Trane Technologies plc (TT) Earnings Call Transcript & Summary

All right. Good morning, and thank you to everyone once again for joining us here at the Ninth Annual Credit Suisse Industrials Conference. My name is John Walsh, and I am the multi-industrial analyst here. We're very excited to be closing out the conference with Trane Technologies. We have the team here with us, Dave Regnery CEO; Chris Kuehn, CFO; and Zach Nagel from Investor Relations. As always, I think Dave is going to make a couple of remarks before we go into Q&A. If you'd like me to ask a question on your behalf, please e-mail me at [email protected]. And with that, I will turn the floor over to Dave.

Thanks, John. It's great to be part of Credit Suisse's Conference. Please pass along our appreciation to your team for putting together a great event. It is an incredibly exciting time to be leading Trane Technologies. The strong secular megatrends behind decarbonization are intensifying every year. The call to action to dramatically reduce global emissions is getting louder and more widespread, and we could not be more well positioned to lead our industry with innovative products and solutions. We are proactively targeting and addressing emerging trends as we see heightened focused on indoor air quality in the cold chain. We see significant funding tailwinds and a need to upgrade AG infrastructure in our schools and make them a safer environment for our children. Last month at COP26, I had the opportunity to talk about Trane Technologies and how we can help change the course of climate change now. For those of you that know me, you know I tend to be a very optimistic person. So I enjoyed sharing the very positive news that we don't need new technology to do this. Trane is taking a leadership role and helping to bend the curve with technologies we have right now like electrification, thermal storage and connected solutions. This morning, we issued a press release announcing our intention to increase our quarterly dividend by 14% in the first quarter of 2022. This is on top of the 11% dividend increase we announced in the first quarter of this year. Combined, we will have raised the dividend a total of a little over 25% in a 12-month span. The announcement reflects our continued commitment to paying a competitive dividend that grows at or above the rate of earnings over time. It also reflects our confidence in our ability to execute and to continue to generate strong cash flow now and in the future. We are committed to making a difference consistently, relentlessly and over the long term. This unyielding approach drives market outgrowth, which in turn helps us deliver top quartile performance and powerful free cash flow to deploy through our balanced capital allocation strategy. The end results is more value across the board for our customers, for our team, for our shareholders and for the planet. With that, John, Chris and I would be happy to take your questions.

Great. So a lot of excitement there. I almost feel bad having to start with the obligatory supply chain question and not just following up on some of those big trends you talked about. But we've been -- we've thus far been consistent. So maybe before we dive into those topics, just give us kind of the mark-to-market on supply chain as you see it today?

Yes, the supply chain remains a challenge, John. It's -- it really isn't any better than what we saw in the third quarter. It's a little bit like if I was trying to explain to a group earlier that it's like the game I play when I was a kid, the whack-a-mole game where you fix one problem and another problem pops up right away. Our teams are working really hard on it, and we'll continue to work that. In the third quarter, we said that we had about $150 million of revenue that pushed into future periods. We thought we could -- we saw opportunities to get about half of that back in the fourth quarter. Some of that's promising, some of that's going to be a challenge, and December is going to be a big month for us. But at the end of the day, if it doesn't ship in December, it's going to ship next year, and the demand is incredibly strong. So we continue to see strong demand, and our backlog is very, very strong. We're going to be entering 2022 with record backlog. And I've been in this industry a long time with Trane Technologies, and I've never seen a backlog is strong. Just to put numbers around it. A typical backlog, John, is like $2.5 billion to $3 billion. We'll be entering 2022 with a backlog that could exceed $5 billion. So I mean, we're seeing great demand, and it's -- our backlog is very firm, and it's strong.

No. And sticking to that backlog theme, I mean as you think about that lift that you're sitting with right now, how does it look across your businesses? Could you give us some color around what's really driving that higher backlog?

It's really -- we're seeing strong demand across the globe, to be quite honest. I mean, we have it in the Americas. I mean, you saw in the third quarter in our commercial HVAC business, had incoming order rates for equipment of both applied and unitary north of 50%. Our residential backlog remains strong. We have strength in Europe. Our Thermo King business continues to have strength, and our business in Asia has got strength as well. I know there's -- I got a lot of questions earlier about concerns about growth in China. And yes, GDP has slowed a bit in China. I think it was 4.9% in the third quarter. What's growing fast in China, we are very strong in those verticals, data centers, electronics, pharmaceutical, health care. So our backlog is widespread. Chris, I don't know if you want to add anything to that?

No, I agree with that. I think the year-to-date order growth, John, has been, I think, 26%, 27% organic growth through the first 9 months of the year. It's putting us in a great position to start 2022 with, and it really is across the 3 segments in terms of the growth.

Great. And then obviously, you both have seen several cycles in this business. I've always thought of this as a replacement business, but is the conversation changing with your customer there? Are they pulling forward before failure?

Yes, that's a great question. I mean, I think -- and I'll talk about -- let me talk about commercial HVAC first. I mean, I think the -- and I've been here a while. So the lens 5 years ago used to be all about efficiency and the return on investment based on the savings you would drive. That conversation has shifted. That's still important. But we're also having a lot of conversations around what does that do to my carbon footprint? And what about indoor air quality? And because we go at this at a system level, we're able to have those conversations with our customers about how do they can improve the efficiency of their building, not just from an equipment standpoint, but also from a control standpoint as well as how they can integrate indoor air quality solutions and have it not be a tax on energy or offset that tax on energy. So that's on the commercial side. On the resi side, I would say, it's still very early innings, but we certainly are seeing the retirement of assets early. And I'll give you a great example. If a homeowner is going to put solar on their home, which if you're in an airplane and you look out your window, like I do, you try to see if there's any solar panels on houses, it doesn't take long for the homeowner to realize it's about supply and demand, right? And if you have an old HVAC system in your home, there's a lot of demand, and the supply with your panels will be relatively constant. So you have to monitor that. So we're starting to see, even on the residential space, people are taking this green approach here and saying, "Hey, look, what can I do that's good for the world and how could I improve the next generations that are going to live here?" So we're starting to see, I'd say it's early innings, but we're certainly seeing momentum on the commercial side.

Great. And we kind of come through the sustainability reports from the HVAC names under our coverage. And one of the things that stood out to me was kind of the level of commitment Trane has made to Scope 3 reduction. So what the customers actually going to realize from your equipment. You said you have the technology today, right? But it seemed like a bigger step function change than others. So maybe just talk to us a little bit about what that product portfolio looks like? And what some of the savings are today that you can realize?

Yes. I mean, first of all, we've been talking about this for a long time. Back in 2013, I think we had our first climate commitment, and everyone looked at us like we're a little bit crazy as to why we did this. We were talking about next-generation refrigerants, and I had to explain to everyone what they were and why they were important. So now with our 2020 climate commitments was our 2030 goals. We have a gigaton challenge out there, which is how we could save our customers 1 gigaton of CO2. And those solutions are widespread, right? They start with using green refrigerants, next generation, closer to 1 is best from a CO2 standpoint, from a global warming standpoint. And then it really comes down to efficiencies. And some of what we're doing is electrification of heating, right? We talk about a heat pump. This is much more than a heat pump, right? What we did was we kind of rethought the problem and said, you have a chiller plant, you have a boiler plant. The boiler plant is using fossil fuel. How do you combine these 2 into 1 system and make them more efficient? And what we were able to do with our systems depending on which heat sink you're using is these systems could be 350x more efficient than the conventional way of thinking. When you think about that concept with sophisticated building controls wrapped around it, we can have a dramatic -- we are having a dramatic impact on the carbon footprint for our customers. And that's why we're excited, and that's why with confidence, we talk about gigaton. And by the way, we have lots of tracking mechanisms that we use here. And it's not just in commercial, we're doing it in the resi space as well.

Great. And then when you talk about these technologies, what verticals are you seeing the fastest adoption or finding the most excited about them?

Really across the board. I would tell you, we're certainly seeing it in health care, but we're seeing it in just office buildings as well. I'll give you a great example, John. I was -- we actually had a Zoom call with a customer in Italy, and they were explaining that -- our European leadership team was explaining what they did with this customer. And this was a hospital, and we developed a system for them. We eliminated their boiler. We put in a what we'll call it our heat pump solution, and the savings that they had were dramatic. And the classic was, as I was telling a group earlier, the classic story here is that they said to Jose, who runs our business in Europe, they were like, and Jose, we really appreciate what you did for our cars. And I was like, thinking to myself, what the heck did we for our cars? So finally, I said, Jose, what did we do with the cars? And he goes, "Oh, no, no, the boiler was coming out of the exhaust pipe on the roof and was causing soot to be all over their cars. And so the knock-on effect of our solution was a cleaner environment for everyone. Just think about having to breathe that in every day with that soot. But now we've eliminated that even as a source. So they were as excited about having clean cars as they were at the carbon footprint that they reduced.

Very interesting. And then when that customer is looking to electrify heat, are there other things that have to be thought about in terms of a consideration like the electric capacity of the building? Or are we talking about something that can almost be swapped in or swapped out?

It depends, John. It's a great question. In some cases, you would need to upgrade a little bit. But in some cases, you do not. Remember, the boiler is pulling a lot, too. So in many cases -- but there is a subsection that you have to do some work there. But at the end of day, the paybacks on this, if you could have a system that's 350% more efficient than what you're using today, the payback becomes pretty fast.

Yes, yes. And you mentioned controls and connected. And we often get the question, where do different players aspire to be in controls. So maybe can you just walk us through what Trane defines as controls? And how deep into the building you'd like to go?

Well, we're very deep into the building, okay? We have -- our building management systems and controls, I used to tell people long ago when I was running our commercial HVAC business that we invest more in our controls platform than we do in our equipment platform. So we can go very deep. We like to be connected to buildings. We like to be connected to assets. We believe that it's a system approach. You can't just monitor the asset -- or the energy use of a component, you need to look at the energy use of the entire system, and in this case, the building. Years ago, we used to think of our service business as a service agreement with break/fix options and when equipment isn't performing. That definition is changing, where our service business now is when an asset or a building is using too much energy, right? What you do, when someone using too much energy? How do you fix that? So it's an exciting time, but our controls go very deep. We lead with our wireless controls. We have open protocols. We developed -- just recently, we developed a really cool solution for VRF systems. So VRF systems, they're very sophisticated, okay? They're within a building like an applied system. There's a lot of different points of equipment within a VRF system, whether it be a mixing box, a condenser, et cetera. We developed our controls where everything is on the same network. You really just press a button now and you say, go discover. And our system will go out and discover all the assets on that VRF system and connect them and configure it. And that's always been a problem with VRF systems. It's not that people can't do it, it's just very time-consuming, and it's hard to get it right. Now our system really optimizes the time to do it and really the integrity of the system. So we're super excited about that innovation that we have.

No. Great. Maybe switching gears to the margin. Obviously, a lot of price increases to cover inflation. Can you just remind us how -- what you're expecting for price cost in Q4 and then as we jump off and look at next year?

John, I'll start with that one. We ended the third quarter -- or in the third quarter, had 4.3% of price realization across the enterprise. And really, what that shows is that our business operating system is working very well, getting a forward look on the demand, understanding the cost structure, leveraging our hedging strategy we have across major commodities and then ultimately, pricing effectively. So we ended the third quarter slightly price/cost positive. View is going to that fourth quarter from our earnings call in November, probably flattish price cost. Price continues to grow. We -- for most of our businesses, we had 3 price increases here so far in 2021. So that price continues to grow and lap, but also inflation continues to be volatile. So calling it flattish for the fourth quarter. We'll see where we fall out for the balance of the year. But as we go into next year, we're -- part of our business operating system is to really drive an outcome to get 20 to 30 basis points positive price/cost spread. So again, we've got the price increases from this year, which will start to lap in the first quarter of next year. We're looking at what, if any, price increases are needed now to start 2022. But again, we're going to go into the year thinking about a positive price cost spread, 20 to 30 basis points.

Great. And then how should we think about Trane's ability to manage its kind of internal mix, while also expanding margin over time? If you just think about it, right, resi, TA, very strong margin businesses, commercial business, service is very strong. They probably don't always line up perfectly. But just talk about how you manage mix as part of the margin equation longer term?

Yes. Let me start and then Dave can jump in. Our long-term framework, John, is to drive 25% incrementals plus. And we start with roughly 30% incrementals, and we're reserving 5 points for innovation and investment back in the business. Some years, we're going to do a little bit better than that. 2021 was a year before inflation, I think about organic incrementals. We had transformation savings, which continues actually into 2022 and '23. But we had strong growth in transformation savings. We had a little bit better mix from our Thermo King business as well, to your point. So underlying organic incrementals were stronger in 2021, where we'll kind of see how that plays out year by year. But the long-term framework and the transformation savings we've driven and the market outgrowth that comes from innovation, we think gives us a lot of confidence to say it's 25% plus incrementals over the long term, taking into account that mix. Maybe one year, it's a little bit better, but we'll have to see what goes year-by-year.

The only thing I would add, John, is innovation really helps us, right? We have an innovation pipeline that's really, really strong. And we just the last couple of days, had the opportunity to do deep dives with each of our strategic business units and look at what they have in the portfolio. And as you're able to drive more energy efficiency and come up with solutions that are -- I'll leave it at really clever for our customers, they tend to drive more margins as well.

Great. If we think about and go -- now take a step back more to a market question. Is it a one size -- well, I know the answer is not a one size, fits all for large and medium buildings. But what are you doing to really drive adoption in medium-sized buildings, which are the majority of right the installed base?

Yes. I mean it's having a broad portfolio really helps us there. Having a direct sales force really helps us there. Go out and talk to customers and have conversations about what their needs are because of the expertise that we have within our sales force, we're able to help them make the right decisions. It is not a one size fits all. It is not a -- if the only tool I have is everything becomes a hammer kind of a conversation, right? I mean you have to really look at it at a system level. You have to look at it at a -- at the needs of the customer. And because we have a broad portfolio, we're able to help them through with that. The direct sales force really helps, John. You don't have a filter going through a mechanical contract about what the needs may be.

Great. And if we think about -- you started off the conversation with the dividend announcement, but if we broaden it out a little bit more, what are the -- maybe first remind us the capital allocation priorities. And then we'll follow up from there, but maybe just get that out there, so that way we can have a conversation.

Sure. Dave, do you want me to go first?

Sure. Go ahead.

Yes. So John, really number one priority is always to fund the business, okay? And between not episodically investing, but to have relentless investment back in the business, drives the market outgrowth, that's our #1 priority. We're generally a CapEx-light business, usually 1% to 2% of revenues. This year, maybe a little bit closer to 2%. But number one priority, the business gets funded. Number two, we're going to grow that dividend over time in line or greater than earnings growth, and that portrays back in the announcement this morning, we mentioned earlier that the 14% dividend increase, the intent to raise the dividend starting with the first quarter next year. So that's really number two in terms of priorities. Number three is really around M&A. And I look at that, and Dave looks at that as a toggle with our fourth priority, which is share repurchase and cash back to shareholders. So it is a robust pipeline. We've been able to have a few transactions closed this year. And you can't always predict when they're going to close, but I know the pipeline remains very strong. We are very confident with the acquisitions we've closed in the last couple of years. In the channel space, we're seeing strong 30% to 40% cash flow returns on invested capital. On the technology side, we're seeing returns, 70%, 80% cash flow return on invested capital. And we've had a great history of taking early-stage technology companies, matching them up with our deep channel and driving a lot of our innovation and ultimately, it becoming a big home run for the customer and for us as well. But M&A can sometimes be a little bit bumpy. When it's going to happen, hard to call. And so we've got the ability to deploy cash to share repurchases as well. For 2021, we've got about $2.5 billion plus of cash we're deploying. Call it about $1 billion, a combination of dividends and debt pay down. And then the $1.5 billion remainder is between M&A and share repurchase. So I think it's a pretty dynamic capital deployment strategy, one that we're always looking at quarterly just to deploy the cash. And number one, across all those priorities is to make sure we're always going to pay out and execute any excess cash that's going to get paid back to shareholders over the long term. So we've got a great balance sheet position, and we're going to keep deploying the cash.

And John, we're super excited about our latest acquisitions, Farrar Scientific. It's precision heating and cooling right at extreme temperatures for biopharmaceutical space. They have some really neat technologies that we're going to be able to scale. So it's very -- if you think about -- I was earlier talking about the electrification of heating and how we took this concept of a boiler and a chiller and combined it into one, a lot of that technology came out of a small acquisition we had in Europe. And again, taking a technology, augmenting it with our own knowledge and then scaling it, we've been very successful.

Great. And then maybe as a follow-up to that, we've seen 2 of your competitors do something around more vertical expertise in the data center. You called it out as one of the big growth verticals. How do you feel about where your portfolio stacks up there? And anything you would call out?

We like it. It was one of the verticals we go deep in. We just had a lot of conversation on that in the last couple of days. So we like our position there. We like the innovation that we have. We like the innovation that we're working on. I can't see the names of these companies, but we're working with a lot of the big companies that have data centers and helping them develop solutions that are optimizing their performance. So it's a great space. We're also working with artificial intelligence there. So if you think about a data center, right, in my own mind, I always think of data center as one of the most efficient buildings that we have or that we've deployed our products to and controls to. We're putting on top of that AI and I was amazed by this because I didn't believe it, but we're actually able to increase the efficiency of what I thought was the most efficient building we had by -- you pick another 10% to 15%. So a lot of exciting things. We like our portfolio there. And more importantly, we like the relationships we have with our customers there. And that's where, John, it goes back to this direct sales force, being able to have those relationships and being able to have a one-on-one and helping them solve problems and having that trusted relationship. It's -- and having degreed engineers out there that can help the customer through that, it's a very compelling story. And it's part of our success factors.

Great. No, very interesting. And so we're going to have a refrigerant change over here coming. Can you talk a little bit about what you're doing to prepare the portfolio for that? And do you actually think this is the more interesting regulation versus kind of the seer change that's coming to maybe drive new technologies?

Well, first of all, we'll be ready for the refrigerant change. We're working with a couple of different OEMs there. And again, we're agnostic as to the refrigerant. We've had kind of a mindset that we're going to work with the refrigerant OEMs, and we're not going to have the way it was 10 years ago where they throw over the wall a refrigerant. We try to make it work, right? We're working hand-in-hand in the testing process. I think that becomes the best solution. So we're more than ready, and we have lots of things that we're working on there. As far as, which is more impactful, it really depends. I mean, I think the way they calculate some of the greenhouse gas as they assume that anything in a residential system escape since in the environment. So that would be a pretty impactful impact by going to a lower GWP. No doubt about it. I mean 410 is pretty high, R22 was higher, and some of the next gens are significantly lower, like below 750, and some of them are significantly below 750. That would be global warming potential.

Yes. And maybe if I could just follow up on that while we still have a minute here. If we go to the flammability, right, so they'll be semi flammable, is that a big sticking point for changing technology and maybe replacing aged equipment? You're not going to repair it because you're not going to be able to get that refrigerant anymore. Is that something we should be mindful of?

I mean, I think that the 2Ls is what you're referring to, which are slightly flammable, which is kind of an oxymoron. But you just need to make sure you build the right sensors around those pieces of equipment, right? And it can be safe, make sure that you have the right technology around it so it is centered. And we're exploring all of that and there's some regulations that are coming on around how that system has to work and what sensors are required.

All right. Great. Well, looking here, that's at our time. I would like to thank the Trane team for being here with us, and thank everyone for joining us as we get ready to sign off on the Ninth Annual Conference here. So once again, thank you to everybody for joining us and really appreciate your time.

No, thank you, John. Thanks for having us. Appreciate it.

Thanks, John.

All right. Take care.

See you now.