Trane Technologies plc (TT) Earnings Call Transcript & Summary

Good morning, good afternoon, everyone. Welcome again. This is Andy Kaplowitz from Citigroup. I'm the U.S. sector head here in industrial research. We are really excited to have Trane Technologies with us. Trane has always been one of my favorite companies. Mike Lamach has always been one of my favorite CEOs, for sure. We have Mike with us as well as Dave Regnery and Chris Kuehn. I'm going to turn it over to Mike in a second, but I just want to say that I've watched the company sort of grow and, obviously, it's separated from its industrial businesses. And the performance continues to get better. Growth rate good, cash flow good. And so regardless of what valuation is, I'm just very excited for you guys and for the continued growth of the company. So with that, Mike, I'm going to turn it over to you for some prepared remarks.

Great. Andy, thanks. It's so nice to be with you guys at the Citi conference and talking to a lot of people today that are missing Miami. I'm one of them. And I'm hoping we do this in 2022. But thanks to your team for another great virtual event. Just a few comments entering 2021 with the thought in my mind that we've made just significant progress in 2020, strengthening the company during the pandemic. Fundamentally delivering on a really strong pipeline of innovation to address the complex sustainability issues that are out there, including things that would help with pandemic-related vaccine distribution or indoor environmental air quality; investing heavily in our people and in technology and, of course, the operating system; and all those things, really, combined to create what we think is a high-performance culture that's very differentiated in our industry. A lot of that from our transformation plans, and I sometimes refer to this as the re-blueprinting of the company. So here, we're on track to achieve the $300 million in savings that we committed to. And we think this is part of a continuous flywheel where with that investment, savings can be partially committed to investment and that drives market out growth and sustainable leverage over time. I also have to say that despite the backdrop of the pandemic, we did expand EBITDA margins last year on a modest revenue decline, and we generated free cash flow of 158% of earnings, and it highlights just the balance and resiliency of our business portfolio. I'd be remiss if I didn't say that this is, in great part, through the extraordinary effort and commitment by our global team, responding to all these challenges with agility and staying true always to our long-term sustainability strategy. And as a very focused global climate innovator, we really do help solve some of the most pressing issues of the day. Reduction in the world's energy intensity and greenhouse gas emissions, enhancing the health and safety of indoor environments, ensuring cold storage and distribution of essential vaccines. And we've been providing our lean expertise to help distribute vaccines around the world as quickly as possible as well. So the short version of all that is that we've been putting our purpose into action since day 1 when we launched Trane Technologies. We're optimistic about 2021, in part, because we have an expectation for an improved pace of global vaccine production, distribution, administration and efficacy. We're excited to realize the benefits of the targeted innovation for growth and profitability that we've got in the pipeline as well as the continued growth and structural opportunities through the transformation plan that we put in place. So we're looking for a strong organic growth of 5% to 7% this year, operating leverage of approximately 30%. And on top of the organic growth we provided, we expect another 1.5 points of growth from acquisitions and continue to see the compounding benefit of the prior acquisitions that we've made in both channel and technology. Perhaps most importantly, we expect to continue to convert earnings to cash at or above 100% and return 100% of our excess cash to shareholders over time. One very quick update I want to make is that relative to our 2030 sustainability commitments, which we announced back in September of 2019, very pleased to say that last week, we identified that our 2030 sustainability commitments were validated as science-based targets. This is our second round of science-based targets. The first was a commitment we made back in 2014, which we achieved 2 years ahead of schedule in 2018. And that certification and this certification is just great milestones for our company. It's a high bar for the industry, and it further really does underpin our long-term strategic focus on sustainability and a strong belief that 1 company can change an industry, 1 industry can change the world, and that's going to be Trane Technologies. At the heart of the targets is a Gigaton Challenge to reduce 1 billion metric tons of CO2 for our customers. It's our internal commitment to be carbon-neutral in our own operations by 2030, and it's the important goals we set for diversity and inclusion. So we approach the future with optimism, Andy. We've got the essence of a start-up. We've got the credibility of a market leader. We've got a high-performance culture. That's going to continue to be a differentiator for us, and I look forward to the questions.

So Mike, thank you for that. I want to look back once before we look forward and just ask. This -- last year this time, besides the fact I was sitting in Florida, you were about to close our RMT. And then we, of course, went through this big global pandemic that we're still in. So when you look at the company's response to the pandemic, obviously, it's been a strong response. So like what has surprised you most? Or what are the lessons you've learned that you can take and sort of apply here as we move forward?

Well, it'd be safety first. We shut everything down in the first quarter, and we took a little bit of a hit there doing that. But we didn't have a hiccup after that in terms of any closed facilities or issues. And the resilience of the supply chain and some capital investment, frankly, we're going to make in 2021 and 2022 that even helped increased resiliency and supply chain was a factor for us. We're formalizing internally to a whole lessons learned, a bit of an after action review across the enterprise, about the things that we've learned. What do we like, and what do we look forward to getting kind of back to. But there's some structural things about the operating system, the cadence of meetings and what we do and how we do it, and we're pretty comfortable doing virtually. Even some of the lean Gemba locks we do, we found a way to continue doing that virtually as well. So although we look forward to seeing people again, the cadence might be different going forward. And I think that's going to be just something that we'll formalize, make it part of our operating system and our structure, and go from there. The other thing I'd tell you is timing makes a difference. We started that RMT process 10 months before we closed in March. Thank god, we did. Thank god we closed in March. We started the blueprinting of the company, gosh, in the summer of '19. And so we were able to hit the ground running, not only with the RMT itself, but the whole re-blueprinting of the company, starting from a clean organizational model. Every single role in the company being redefined. Every single cost center, 600, 700 cost centers being zero-based budgeted. Making strategic choices about what do we want to invest in. As a public company, there are certain things you have to do, there are choices you make. We made strategic choices about the things that we wanted to invest in that are important to the company, its operating system and its culture.

It's interesting, Mike. So like if there's anything possibly to pick at pre-pandemic for you guys, maybe it was incremental margin, at times, was a little lighter than some of us wanted. But as we now have gone through this pandemic, and you've obviously given us this $300 million of savings that we're talking about and higher incremental margins, it does seem to -- the whole sort of margin blueprint has seemed to improve. Part of the thesis that I've had is you separate, you become more focused. But sort of you talked about this sort of lessons learned and getting better on lean. So maybe you could elaborate a little bit more. Because, again, we all know about sort of what you told us at the Analyst Day and higher incrementals in 2021. But it does seem like a fundamental change in the company toward better margin performance. And I think it's important in the context of you've got inflation out there. So a lot of people ask me about price versus cost. And I should -- I tell people like, listen, let's not worry about that too much. I'm sure you worry about it a little, but...

Yes. Like in an 11- kind of 12-year look back for me, kind of a run off of that period, first 5 or 6 years, the incremental margins were probably measured, on average, 40, 35; something pretty high. We ran into some headwinds like maybe '16, '17, '18. A lot of different investments we're making, ERP systems conversions, mix of businesses were a little bit different back then. But we think about that sort of 25% long-term incremental based on the pipeline for productivity and based on the top line margin expansion opportunities, including pricing of the company that is sustainable. What's different about 2021 is 2 things. One, the transformation savings structurally are creating a nice tailwind for us. And secondly, we will see a mix up in the Thermo King business, which has a higher margin than our HVAC business. So those 2 things really allow us to be able to get closer to 30. What we also have in that 30, though, is the ability that we still got that 5 points of investment kind of baked back into the system. And I think about it as a flywheel. We have to keep investing in innovation, in technology, in the channel with the sole focus of reducing energy intensity in buildings and in transport refrigeration and reducing greenhouse gas emissions. If we're on that side of the equation in our strategic choices, we feel like we're going to be rewarded.

So one of the big questions I always get, and you've alluded to it a couple of times, is on innovation and what makes Trane different, right? And if I look at your European performance, for example, over the last few years, I mean, it's markedly above peers and the market. And one thing I remember is you bought a bunch of sort of smaller pieces, if I go back a few years ago, and you've been innovating. So maybe talk about what you've established there. Because I think everybody focuses on the U.S. commercial HVAC market. We focus a little bit on China, too. But off of a low base, you've really been able to grow that business and outperform.

Yes. This has been a great story. And Dave's on the line. In a lot of ways, we think about this as Dave's baby. Because we were both there when things weren't that way. So Dave, maybe give your color. And I'm sure I won't be able to keep my mouth shut either, but go ahead.

Yes, thanks. Thanks, Mike. Thanks, Andy. Europe's been a great story for us, right? And it's really having creative leaders there and being able to think around the corner as to what's coming. I would tell you, if I think about what makes us different on the innovation, what's made us successful, #1 is it's the constant investment we've been making, okay? It's not like we're -- it's not a stop/start kind of a thing. We've been consistently investing. I think you remember, Andy, long ago, when we got caught a little bit short with the refrigerant change when we first acquired Trane, when we were part of Ingersoll Rand, we never stopped investing from that time period. So we've kept that high level. The second thing is our business operating system around innovation. We get a lot more through the pipeline than we did in the beginning, okay? And we've worked out all those redo loops that we used to find ourselves in. A lot of that -- I mean if you think about innovation, you say, "We don't put process around it." No, you do need process around it because you don't want to have the rework that occurs. And we've really been able to iron that out and come up with a very comprehensive smooth system. And it's well-known and documented in our operating system, and it's executed too flawlessly by our teams. The second -- the last thing I'd say is we take a systems approach, okay? So it's not just about a component. We're always looking at what's the impact around a system, and how could we -- how could 1 plus 1 equal 3 within that system? So it's a different kind of view. You hit on a couple of the acquisitions. Yes, we acquired a small company in Italy. It wasn't about the small company in Italy. It was about the technology. It had to do with the heat pump technology. We took -- we bought that company. We took that technology. We enhanced it with our controls. And today, it's a big market that we're playing in. It's right in line with our strategy about reducing the energy intensity of buildings and making them greener. So that's a good example.

Yes, that's a great story because -- it's why I can't keep my mouth shut. Because if you think about the electrification of heat in Europe, what it means is not having fossil fuel boilers being replaced with fossil fuel boilers, right, and burning gas. Every unit of energy, put it into a boiler, you get 0.6 units of heat out. Every unit you put into these variable water flow systems we have, you're getting 350% more efficiency. So if, actually, the grid has been green the efficiencies are 300% better and there's zero carbon emission solutions. So now, it's a billion-dollar market in Europe in which I think we're the leader. And that is going to just move all over the world around this technology being -- in other parts of the world that we're going to be able to use this technology. We would have probably paid for that acquisition in a matter of months, looking back retrospectively, versus kind of if you think about those acquisitions makes just a ton of sense on a novel technology, looking for a very technical sales force, a very direct model with service, and the ability to put those novel ideas through that channel creates a billion-dollar market. We were really in the ventilation and air conditioning business. We weren't much of an H. So here's a billion-dollar market in heating on electrification and heat, which is really code- and log-driven in the EU.

Excellent. And Mike, I think I remember you telling me several years ago that your last big chiller took carbon emissions down by like 99% or something like that versus its predecessor. And so like I get the question very often, right, so what is Trane going to do next? And how is it going to stay ahead of the couple of big peers that are talking about sort of big investments? So without giving away all the trade secrets, what are you going to do next? What's the encore?

What I'll tell you is if you have me back and you say, how did you outgrow the market in '21, I'll tell you what we did. That's how I'm going to do that.

All right.

What I will tell you, like in the European example, is we've got some competitors announcing a product. It's interesting, it's a product. And we're on our fifth generation of technology across the platform. And we've been able to do this because we've modularized a lot of the components. We've separated new technology development from new product development. We're not testing and stop/starting in the process of deploying a new product because the technology has got issues and problems. And then building on this modularized systems approach, we're able to go a lot quicker. So again, it's this notion of it's process, it's people, and it's the system we're operating in that's allowing us to go a little bit faster here. And we really think about that in the TK business too. Europe, just sticking there, announced that they're going to do 18 product launches in 18 months. We're 4 or 5 months into it. We launched a brand-new trailer platform, refrigerated trailer platform there. It uses 30% less fuel than the predecessor technology, which was our technology, the best in the market. So this has been sort of a step function change, bringing in hybrid electric into the refrigeration cycle for trailers, utilizing an acquisition we made in 2015 that had that capability brought into the FRIGOBLOCK acquisition. So it's a nice combination of taking, modeling the simulation and technology that we already have, marrying that with these novel ideas coming to market very, very quickly and keeping that pace going.

So -- and just moving along, I -- people ask you about indoor air quality all the time. I know it's very, very important. Let me ask you about the durability of it in the sense that the question I get is, "Well, "Andy, like if vaccines do ramp up, are building operators really going to focus on this stuff anymore?" And I know you smiled because I smiled, too, because it's like it's still pretty important probably for a while. So maybe you can sort of talk about the durability. And then is there -- like when I look at your service business, I see it was up low single digits, for instance, in Q4. Is it possible to tell us, would it have been down if it weren't for IAQ? Like how meaningful that is?

Yes. To your first question, you first got to say, do we really believe this is the last pandemic we'll ever see? And sadly, no, I don't think it will be. And therefore, do you ever think you'll walk into a building or a restaurant and not think a little bit differently about the quality of the environment? And you're going to look for some demonstrable way of hearing about that or seeing that, right? You're not going to go back into the city buildings, I'm sure, without understanding somewhat what's changed. What have we done to improve air quality? How do we know? And then the importance of ventilation dilution, pressurization, humidity control, filtering and other technologies to be able to manage spaces when we do have pandemic, so we don't need to shut down the economy in the future. We can manage this. And where buildings can actually be used as a tool or a weapon in the arsenal for how you think about this. Much like we think about cold storage for vaccines, buildings can be an arsenal to help dilute, manage and kill and contain all these pathogens. And so I don't think it will be thought of differently. It's a $400 billion commercial market. Now we're not going to play on every bit of that. But the 40 billion plus square feet that we do really play in, it's going to take us a long time to get to it. And it's going to depend on the mission of the building. A hospital or school is going to have a mission which is going to be more urgent than a movie theater, right, a retail shopping center. And the financial health of that customer is going to be different. In terms of -- stick with schools, right, a poor school district might need many years to really embark on a capital and maintenance campaign to get to the high end of a standard. Now we need to help them get to a standard immediately. But to really get to where they want to go, it could take them a long time. A wealthier school district might be able to do a project and do this en masse. And then if you facilitate that with like the administration talks about $150 billion of money being injected in the ventilation in schools, you can see the catalyst around that. But I think as you look at the industry, it's not a zero-sum game. Lots of players need to participate. You got to cover a lot of ground. And we're all going to have to do better with buildings. If you're operating a building, the first thing you want to know is what should my building look like in terms of air changes and other metrics? What's it operating at? How do I get it inside the standard? And what do I do to get it better? Then how do I tell people what I did? How do people, patrons, employees, visitors feel like this is a safe place to be?

So you mentioned the 5% to 7% growth that you expect this year. We already talked a lot about Europe. When I think about sort of U.S., Asia, any meaningful difference in visibility to the markets? And again, I want to talk about funding a little bit too, because you mentioned it. But just as a big picture question, any meaningful difference in the geographic...

Do you guys want to take that one?

Yes. I'll jump in. I think given the Americas segment's about 70% of the company, Andy, I think that top line revenue growth is right in that range of the 5% to 7%. You've got really meaningful tailwinds from the transport markets. We're expecting those markets in the Americas to be up 26% on a year-over-year basis. Mike talked about the normalization of residential. And then our commercial business in the Americas, we're seeing those end markets down mid-single-digit in 2021. We think we can actually get those markets for ourselves back to flat to maybe a little bit up, given our innovation. So America's still in that range. EMEA, Asia, maybe a little bit higher than that, right? I think about China and the real tough issues they had in Q1 and Q2 of last year, the pandemic, we'll see some easier comps there. But all in, maybe a little bit higher in EMEA and Asia, but all not too far off from each other.

Yes. I think you need to remember, in the Americas, the 70% part, think about really half of the business being service-related. And you could say like there's no visibility on service, but you can say, well, service works like clockwork as long as buildings are actually open. So pretty good visibility that buildings are open. We're going to be busy with service. IAQ shows up as a tailwind there initially, and then it begins to sort of morph over into projects. Some of those could be turnkey projects. Some of those could be larger projects. So it will evolve over long periods of time, in fact. So yes, when Chris said if the [ Dodge ] markets are down 15%, the [ put in place ] markets, how do we get to flat or positive growth? You see positive growth in services. You see positive growth in a number of critical markets for us, like data centers, warehouses. We think schools, we think health care will see growth. And to your point, services should always outgrow equipment, except for these wild snapbacks that you have after recessions with equipment. But over the long run, it's always going to outperform the equipment. And I think it will be a meaningful kind of 1%, 2% kick around organic growth for a long period of time. And I would say, I think the fourth quarter was probably embedded somewhere in there, I'm sure.

Yes. And Mike, to your point, your contracts are basically all performance contracts nowadays on the service side, right? All or most?

Yes. We try to offer a pretty broad menu of standard opportunities or standard approaches to customers. I would say increasingly, you're going to be on the hook for some performance level. And we like those, right? We like that risk shifts. We like when we can manage these things and be paid to manage those things with higher margins.

Right. What I'm getting at though is that gives you the visibility on the service business. Because I mean you've got the high attachment and you can see the contract. So you kind of know what's going on in the service environment in terms of visibility quite well. So to your point, as long as the building's open, and you can get in if you need to, like you should have the service revenue, correct?

Exactly.