Trane Technologies plc (TT) Earnings Call Transcript & Summary

Great. So welcome, everyone, to our fireside chat. It's my please to have now, from Trane Technologies, Mike Lamach, Chairman and CEO; and Chris Kuehn, CFO. So I'll obviously go through Q&A for much of it, but I'd like to hand over to Mike to make some introductory remarks first. So Mike?

Thanks, Julian. Thank you. It's great to see you. It's great to be here at the Barclays conference. Missing Florida right now like years of the past. So your team has done a great job making it happen this year again, and hoping that we'll be together -- all together in '22. Maybe just a few minutes. As we enter 2021, I want to say that we've made significant progress in strengthening the company during the pandemic. We've continued to deliver strong pipeline of innovation and certainly addressing a lot of complex sustainability challenges, including leading solutions for pandemic-related needs, into air quality and vaccine storage distribution. We've also been investing heavily in our people and technology and the operating system of the company, which we think helps to bolster the performance culture that we've built over the years. We're also making a lot of progress on our transformation efforts, and I'll refer to that sometimes as the re-blueprinting of the company. We'll be on track to achieve the $300 million to annual savings that we've talked about. And in my mind, that enables a continuous flywheel for investment, and it drives the market out growth and sustainable leverage that we want to achieve over the mid to long term. And so despite the backdrop that we have with the global pandemic, I do want to say that it was really pleasing to see that we expanded EBITDA margins on modest revenue declines. We generated free cash flow of 158% of earnings. And then we highlighted, I think, the balance and resilience of the portfolio itself. So I want to say, all that is a great part of the extraordinary effort of our team across the world as it responded to challenges in 2020 with a lot of agility and while staying true to our long-term sustainability strategy. As a focused global climate innovator, we're helping to solve some of the most pressing issues of our time, reducing the world's energy intensity and greenhouse gas emissions, enhancing the health and safety of indoor environments, ensuring the cold storage and distribution of the vaccines. And we are actually providing our lean expertise to help distribute vaccines around the world as quickly as we can as well. So that is nice that our team is able to help that way. The short version of all that, that's pretty simple. We put our purpose in action from day 1 when we launched Trane Technologies. It will be 1 year on March 2. I'm optimistic about 2021, in part, because we have an expectation for an improved pace of global vaccine production, distribution, administration and efficacy. In addition, we're excited to realize the benefits of the targeted innovation for growth and profitability that we've been making, as well as continued structural growth opportunities through our transformation plans and a better cost structure. So all in, we expect organic growth to be in the 5% to 7% range this year, operating leverage of about 30%. And on top of the organic growth we provided, we expect another 1.5 points or so from acquisitions and continue to see the compounding benefit of those prior technology and channel acquisitions that we made over the years. Perhaps most importantly, we expect to generate cash, converting earnings to cash at or above 100%, and we'll return 100% of excess cash to shareholders over time. One quick update I'd like to make with you today is that relative to our 2030 sustainability commitments, we announced those back in September of 2019, pleased to say that last week, we notified that our 2030 sustainability commitments were validated as science-based targets. And this is our second round of science-based targets. The first approved targets we had were for commitments we made in 2014, which we achieved 2 years ahead of schedule in 2018. So the certification is a great milestone for the company. It's a high bar for the industry. It further underpins our long-term strategy and our commitment to sustainability. And it also signals a very strong belief that the notion of one company could change the industry, and the industry can change the world, and we think Trane Technologies as that company. At the heart of this is our Gigaton Challenge that's to reduce 1 billion metric tons of CO2 for our customers. It's also our commitment to being carbon neutral in our own operations and the important goals that we've set for diversity and inclusion across the company. So Julian, we're approaching the future with a high degree of optimism. We've got the essence -- energy of a start-up. We've got the credibility, I hope, of a market leader, and we've got a performance culture that I think will continue to be a competitive differentiator for us. So with that, let me turn it to you for questions.

I suppose one question might be I think some of what you talked about around energy efficiency and climate change and the impact that has on HVAC demand and maybe the business model. Some of what's happened in the past year, I think, has accelerated some of what was going on before COVID in terms of things like contractual service or remote services within commercial HVAC, for example. Maybe help us understand sort of, as you sit here today, what are the most meaningful differences or things that are happening more quickly now as a result among building operators or customers?

Yes. I think the most evident thing is that anybody that's operating a business, going forward, operating in a building is taking a different view toward indoor air quality. And so we've done literally many thousands now of assessments. We probably have stopped counting because it really is just something that has been constantly happening for the last 6, 8 months across the company. And what we found is that rather than just doing these assessments and then providing a proposal, we're figuring out that, while we've got the teams there on site, we're able to do quite a bit of work in getting the very remedial things done while they're on site. So there's been, I think, more urgency to do things as businesses and buildings begin to open, and we're seeing the benefit of those, certainly those surveys, those audits coming back in terms of road maps for customers to follow. We would also see that services should outgrow equipment. Of course, we're optimistic that equipment will grow, but services should grow at a higher rate. And to your point, I think there's been an acceleration in acceptance of digital technology to help deliver some of those services. You can imagine all the buildings that we've got connected and the ability where we couldn't go on-site necessarily, maybe a hospital would be a great example. I can tell you that my son was having his first grandchild, and it wasn't until the day of the birth that he was going to even be allowed in. The rules have changed here in North Carolina. Yet, we're able to look at the hospitals operating conditions, remotely manage it and service it. But technicians weren't going into the hospital, unless there was an absolute emergency for hands-on service. So I think the acceptance of that really has accelerated maybe 3 to 5 years in terms of that being a viable and an important addition to service delivery.

On that notion of sort of service, some of your competitors, and of course, Trane, itself, have talked about reducing attrition rates on service, increasing attachment rates on service. So perhaps give us some update on how attachment rates of service in that large commercial HVAC business, how do they sit today. Maybe any color on geographies or different verticals and where do you think you can take that attachment rate up to medium term?

Yes. I mean the attachment rate on an applied system nowadays is 100%. It's interesting that that's a question, I guess, people are answering other than 100%, and it's probably been 100% for a few years as best we can tell. That's all over the world. Now it may vary in terms of its form and its length and what you're providing and guaranteeing or not guaranteeing, but the fact that you're going to use service with these complex applied systems is absolutely a truth. We sit at about 50% service in the Americas and about 50% in Europe. We're probably about 30% in Asia, but that's up from, gosh, teens, 5 years ago or so. So that's increasing at a rapid rate. And yes, I think there's no limit to it. I believe we're the largest HVAC commercial service provider in the world. But with that, we might be just 1% in some of these regional markets. So it's a huge fragmented opportunity to consolidate over time and grow over time, but the attachment rate is 100%. And as equipment is being replaced, that number will continue to creep up closer to that number. And that's our goal, 100%.

And what about within the service, the sort of portion that's contractual service, if you like, in different ways of cutting and defining the pie. But where is Trane on that front? And where do you think that contractual service aspect could grow to over time?

Yes. Interesting, contractual versus recurring. It's interesting because, although, on one hand, the entire service business, you could think about as being book and turn, we don't even take service agreements and try to amortize them over the year and somehow claim them as backlog. We really think about the stuff is book and turn. And on one hand, you could say, "well, how much visibility is there to the service business, but it really operates like clockwork." We pretty much can estimate every month, every quarter what the service annuity should be a combination of parts and various time and material and planned service, and then certain small retrofits that we would do on a routine basis per plan for our customers really happened like clockwork. I mean the only thing that in my 35-plus years of being in this business that was different was in a pandemic when you couldn't physically get into buildings, right? But other than that, it's operated like clockwork for years and years.

And when you're thinking about the equipment business and the replacement aspect of that, is there any grounds for optimism around broader sort of accelerated replacement of equipment, whether it's because of energy efficiency or average installed age or IAQ or a combination of those factors? Any sense of how we should expect that large equipment replacement rate to trend?

Yes. I mean it was trending -- well, anyway, right, energy efficiency and greenhouse gas emission reduction were strong enough motivations to go make a proposal to a customer and try to drive demand and drive change. But I think indoor air quality drives a point or 2 of growth, probably for a decade, before you get at it all. And in some of the proposals that we would be giving our customers depending on their capacity to fund, they would go out over system 10-year lives and the ability to move people up toward a higher and higher standard over time. So I think the indoor air quality probably is the push on top of the greenhouse gas reduction and energy intensity aspects of the business that are exciting. There's not a customer on the planet, really, in any kind of a communal commercial space that's not thinking about indoor air quality nor anybody walking into a building or a restaurant that's not thinking about what the landlord, the owner, the -- has done with that space to make it safer for tenants, occupants, employees.

All right. And if you look sort of more short term or the cyclical aspect within commercial HVAC globally, you saw a decade ago, a steep downturn and then that recovery shape or slope. How would you assess the shape or slope of this upcoming recovery? I think you said on the earnings that you'd expect some improvement as you go through the year in commercial HVAC. But maybe more broadly, beyond just this year, what sort of rate of rebound?

Well, I'll tell you, in the commercial HVAC space almost globally, with the exception perhaps of Latin America, it's been virtually impossible to detect cycles. And all of our metrics around that really don't work. And it's probably because, really, 15% of the business, at least in North America, where the markets are pretty well established would; operate with this notion of starts and dodge data, 50% of the business is service and 35 points of the mix are really retrofits and things were driving uniquely, not in a competitive situation. So generally, it's at 15%, which is some combination of competitive and noncompetitive, new square footage or sort of dodge reported activity. But fundamentally, that's the only portion of the market that continues to roll up and down a bit, but it's small relative to the portfolio. And then within that, you just got such different markets. Even office has data centers and warehouses in it. So you really got to unpack offices all the way from small Class B and C properties to, A, all the way through to data centers, warehouses and everything in the middle and really understanding that's important. There is still growth markets sitting inside what we think to be the commercial space. And of course, industrial -- I'm sorry, institutional markets, you think about K-12, higher education, kids coming back to work, the need for ventilation, potentially some stimulus coming into or some relief coming into education, $150 billion, perhaps, if the new administration would have its way coming in from ventilation into schools. I mean, all those things kind of support the thesis around us 1 or 2 points of growth over a long period of time due to IAQ.

Yes. And then switching perhaps to residential for a moment. I suppose how do we think about the health of that replacement cycle after this year? Do you think we can still see that sort of low to mid-single-digit type market growth similar to 2021? And I suppose, any thoughts on the likelihood of some kind of prebuy next year? Or do you think the efficiency standards change is not substantial enough to drive any significant prebuy and then flip over?

It's other market where the cycles almost don't exist since 2009. 2010 was a significant refrigerant change. There's been efficiency changes in the res market. 2014, as an example, the one you're referring to, could happen around refrigerants again in 2023. There's constantly efficiency tweaks, whether it's furnaces or indoor units that are happening. The tenancy, I think, with somewhat of a hybrid workforce potentially in the future, people will still work somewhat from home. I think they'll continue to invest in systems. Surprisingly, the market didn't retreat to lower efficiency and repair versus replace. So I think that continues. There's still about 20 points worth of penetration left, at least in North America on HVAC. Heat pump technology is moving further and further north as temperatures warm all the way to the north. So you think about residential kind of over time, moving more like a GDP business, but it's really a GDP-plus because the efficiency regulations and the refrigerant regulations always require more expensive systems to be implemented. And so there's a natural kind of sort of growth on top of GDP there. But again, I don't really see these cycles that we used to look at in the '06, '08 time frame time.

Yes. Makes sense. And maybe switching to operating margins. You mentioned at the beginning a very high rate of operating leverage or higher than perhaps the medium-term communication where you're seeing 30% plus this year. When you look at the IT savings that are lined up and some of the other initiatives around transformation as a standalone HVAC company, could we see higher operating leverage than the 25% for some time? Or you think there's some exceptional factors this year, and 25% should be the sort of go forwards after this.

Let me have Chris start this off, Julian, and then I'll come in the end if I have anything to add.

Perfect. Yes. Julian, you're right. I mean the long-term framework that we set up in December was really a 25% operating margin leverage going forward. It allows us to leave, call it, 5 points for innovation and that reinvestment back into the company. So we really view it as this high-performance flywheel that allows us to deliver on investments within the organization and also drive really powerful cash flow. So I think long term, we're going to look at 25% margins. For 2021, we did want to call out that we see stronger operating leverage on a year-over-year basis. And that is, to your point, with some of the transformation savings coming in, where IT is a piece of that, supply chain is a piece of that, outgrowth from our investments. That is all kind of driving towards a little bit stronger leverage here in 2021.

Understood. And if we look at the aspect around sort of investment spending, I assume that 1 or 2 of your peers, perhaps, are putting more money into at the moment, we're certainly talking about. If we look at Trane, is there any reason for that investment spend to also materially from current run rates? When you look across selling costs and R&D and capital spending, all of those are in a place in terms of absolute amounts, but also return on those investments, but there shouldn't be a big need for any kind of step change medium term.