Trane Technologies plc (TT) Earnings Call Transcript & Summary

Hi. Good morning. I'm Josh Pokrzywinski, Morgan Stanley's electrical equipment and multi-industry analyst. Thanks for joining us for day 2 of our Laguna Conference, virtual again this year, but knock on wood, back on the beach in 2022. Joining us for our next fireside is Trane Technologies. We have CEO, Dave Regnery; and CFO, Chris Kuehn. Thanks, guys, for joining us. Before we dive in here, Dave, I understand you have a couple of opening remarks. I do need to remind folks real quickly though, that for research-related disclosures, please see our website at morganstanley.com/researchdisclosures. And for all other questions, please contact your Morgan Stanley salesperson. So gentlemen, thanks for joining us virtually from the friendly confines of Davidson, North Carolina, where it looks like it's a nice day there, Dave. I'll pass it off to you for opening remarks, and we can dive on it.

Yes. Thanks, Josh. Yes, it's nice in Davidson, but I'd rather be in Laguna Beach for sure. It's great to be a part of Morgan Stanley conference. Your team has done a great job putting together another successful event. It's been -- I've been sitting in the CEO seat now for about 2.5 months, and I've had the opportunity to meet virtually with many of our shareholders. And as I've highlighted in those meetings, this transition in leadership is an evolution. It's not a revolution. Mike Lamach and I have worked together for a number of years and have co-created the Trane Technologies strategy. And our strategy as a global climate innovator remains steadfast. We're focused on innovating rapidly to address complex and pressing sustainability challenges for our customers and for the planet. And we're setting bold goals and challenging what's possible for a sustainable world. If I -- the long-term sustainability megatrends that underpin our strategy have only intensified. And our innovation leadership is transforming the climate industry as the world decarbonizes. Our aggressive goals and bold actions can dramatically reduce carbon emissions and accelerate the world's progress. In addition, we are proactively addressing emerging trends as we see heightened focused on indoor air quality, energy efficiency, cold chain and the need to upgrade aging infrastructure in our schools. We remain committed to deploying 100% of excess cash over time, taking actions that add value to our shareholders. Historically, business reinvestment is a proven high ROI method of deploying capital. So we continue to fully invest in our businesses, and we're committed to a healthy and growing dividend, and we see value in our shares and in M&A. We've talked a lot about having an active pipeline in M&A and opportunities, and we announced yesterday that we were able to action a piece of that. So we signed an agreement to acquire Farrar Scientific. It expands our capability and low temperature control and increases access to the biopharma and other life science markets at highly accretive margins. Farrar Scientific is an early-stage business that brings some great innovations and a group of talented employees to Trane Technologies, and we look forward to adding them to our team. This acquisition is just another example of how we're committed to make a difference, consistently, relentlessly and over the long term. This unyielding approach drives market outgrowth over the long run, which in turn helps us deliver top quartile performance and powerful free cash flow to deploy through our balanced capital allocation strategy. The end result is more value across the board, more for our customers, more for our employees, for our shareholders and most importantly, for our planet. So with that, Josh, I'll turn it back over to you for your questions. And Chris and I would be happy to answer them for you.

Excellent. And I want to remind folks as well that we do have the portal up and here running. So if there are any questions folks on the line want to ask, please feel free to submit them and I'll check them as we go along. I guess the word of the hour here is supply chain. And I think for other attendees, they would describe it as kind of a whack-a-mole environment between the price-cost environment, kind of managing inputs and then product availability as well as the logistics and freight piece of that. You guys have had sort of your own brand of that, I think, in residential in 2Q. So maybe that's a good place to update us is, how do you see the supply chain environment today kind of in totality? And what progress that you've been able to make specifically in residential now that we're a little bit removed from kind of the most acute parts of that?

Yes. Josh, it's certainly a good question. If you look at the second quarter, we see -- we saw unbelievable demand, right? Our demand incoming order rates were up over 30% organically. And if you look at the first half of the year, our order rates were up in many of our businesses, up 40%. With that type of demand, as we said in our second quarter announcement -- earnings announcement, we outpaced our supply chain. And I think we used the terminology saying it was choppy. It's not unique just to our residential business, but we're seeing a supply chain that's choppy and really across the globe. At the end of the day, we look at this as a short-term phenomena, and you could define what short term is. But if you look at what our incoming order rates are, if you look at our backlog, I mean, our backlog is 50% higher than you pick a quarter, okay, but it's 50% higher than any quarter we've had in the past. So we have very strong demand for our products and our innovation. The only other thing I would say on supply chain is a lot of times we think about supply chain, it's just components coming into our factories. And that's true, but you also need to look at our customer supply chain. So we are seeing job sites that are also being faced with some supply chain problems. And that would cause us not to ship a completed system to that job site because we don't want to obviously ship anything to a job site that's not ready to receive it. So it's choppy and we continue to manage it on a daily basis.

Got it. So I think in residential specifically, like you mentioned, not typically a backlog-directed business and there is a seasonal component to that. Is that something you think you'll be able to sort of catch up on within the season proper? Or does that extend into some of the shoulder periods just given the size of that backlog relative to you?

Yes. I mean as we said in our second quarter call, we typically measure our backlog in our residential business in weeks, right, 1 to 2 weeks. At the end of the second quarter, we had 2 months of backlog. So we continue to see demand in our residential business as we saw in the second quarter. So there's no doubt that we'll go into the end of the year with a stronger backlog than normal, and we'll continue to work that.

Got it. And then just shifting over to the commercial side. A lot to talk about here between the near-term environment, some of what's happened over the past 1, 1.5 years with COVID and the focus on indoor air quality, but also this kind of broader building decarbonization, modernization cycle. But we've done a lot of work and certainly have high confidence in that. When you look at the strength in orders today, how would you sort of break down kind of the influence of those 3 factors? Now at the end of the day, an order may be fungible, so it's hard to parse out. But do you think you're seeing those longer-term dynamics around air quality and efficiency kind of take the lead in terms of this order, just trying -- maybe implying a bit more sustainability? Or is this really kind of the cyclical piece kicking in after some artificial lows last year?

Yes. Josh, I would tell you that the megatrends that really are tailwinds to our business continue to intensify. So if you look at -- you talked about indoor air quality, we said indoor air quality, 1% to 2% tailwind. This year, it will be closer to 2%. We don't see indoor air quality going away. We see that being something that is -- will be with us for a while and people understand the importance of making sure they have a safe environment to go into whatever that confine is they're going into. As far as decarbonization, that continues to intensify. And we've had a strategy for a long time that we're not waiting for regulation to take effect before we start inventing the next best solution to help the world decarbonize. And we started that back in the, gosh, 2012 time period with next-generation refrigerants, and we haven't stopped. So we're constantly reinventing our portfolio and constantly looking for greener ways to help us decarb the world. I mean it was funny. I had the opportunity to sit at the World Economic Forum the other day and because of my title change, I get to go to that meeting. So I was sitting there with 115 or more CEOs. And I was just -- I didn't know what to expect, but the vocabulary that was being used about, hey, let's take inventions that already exist and accelerate them. Let's not wait for regulatory authorities. We have to act now to help the world for next generations that are going to live here. I mean that's becoming very, very powerful, not just at Trane Technologies, but really across a broad, broad subsection of businesses. And it was just so -- it was so refreshing for me to hear the conversation about let's work on the next innovations, but let's deploy what we have today because it can have a dramatic impact on our business. And we're seeing that today. I mean look at this -- I mean, if I look at our backlog and we dissect that and I look at some of the innovations that we have in there, whether it be the Advancer product that we introduced in Europe in the TK space or our variable water flow systems for electrification of heating, those are big parts of our backlog. So it just says that our innovation pipeline is really hitting the mark with our customers. So we're excited about the future. And I think you're spot on, the commercial strength is there. And it's -- I'm sure there was some pent-up demand that's being released, but a lot of it has to do with making sure this world is a better place for the next generation.

Got it. And are you seeing that with the types of behavior from your customer? I mean at some level, HVAC and I can only speak for myself as a residential customer, which I -- you're welcome. I've been a customer for quite some time for Trane.

I was going to ask that question, but I won't.

The training carrier over time, full disclosure, but you guys have cut some dollars from the Pokrzywinski household. But at the end of the day, it's something that maybe you don't think about until it's broken and when it's broken, it's all you think about. Are you seeing more customers reach out and saying, "Hey, Dave, everything is working fine today, but we still need you to come in." Is the incidence of that picking up? Or is it still you got to knock on doors and tell people, hey, this is a big opportunity if you let us come in and do some work?

Well, I think in the commercial space, which I think is where your question is, obviously, customers are well aware of their energy consumption. And especially when we were doing a lot of work with indoor air quality, and we continue to do that work, but people understand the tax that's put on the energy use for many of the solutions. It's really gone to a high level in those industries where people are saying, "Hey, you fix my indoor air quality. How can you help me with my energy needs?" So that's one trend that we're certainly seeing a lot of. On the resi space, you'd be surprised, Josh. We are seeing consumers actually retiring assets early. And it usually happens when the homeowner is going down the road of putting solar on their homes, and a good solar salesman will explain to a homeowner that a big tax on their energy is their HVAC and to upgrade, it could have a dramatic impact on their footprint. So we are seeing that. I would say it's early stages, but I do believe the going green initiative is more than just on the commercial side, it's happening in the resi space as well.

Got it. And within commercial, one of your big commercial competitors kind of recently spelled out their own agenda at their Analyst Day. But controls and digital played a big role in that. And obviously, you guys have been leaders in that area. Is that something where we should expect those type of businesses to be these double-digit type of long-term growers because the paybacks are so short, because that installed base is kind of comparatively less software control, just dumber pieces of metal that have a big opportunity. Is that the way you guys see it as well where technology is kind of tip of the spear?

We see a lot of opportunities in the control space. We see -- and by the way, we've been investing in our controls business for a long time. And I can remember back in the early 2012, I guess, it was when I was running our commercial business. I used to tell people, I'm investing more in our controls business than we are in our equipment business. People look at me like I'm crazy, but it's really paying dividends. We're very happy with our controls platform. We're leading with wireless technology there. If you think about a retrofit there, if you think about these dumb pieces equipment and making them smart, if you go in with a wireless solution, it's really a competitive advantage you have. You don't have to be running wires. And you can connect to these systems because all of our unit controllers on our equipment are factory mounted, okay? So you don't have to deal with that complexity. So we see a big opportunity there, and we're capitalizing on it. And that's why one of the reasons why our business is growing nicely.

Got it. Specifically within this, something that's sort of come up a lot in recent years, even though it's been around forever, is performance contracting. So I think as an offering, it's maybe 20 years old, give or take. But if the upgrade sort of pays for itself, why isn't this a huge percentage of the opportunity out there or just growing much faster? I think all the OEMs, yourselves included, talk about it, but it's not a huge piece of the portfolio. Is there a particular reason for that? And why couldn't we be sitting here ideally on the beach with a few cocktails 5 years from now talking about this being some significant double-digit percentage of what you're doing in commercial?

Well, we've been in the performance contracting business for a long time, as you said. And we really like that business. It's very attractive in certain verticals, especially where you could float a bond. Municipalities, health care, government, for sure, we see that and we use it all the time. That's certainly a way that -- one of the ways we go to market there. Some of the other verticals, it's less known. We do kind of a takeoff on that where we'll talk to the customer about offering a guarantee. Usually, what happens in those situations when we talk about a guarantee and the customer sees that we are willing to step up and commit to what we're saying, they usually don't want to go down that route. They just want to buy the equipment outlay. Some of it has to do with cost of capital. Some of it has to do with funds availability, but it really depends by vertical. Chris, I don't know if you want to add anything to that.

I think that's a good update, Dave. Yes.

Got it. So just kind of sticking on the commercial side and some of these long-term options. The regulatory environment, I think, ends up playing a role as well. You guys have been part of this. And I think at some level, kind of champion where the industry goes vis-à-vis standards. You have some infrastructure stuff in the U.S. starting to get prioritized. Europe has also done its own legislation. When Trane meets with lawmakers, what are you guys talking about? What are you prioritizing or saying, this is how we should really approach the problem versus some other alternative methods? Like what are the good outcomes? What are the bad outcomes when you have these sorts of meetings?

Yes. I mean Josh, it's an interesting question because we made a decision several years ago that we weren't going to wait for any regulatory change to help make this world a better place for the next generation. So we're not waiting for efficiency changes to come up with products that exceed existing regulation. We're not waiting for regulation around refrigerants before we developed our EcoWise system that was next-generation refrigerants that has close to 0 GWP. So we made a decision early on that we'll talk to legislation. We'll talk to government officials. We do it more from a, let us show us what's possible from a large OEM in the HVAC space, and we could demonstrate what we do. Do we support legislation that around sustainability, around efficiencies, around refrigerants? Yes, around the globe, right, whether it be in the United States with 2023 changes or refrigerant changes in 2025, whether it be the Green Deal in Europe, whether it be what's happening in Asia right now with China saying that they want to be carbon-neutral by 2060, right? We'll support all of that. But understand, we're not waiting to innovate waiting for those regulations. We're going to be in front of those regulations on a consistent basis.

Got it. And then I guess the last piece of the puzzle there and one that you guys have also been vocal about over time is that the payoff here is also in the long tail on services, especially with applied. I think you guys said pretty recently, your attachment rate is essentially 100% on applied. I suspect that's on all new units. How would you characterize attachment on the total installed base? Where do you think it could go? And as some of these more digital offerings have rolled out, is there some kind of dollar per unit expansion that you guys have been able to unlock because there are more services available than maybe the wrench turning that would have been more common 10 or 15 years ago?

Yes. I'll start with -- yes, our applied systems are -- we basically assume that everything is going to be connected in an applied system, right? Why would the customer not want us to be connected to it to understand the very sophisticated systems, and they want to make sure that they're operating at the design state. And by the way, we want to make sure they're operating at the design state, too, is probably a warrant -- there is a warranty attached to this, right? So we want to be attached to these units and the customer wants us to be attached to these units. As far as digital connectivity, absolutely, a lot of this is remote. I mean all of our -- where we're talking we're connected, we're connected to the cloud, right? So we're looking at data. We're analyzing that data. I would tell you what's changed is it's not just about running a truck to a job site when there's a manufacturing requirement from a piece of equipment going down. This becomes where energy is being consumed at a level where it should not be. So the industry, at least in Trane Technologies, we're moving from what we'd call a break/fix to a, hey, your system is consuming more energy than the way it was designed. We need to understand the why. And the why could be varied in reasons, okay, from mechanical overrides to changing the configuration within a particular space. But that's where our industry is going from a service capability standpoint.

So the one thing that it seems to stand out and you guys have mentioned it as have others is there's a bigger low-hanging opportunity on the upgrade today. Someone doesn't need to go out and buy $0.5 million chiller to recognize some pretty significant savings. We know the market's old. We know the market's big. Any sense for how much of the opportunity out there in front of you guys over the next couple of years is just, "Hey, man, you don't need to write us a big check, but we could do these 3 things and save you a bunch of money." Is that the lion's share of the opportunity in front of you where that alone would just give you confidence? Or do you feel like you sort of mined that out?

Well, it's certainly an opportunity, Josh. As far as what percentage is, I wouldn't be able to give you a specific number, but I would tell you that when we go in and do an energy audit in a building, I mean, our typical savings is depending on the vintage of the building and how it's been maintained. I mean 30% is the average, okay? We see some buildings we went and we could save the end customer 40%, 50% depending on what they've been able to do. And you're right, it's about working with the customer and not saying I need to rip everything out and put in everything new, whether that be on the controls side or whether that be on the equipment side. And we've been developing sophisticated dashboards to help our customers with integrated solutions and being able to operate in a more sophisticated way to upgrading equipment in place and putting drives on equipment so that it could be more efficient, so you don't have spikes when you start to go up on more of a gradual way all the way through indoor air quality, which is how do I make my space more safer for the employees that are going to work here every day. So all of that is part of that. And -- but you hit a good point there. It doesn't need to be. It could be certainly something that can be we give our customers what we call a day 2 work schedule, which is how do we help you get to where your end goals are over time and work with you on your capital deployment. But these are all the things that we could do today. These are the simple solutions that we can do tomorrow that can help you dramatically improve your energy efficiency. And longer term, yes, there's usually a longer-term plan, too, as equipment continues to age.

Have you noticed anything changed competitively? Some of your competitors out there have launched their own IoT platforms over the past year or 2. Has that directed any kind of focus for yourselves in terms of advancing your own product set? Anything that you've noticed out there in the market share-wise? Or is there just so much green grass that you guys don't bump into each other that much?

Well, there's a lot of green grass, but we do bump into competitors obviously. We like our portfolio. We like our portfolio from an equipment standpoint, we like it from a controls standpoint. And we like the fact that we have a direct sales force, and we have company-owned service. So we like that formula. It served us well, and I'm sure we'll see lots of opportunities in the future as well.

Got it. Pivoting over to maybe something a bit more regional. On China, we're kind of past the initial big spike in recovery. I think a few indicators in the property markets have backed off a little bit. What are you guys seeing there inclusive of stuff like lockdowns that have gotten a bit more acute over the past few months?

Yes. I mean I think Asia in total has certainly -- the lockdowns there for COVID are more dramatic than we've seen in other parts of the world. Even like Chris and I run a call the other day with our team in New Zealand, that's locked down now. So that's occurring there. I mean in China specifically, Josh, we invested in a direct sales force about 4 years ago there. We've had really nice success there. It's about explaining to our customers' value proposition. It's about being able to talk to engineers, being able to talk to architects, being basis of design. We've seen nice margin expansion in Asia over an extended period of time. So Chris, I don't know if you want to give any more specifics on that, what we're seeing specifically in China.

Yes. Josh, I would say the team there is incredibly disciplined in terms of the order intake. Over the last 2 years, we've seen 270 basis points of margin expansion in the region. Think of the region, roughly half China, kind of rest of Asia in terms of its split, predominantly a commercial HVAC region, but also transport refrigeration throughout. So the ability for them to grow margins over the last 2 years as well as to Dave's point, the investment 5 years ago -- 5, 6 years ago in the direct sales force is just something that we're going to be, I would say, not episodic with. I mean that is the new dynamic of how we're in the market. It's really winning. And the team is incredibly disciplined on the new order intake as well, making sure it's what we can affect and good margin expansion.

Got it. Chris, a question for you on the price-cost side. You guys did a good job in the first half, added some more price to cover the additional costs that you've seen. Obviously, that environment is still pretty inflammatory here in the short term and things like contracts and hedges and customer agreements sort of have a tail on what that could look like. I guess first, how is that price taking? And second, do you need more just based on how that tail is forming at this point?

Yes. What we said, Josh, in the second quarter is, you're right, unprecedented is the word we've used around the inflation side. On the opposite side, on price, we've had 3 price increases this year as well, and I think we'll use the unprecedented word for that as well. So I'm really proud of what the team was able to accomplish in the first half of the year. We got ahead on the first round of price increases and second round of price increases, and we saw that inflationary pressure really at the end of 2020. It led us to the first quarter, second quarter being price-cost positive, so price-cost positive for the first half of the year. As we navigated through the second quarter and just saw that higher volatility in inflation, that's where we saw another $150 million of inflationary pressure in the second half of the year. And with the third round of price increases all in, we felt like we would be flattish price-cost for the second half of the year. So getting $150 million of price and $150 million to offset the cost. So we'll see how that plays out for the balance of the year. But we get really good demand forecasting where we can on our inflationary commodity. So if I think about our $5 billion of spend for materials, roughly 10% of that is Tier 1. So that's steel, copper and aluminum for us. And think of it equally split about 1/3 each for those 3 commodities. We're hedging or have forward buys in each one of those to try to smooth out inflationary trends. So copper would be, say, 70% hedged going into any 1 or 2 quarters out. Aluminum would be probably 60% hedged now. And then steel, we've got about a 6-month lead time in terms of those price increases based on our forward buys. So we've done a nice job getting our hands around what we think the cost is going to be and then ultimately pricing effectively to it. Let's see where it plays out. But our goal as we go into 2022 and really any year would be getting a positive price-cost spread right around that 20 to 30 basis points. Let's see where it falls out for 2021.

Got it. And then, Dave, for you on maybe a couple of the stars of the portfolio so far in the recovery, TK and the resi business. I know TK, you basically saw a little bit of a pause just because you maxed out 2021. How has that trended with opening up the book for 2022 at this point?

Yes. I mean our TK business, you're right, Josh. Our bookings in the first quarter were exceptional, okay? Many customers booked for the entire year and was a bit of a pause in the second quarter. But really, they've already placed their orders for the year. Thermo King business, ACT just released their latest numbers on Friday, and they basically have pushed down the 2021 number now. I think it's at about 20% growth over 2020. And they pushed to the right, okay? So they pushed some of it to 2022 and then they pushed, some of it will eventually go into 2023. So right now, we're seeing 20% growth in 2021, a little bit over that, 2022 and 2023 is another strong year. So the constraints in TK haven't changed. I mean there's 2 really constraints there. It's the trailer OEMs for sure, as they're ramping up, and the other is the tractor OEMs, right? There's a lot of -- I'm sure you're reading electronics and the impact to Mercedes Benz, other main freightliner, et cetera, where they're being constrained as well.

Excellent. And then just final question here as we wrap up. Resi has obviously been pretty strong. At the end of the day, it's still a replacement business. How do you think about past the backlog visibility has had for maybe the medium term, what this industry looks like over the next couple of years? And what the definition of normal is, in your mind, following a massive, call it, past 15 months?

Yes. At a high level, Josh, we look at our resi business as a GDP-plus business. You tell me what GDP is. You tell me what consumer confidence is, which are usually very linked very closely. We could tell you what our resi business is going to do. I mean we have models, obviously, that we run, but we first look at a high level, and then we'll dive into our models to make sure they correlate to what we're seeing there.

Great. I think we'll leave it there. I appreciate the time. As always, guys, good to see you. Like I said, we'll do this...

Yes. Nice to see you.

Good to see you.

Maybe with a bit of a tan next year, but be well in the meantime. Thanks as always.

Bye. Okay. Thanks.

Thank you.