Trane Technologies plc (TT) Earnings Call Transcript & Summary

Well, I think we're ready to get underway. So thanks, everyone, for coming. It's my pleasure to have up next Trane Technologies' Dave Regnery, Chairman and Chief Executive; Chris Kuehn, CFO. So thanks very much, Dave and Chris, for being here. Just a quick reminder, you can see there the code on the screen. Please open that up for the audience response survey questions. And also, of course, for any questions for Trane, you'd like me to ask Dave or Chris, you can do that via the code. Thanks very much for coming, Dave. I think, you have a couple of opening remarks. So please go ahead.

Thanks, Julian. And as I was telling you earlier, this is a terrific event. So hats off to your team for a job well done. This is -- the planning has just been exceptional. I know it was probably some challenging times. And hello to everyone. This is a welcome change after what we've seen in the last 2 years. So hopefully, you believe that as well. And hopefully, this is the new norm, and we're no longer talking in the computers. Just some quick comments and we'll get into your questions. But at Trane Technologies, our purpose is to challenge what's possible and to innovate for a sustainable world. And this allows us to really drive differentiated returns for our shareholders over time. The mecular -- secular mega trends, here you go, that's my word, mega trends around sustainability and decarbonization are only intensifying. And unfortunately, the rate of global warming continues to accelerate. So we need to act now if we're going to bend the curve on climate change. And at Trane Technologies, we're scaling technologies that exist today and we're relentlessly investing in technologies for tomorrow. This unyielding approach allows us to consistently outperform our end markets and generate powerful free cash flow, which we deploy through our balanced capital allocation strategy. In 2021, we saw record demand around the globe for our products and services. And as we said in the fourth -- in our fourth quarter earnings call, like the broader markets, we are facing supply chain challenges. We're working very closely with our suppliers on a weekly, often a daily basis, and we believe these supply chain constraints will improve in the back half of the year. With our backlog nearly doubling in 2021, we are well positioned to drive value in 2022 and beyond. So thanks for joining us today. And with that, I'll turn it over to you, Julian, for whatever questions you may have for Chris and I.

Thank you, Dave. I suppose first off, a lot of companies at this conference, it's a very kind of back-end loaded year for various reasons, revenue comps, price/cost sort of playing out on the margins. Trane somewhat unusual step [indiscernible] for it, a very helpful one of sort of guiding for the first quarter to sort of make sure people understood the seasonality. So maybe just any update on how the first quarter started out? And how comfortable do you feel with that sort of loading of margins through the year?

Yes. Why don't I start, Julian. So a few weeks ago when we guided the first quarter, we gave our best view as to what we saw supply chain contributing in terms of performance. So it is not a demand-constrained environment. It is a supply-constrained environment. So we guided a low single digit to high -- to a mid-single-digit revenue growth in the first quarter, primarily that coming from price because the volumes and just the visibility of the supply chain, we see that getting better in the second half of the year, and that is from talking to suppliers coming up with some other ideas and options for us to reinvent some products to ultimately allow for that to happen in the second half with stronger volume. But we do see first half, we're going to be comping against a very mild inflation from a year ago. We're really proud of how we got in front of price 1 year ago in terms of our price/cost equation. We carried that benefit throughout the year. We are actually price/cost positive on a full year basis in '21. But as you go into 2022, we're going to start comping against moderate inflation in the first half, and that gets easier in the second half as well. So volumes, inflation, productivity gets better in the second half of the year too as you have a more streamlined supply chain, the plants can run on a more operationally-efficient basis because you've got more line of supply and labor. All of that really gives us some confidence in the second half.

Perfect. And when you look at the demand environment, you sort of -- you report regionally, but a lot of investors have to think about it on a sort of a product basis, commercial HVAC, resi HVAC and transport. How are you thinking about the organic growth rates kind of across those 3 buckets when you look at the guide of sort of high single-digit organic growth overall?

Yes, I'll -- Chris, you could add on here. First of all, we love our regional structure because it allows us to be close to our customers, which really fuels our innovation. So we like that structure. If you go around the globe, I mean, in the commercial HVAC world, in the Americas, we see a lot of strength. I mean you think about it, you've got architectural billing index now for a year has been above 50. So that's a great leading indicator for 6 to 9 months. We have strong GDP, tremendous backlog and really growth in almost every vertical, which is somewhat unique, or I haven't seen it in my career, but it's really all the strength in all the verticals. If you think about some of the secular mega trends that are happening in that space, whether it be on indoor air quality, whether it be on decarbonization, these continue to be nice tailwinds. If you move over to commercial HVAC in Europe, again, the markets there will be somewhat muted, we see, for the year. But our innovation there is really fueling us. And what we've been able to do with electrification of heating and process cooling is really what's driving our -- the demand that we're seeing in Europe. If you go to Asia on the commercial HVAC side, China, where -- although they've -- the GDP is still mid-single digits and maybe they're used to high single digits, but where the growth is, we also have a lot of strength. Electronics, pharmaceutical, health care, data centers, those are verticals that we're very strong in. Outside of China, it's a little bit spotty based on what the conditions are with managing the virus. If you go to our Thermo King business, again, we see growth in 2022 and 2023 really on a global basis. ACT is saying that the trailer market in North America will be up 16%, and it's up double digits in 2023 as well. IHS is saying mid-single digits or low to mid-single-digit growth rate in '22 and '23. So we see that to be a good market. And again, underlying demand there with the need to transport perishables, whether it be food or pharmaceuticals, a lot of growth opportunity. And I think you've heard me before, Julian, talk about the amount of food waste that still exist in this world. So that's something that we all need to be thinking about and how we can stop having 30% of all food produced be wasted. And about half of that is wasted because it's not being transported properly. So that's absurdity that we need to fix as a world. If you go to our resi business, we expect to see the new construction to continue to have some growth. That's a smaller part of our business. Residential, just so everyone is on the same page, it represents about 20% of our total business. So if I said in the -- our fourth quarter earnings call, we don't expect the replacement business to fall off a cliff. But if it did fall off 10%, which we don't think it will, that would represent about a 2% reduction for the company. And there are so many opportunities that exist with innovation in our residential business, but in our other businesses, whether it be the Thermo King or commercial HVAC business that we have a lot of growth opportunities with some of the -- what we're seeing on decarbonization.

Thank you. And Dave, just to circle back to that resi replacement point. How good you feel about that replacement market when you look at utilization rates, the upcoming SEER standards change? Was there may be some early kind of prebuild ahead of summer selling -- a lot of different factors play a tough comp. Rolling it all together, how do you assess that resi replacement outlook today?

Yes. I mean I think at a very high level, we look at our residential business as a GDP plus business over time. We have some -- if I think about the tailwinds that we have in our residential business, we have a very strong backlog. We have very strong price realization. And we have some great brands that everyone wants to buy, right? It's hard to stop Trane. And so that's sort of the tailwinds. We'll see how the market plays out during the year. But again, if it -- we don't see it falling off a cliff in the replacement market. If it dropped 10%, which we don't think it's going to, it's a 2% impact on the business.

Perfect. And then market share, now that you've got 4 reasonably comparable companies out there in HVAC in the U.S., people always try to slice and dice share across the floor. What's your perspective on how Trane's market share is trending in different areas?

Maybe I should ask you...

I mean, everyone...

Everyone's growing, that's fair, right?

That's -- yes.

I mean, we've been able to outperform the end markets over a period of time, okay? So this isn't episodic for us. This has happened over a long period of time. And it has to do with a system of things. I talked earlier about how we're organized on a regional basis. We love being close to the customer, right? We love to innovate with our customers. We love to take their ideas and bring them back and innovate them through our engineering centers and scale them across the globe. That's what's allowed us to really stay ahead of the markets. And the results, they speak for themselves. I'll point to our Thermo King business in 2021. I mean, we had 30% growth, 30% growth. End markets were not close to 30% growth. So that's just an example. But we've had share gain in all of our businesses. And you just need to look at it over a period of time. 2021, we had record demand for our products and services, record demand. And as Chris said earlier, 2022, we're going to -- it's going to be choppy in the first half of the year, for sure. We see that improving in the second half, working with our suppliers. But we're constrained by supply chain. We're not constrained by demand. And the demand for our innovative products and services, I've been in this business a long time, I've never seen it stronger than it is right now.

Yes, I mean, almost 30% growth in bookings in 2021, record backlog ending the year starting 2022. And I would just highlight, that's not in any one of our businesses where it's over-indexed on the backlog growth. It's really across the board, across the regions record backlog contributing to both the Thermo King, the residential and the commercial HVAC market. So you're seeing it diversified across the portfolio.

And on Thermo King bookings, I think, Dave, some investors from the last earnings call thought that maybe you sounded cautious on how those bookings play out from here, but realize there's that dynamic around slots opening and all the rest of it. So maybe just clarify sort of what you expect for those TK bookings.

First of all, we have a very strong backlog in Thermo King. Our bookings were, help me out here so I don't quote a wrong number, over 30%. I mean it's very strong. Obviously, you really need to balance what -- if you look at it on a quarterly basis, which I did not, but if you did, you'd be looking at it, you got to manage backlog and incoming order rates. I would tell you that our demand in our Thermo King business is extremely strong. And we really are marrying up when a trailer unit would be ready for a reefer unit and making sure that, that customer has a system to operate at the right time. And the OEMs are constrained on the trailer side or on the tractor side when it comes to the APU and we're helping them marry up that demand. So we are systematically opening up our backlog in 2022, and we're doing that for a reason, right, because we want to make sure that we can price this product properly the first time. And therefore, we're probably -- we just opened up the third quarter right now. We haven't opened up the fourth quarter, and we're really limiting what the slots are for that time period.

Perfect. And then something that I think Trane has talked about a lot for years is service and getting that contractual service up there. Your peers are talking about that much more than last sort of few days over the last 18 months, depending on the company. Maybe remind us sort of the scale of your service business, how you're defining it in terms of sort of break fix and contractual? And what sort of growth rate do you think your service business should generate medium-term?

No, as you saw in the fourth quarter, we had some of the highest service rates coming into our business in the commercial HVAC. So we're very proud of our service business. We've been very proud of our service business for a long time. These are all Trane Technologies' employees. They're factory trained on all of our new products. It's one of the reasons why we can implement products into the marketplace so quickly is because we train our service technicians on how to service these products. As far as growth rates are concerned, it's -- we're very happy with them. I mean, I'll leave it at that. I mean, if you think about our split between equipment and services, and I'll use the broad definition of services in our commercial HVAC business in America, it's about 50-50. In Europe, it's about the same. In the Middle East and Asia, it's a bit less. It's about 1/3, 2/3. So it's a growing business. I think what's transchanging in that business is how you service. And as we're becoming more connected to, and we have millions of assets that we're connected to and thousands of buildings that we're connected to, the model is shifting to let me go fix something when it's broken, a break-fix model to one where it's let me come service your building when you're using too much energy. And so it's a different mindset. It really ties back into the whole sustainability and the decarbonization mindset that the world is adopting. And over the last 10 years, Julian, the mix of service to equipment that service mix has grown about 10 points. So we continue to see that growth, and it's been demonstrated over time as well.

Perfect. And how do you see on that service front, sometimes there's a debate or some of your peers who have a broader offering in the building might say that's an advantage of sort of one-stop shop sweep. You're more focused on within buildings, HVAC very clearly, not much refrigeration and no fire and security. How -- when you talk to the customers, commercial building developers, owners, operators, do you see any secular shift one way or the other on that best-of-breed approach that Trane has and then the sort of the one-stop shop that some of your large peers offer?

Yes, I mean, I would tell you that our service technicians are very well trained on HVAC and controls. We don't often get asked to look at the fire system in a building. I don't think I've ever heard of that request, but maybe it's existing. So the synergy that exists here, I don't know. I would tell you that it would probably be more of a supervisory type service if it happened at all because the tactical expertise that's required to work on those systems, I'm sure, is immense. But we like our direct model on service. We like the ability to work with our customers. We like the ability to understand what their needs are, and we get a lot of great innovation ideas from our technicians because they're out there on a daily basis with our customers and on their sites, and we just see that growing in the future. And it's really going to -- it's evolving into this connected building solutions with the service as well as part of that.

Perfect. And how much -- I don't know if you've talked much about within your aftermarket or service that, that mix shift sort of contractual versus break fix, how is that sort of evolving?

I think that if we're going to probably look back at COVID one time and say there's going to be good things that we're going to take away that none of us liked living in the last 2 years, but I think we all learned how to work virtual, which may be a good thing. In the service world, I think that everyone realizes that being remotely connected is a big advantage. And if you think about it, I mean, if you had the unfortunate event to have a loved one in the hospital, you probably weren't even able to go visit them. Well, if you had a problem with your HVAC or control systems, you didn't want a technician necessarily there. So the power of being connected has been -- we've seen that accelerate at a great clip, just because of the fact that it's -- yes, it's great to have your building continuously commissioned. It's great to be able to have someone looking on the outside to understand, if there is a problem, what the problem is and how do I make sure I'm in your space as for a shorter period of time as possible. So that's certainly been accelerating.

And then maybe switching to sort of operating margins and you have some sort of some odd dynamics this year, as you said, first half, second half. But taking a step back when you look at kind of industry discipline, the greater mix of contractual service perhaps versus the company total, maybe give us some color as to that longer-term operating leverage. And there were some points you made on that at the Investor Day late 2020. Any sort of updates given what's happened in the interim.

Dave, you want me to start?

Sure.

Julian, our long-term framework is really to drive 25% incrementals, and we think of that as 30% or better incrementals from the operations and then reserving 5 points of those incrementals to reinvest back in the business, reinvest in innovation, and that helps drive our market outgrowth on the top line as well. So we see that as the long-term framework. Last year, we were able to generate 29%, almost 30% incrementals, even on an inflationary year that we saw in the second half. And if you compare 2021, you add 2022 to it with our guide in this year is 20% incrementals on the full year, we're really right on average, 25% over the 2 years. One of the things we're really impressed with and want to give a lot of credit to our team is what we've been able to do with pricing. All of 2021, we remain price/cost positive each quarter throughout the year. Now second half of the year, we saw the inflation coming. We got in front of that with really strong pricing in Q1 and Q2. And so that's much improved from where we were 4 or 5 years ago in the last inflationary environment where we were behind on the price/cost equation 5 or 6 quarters in a row. So I want to give a lot of credit to our teams for getting in front of that. We saw the costs. We have a hedging practice, of course, for commodities and so on. That gives us visibility, better visibility. But we got in front of that. Now we do comp against that here in the first half of 2022. The inflation is much more severe in the first half of the year, very modest versus a year ago. We're carrying over price, and we're targeting on a full year basis, 20% incrementals, and part of that is slightly price/cost positive. That price/cost dynamic, when you do the math on what we guided a few weeks ago, it's probably a headwind around 40, 50 basis points on the margin, just getting enough price to offset that cost on the year. So we're going to remain flexible. Underlying margins and incrementals in the second half of the year should be strong. It is that confidence we saw on the supply chain when we gave our guide a few weeks ago. It was a confidence on improving logistics, improving productivity in the plants and getting that through and then ultimately having an easier comp in the second half of the year with inflation as well.

And then -- as you said, these sort of the pricing actions have been very rapid and timely. If we try and look at the sort of normal inflation environment, I suppose it's been a moving feast for 6 months and then what happens overnight, maybe it's moving again another few months further out. But whenever you get to that normal inflation environment, how do you assess the ability of Trane to get a good spread, a positive tailwind in the gross margin? You talked about the 40, 50 bps of headwind...

Just on the math for this year...

Yes, exactly. Do you capture sort of decently a material positive on the other side, do you think? Or...

Well, I would tell you that with the construct for every point of revenue growth on 25% incrementals, that drives 10 basis points of margin expansion. So for the guide this year at 20% incremental, maybe that's a little bit less. We'll see how that falls out. But over the long term, we should be able to get 10 basis points of margin expansion on that. And that is from going into any year, looking for 20, 30 basis points of price over cost. We want productivity to offset inflation and then we drive those investments as well. So second half should be strong, and we're setting it up for the year, and we'll be reactive if those commodities, if that inflation is different from where we see it today, we've got the ability to continue on pricing as well.

And as Chris said, I mean, our operating system, we have this embedded in with our operating system, and you've seen us perform for an extended period of time where we've been able to demonstrate this.

And so yes, if that cost inflation does recede, the model should capture a decent...

Model should capture it. We've simply gotten some questions around do we see commodities receding. I'm not so sure we're seeing a lot of that right now between copper and aluminum. Steel would look like maybe there's a little bit of push and pull back, and we lock in prices for 6 months on steel. So if there was a benefit, that would be more second half weighted. But Julian, we've had 4 price increases for the majority of our products over the last 13 months. So I think we put the -- discipline is there, and we're going to watch those input costs and labor costs and otherwise and price appropriately to get the margin expansion on the framework we've laid out.

Perfect. And then maybe on the sort of the capital deployment front, pretty underleveraged balance sheet, the stocks come in a bit with a lot of others, obviously, in the last couple of months. So maybe update us on the kind of the buyback philosophy and how attractive buybacks are right now?

Yes, I'd say we think there's a lot of value in the stock today. But is it changing the way we're operating the company and driving to the long term, answer is no. We deployed or we said we're going to deploy in 2022, $2.5 billion of cash. We just raised the dividend. We announced that a few weeks ago with the Board approving a 14% raise. When you combine that with the dividend raise from a year ago, it's 26% over the last 13 months we've raised the dividend by. So that's a strategic part of our deployment. Of the $2.5 billion that we're deploying this year, think of that as $600 million to the dividend. And then we bought back $350 million of shares so far here in the month of January. So we've got about $1.5 billion left to deploy in the year, and we're really going to toggle that between M&A and share repurchase. We've got a lot of firepower from a share repurchase perspective. Two authorizations combined is a little over $4 billion that we have at our disposal. But right now, we're targeting that $1.5 billion, and we'll see as we go throughout the year, we deploy it to those 2 options because we've had some great M&A transactions over the last 5 to 6 years that have driven some very strong returns. And so we like that optionality when it presents itself.

And then Dave, as you've been in the CEO role for 6 to 9 months now, it's enough to get your sort of feet under the desk. And obviously, you're at Ingersoll and Trane for some years before that. But any sense of kind of tweaks you're thinking about making to the strategy or areas you're spending more time on than perhaps you thought when you first got the role, from a strategic standpoint. I understood the supply chain is day-to-day, 25 hours out of 24 or something that's...

Yes, it's been 9 months now, seems like just yesterday. But when we -- Mike and I planed the transition for me to be in the CEO role, which obviously started way before it was actually announced and we were re-blueprinting Trane Technologies. Those are really -- how we organize was really a lot on me, right? And I like a regional structure, and I like to be closer to the customer and our strategy around sustainability is not going to change. And I think it's probably easier for me to answer that question by telling you what I'm passionate about as the CEO. And it's really our purpose, right, to challenge what's possible for a sustainable world. It's our employees, 36,000 of them believe every day that they can make this world a better place for the next generation. And it's a great feeling to get out of bed in the morning and know you're going to go work for a company that can have that type of impact. The second thing that's very important to me is I spent a good part of my career in front of customers, right? I always tell someone start with the customer and work your way back through the value chain. Where there's good, double down. If there's waste, eliminate it. And you always have to have the customer at front of line. The third area that's extremely important to me is innovation. We're never going to stop innovating. I was telling a group yesterday that someone early in my career told me that if you stop innovating, you start standing still. And if you stand still too long, you know what, you get passed. We're never going to get past the Trane Technologies because we're never going to stop innovating. And the last area that's very important to me and probably one of the most -- certainly the most important is culture, right? At Trane Technologies, we have an uplifting diverse culture. It makes us unique. Our competitors can, maybe over time, copy our products and services, Julian, but they're going to have a really difficult time copying our culture. And if you look at our employee engagement surveys over a number of years, it's top quartile performance. So that's what differentiates us as Trane Technologies. That's what I'm extremely passionate about. And I would tell you that this whole sustainability of decarbonization, it's real. It's our North Star as a company. We believe that we can influence an industry and that influence can help change the world. And you're starting to see that happen.

And just on that point around sort of innovation and the customer point, again, there is the opportunity for M&A that Chris mentioned. What are some of the areas that you think Trane is kind of most interested in?

That's a great example. We were working in our Thermo King business on the mRNA vaccine distributions. If you remember, 1.5 years ago, that was in the news all over time. And when we were working with the customer at very high levels, we started to become very interested in their process to manufacture the drugs in the biopharmaceutical space. And it led us to a technology that was owned by a company called Farrar Scientific that is basically being able to operate at extreme temperatures. When I say extreme, it's minus 80-degree C type temperatures. And we acquired that because we loved the technology, and we see where the biopharmaceutical industry is going and how we're all going to be treated with medicines in the future. So that's a great example of being close to the customer, right, understanding their needs, finding a technology that meets those needs. Now we're in the process of augmenting that technology and then scaling it at a large scale.

That's perfect. And then one last kind of fiddly one I got in, more for Chris. Does the guidance for the year embeds extra price actions not announced or it's based on the price actions the last 13 months that...

Yes, our guide on the 31st would have included any price actions that we had announced at that point. I think for the majority of our businesses, we had done that to start the year of 2022.

Perfect. Great. Well, I'm afraid we're out of time. Thanks so much, Dave and Chris.

Thank, everyone.

Thank you.