and help drive those standards. In so many cases, the technology exists. Like we, today, have all the technology in the applied space to take out nearly 100% of the greenhouse gas emissions out of the refrigeration cycle in an applied system. It's one of the reasons we're winning in places that focus on it like the EU or parts of the U.S. and parts of China. So it's really getting this technology embedded in standards and codes and expectations that really will drive the sustainability trend and eventually lower the greenhouse gas emissions curve in the world.

So I think just kind of taking a step back and maybe as a bit of a history lesson. A lot of what you're talking about has certainly evolved over the past, call it, 10 years. But it seemed like in the aughts that everyone in the HVAC space had some sort of green technology, but customers weren't really paying for it. Did we just hit a tipping point on kind of sustainability where it became something on people's minds? Or did the technology get to a point where the paybacks were shorter? Like, I guess, why now? And what gives you confidence that, that has kind of further legs?

Well, we created a tipping point in 2013 with the first EcoWise systems that we provided out into the commercial HVAC space. These systems use next-generation refrigerants, meaning nearly 0 carbon emissions. But the trick was we did it at better efficiency levels than the predecessor product, which were often our own products. So in the EU, where our growth rates have been 5x GDP or have been double-digit now for a long period of time, it's because we're offering the right refrigerant solution, greenhouse gas emissions at the best-in-class efficiencies for systems, so customers don't need to make choices. Same things happened in China. Same things happening in parts of the U.S. here. By 2016, we really had it across the entire applied portfolio. In 2015, we only had 1 refrigerant in Europe. Today, we have 6 refrigerants in Europe. And 5 of those are environmentally responsible refrigerants being used in our applied systems. We, in the Thermo King business, a couple of months ago, launched a new trailer platform for Europe. It's 30% more fuel efficient than the last trailer system in the market that we had, which, by the way, was also the most efficient in its own right before we replaced it. So a 30% efficiency in the trailer package in Europe, dramatic, dramatic improvement. And here, it was a matter of bringing in hybrid electric systems into our diesel engines that power these refrigeration systems. Again, that's using next-generation refrigerants to be able to do that. So again, that formula has been a great formula for us. And obviously, the market is responding the way we hoped it would.

Got it. So maybe as a shift over to the other parts of the business. Residential was obviously -- is an area that's had truly unusual year, kind of starting off with some lower inventory, and then you turn up the heat, people stay at home, and lo and behold, end up with a pretty strong end to 2Q. I guess first, how is kind of the season wrapped up? And then how do you think about our progression from here? And what constitutes a tough comp versus something that just kind of stays within the business?

Yes. Residential is about 20% of the total of the company these days. And we're split 50-50 between independent wholesale distribution and company-owned distribution. So we've got kind of a unique view into both those channels. The independent wholesalers, again, 10%, if you will, of the volume of the company revenue of the company, had made a decision in the March, April, May time frame that there was going to be a recession, consumers would pull back, confidence would drop, people might drop down, and SEER ratings were mixed down in terms of what they were buying, maybe even repairing. And what happened was the opposite. Consumers mixed up. They remain largely resilient. They were working from home. And so you entered really June where there are probably 50% of the inventory levels they should have been at like 1.5 months versus, say, 3 or 4 months. And so it drove this enormous June and enormous July as they were catching up. But in our company-owned distribution, it was more of a steady state sell-through there that we were seeing with a resilient consumer continuing to buy. So very much an anomaly, and that the season itself was probably extended by virtue of the late ordering by independents, but also the work-at-home phenomenon that we saw as consumers were both buying and mixing up as they were doing that.

So as we think about what changes into next year, people -- and hopefully, we'll be working from home a little less, maybe some of the economic stimulus and unemployment benefits aren't quite as pervasive, is that something that constitutes a headwind? Or at the end of the day, is this just a replacement business and people are overthinking it?

Well, first of all, it is a replacement business anyway, but I think the things to watch is consumer confidence and unemployment. What's the health of the consumer? What's different for us, if it was a recession, would be -- this is the first recession as a company, 100-plus years, that we've ever gone through having a suite of products in the residential space and brands that address the value segment of the market. So if, in fact, consumers were to mix down, this is the first time we're actually meeting them with product brands and a dealer network to address that. So there's some optimism that we have and some curiosity, frankly, about being able to play down in the value segment, if necessary. So a fuller suite of offerings. The comp question you asked is probably tougher on the commercial side because last year, fourth quarter, I don't know, Chris, we might have been like 18% or some kind of high teens number. Right?

That's right.