Trane Technologies plc (TT) Earnings Call Transcript & Summary

Yes. Perfect. Well, next up, it's my pleasure to have Trane Technologies' David Regnery, Chairman and CEO; Chris Kuehn, CFO. So welcome both Dave and Chris for being here, and thank you. Maybe Dave, just start off with a couple of quick introductory comments before the Q&A.

Thanks, Julian. Thanks for having us. Your team has done a nice job of organizing this event. So we're glad to be here. A little bit different than last year. Remember, last year, we were here, it was the -- I think it was the first conference I spoke at in person. So it's a lot different. But before we just dive into your questions, just a little bit about our strategy and our purpose, right? Our strategy is fundamental to our ability to drive differentiated returns for our investors over time. And if you think about the mega trends around decarbonization and sustainability, they continue to intensify. Unfortunately, the world continues to get warmer. And if you look at the last 7 years, they've been the warmest on record for the planet -- the warmest on record for the planet. And the harsh reality of it is, is if we don't do something about that, they will be the coldest 7 years for the rest of our lives. So we need to take action and we need to take action now, and at Trane Technologies that's what we're doing. We have technologies today that we're scaling that can dramatically reduce the carbon footprint for the built environment. 15% of all greenhouse gas, 15% comes from heating and cooling of buildings. And most of that is for the heating side. We have technologies that eliminate the need for fossil fuel in building, which will dramatically reduce -- dramatically reduce that carbon footprint. We finished 2022 with records. I'm sure you read our fourth quarter earnings release. We had -- for the year, we had organic revenue growth of 15%. We had EPS growth of 21%. For the year, we had a book-to-bill of 109%. We had strong free cash flow. We ended the fourth quarter with record backlog. We have over close to $7 billion of backlog, which is more than 2.5x what would be normal entering 2023. We're very well-positioned for 2023 and beyond. So with that, Julian, before I get too passionate talking about how warm the planet is, I'll turn it over to you for questions.

Sure. Thank you, Dave. Yes. Maybe firstly, you ended on that point on the backlog. How you're thinking about orders, book-to-bills playing out over the balance of this year? We're coming off a very abnormal couple of years for you and most companies at the conference around huge order growth, massive backlog build. Now maybe things are a bit more uncertain, more macro questions, easing supply chains. So how do you see the...

Yes, I think -- I start with the supply chain is getting better, okay? It's getting better slowly. I'm sure you heard that. We talked about that in our fourth quarter call. We continue to believe that supply chain will get better in the future, but it will be several quarters before we get back to what I would call a normal state. As far as backlog, we entered the year with, as I said, close to $7 billion in backlog. We said that we will enter 2024 with a backlog that will be $6 billion or plus $6 billion or north of $6 billion. If you do the math on that, we gave a guide for 2023 of organic revenue growth of 6% to 8%. If you take the midpoint, and you assume a $6 billion backlog, you do the math -- I'll help you with it -- it would say that you have bookings decline in the year of about 6%. We think that's a minimum $6 billion, which is almost 2x what's normal. So we're going to enter 2024 with a very, very strong backlog. Chris, if you want to add?

No, I think that's a good summary. If we were to hold bookings on a year-over-year basis, we'd actually add backlog by the end of 2023. So the construct we put out there is that we can still be an elevated position going into the 2024. $6 billion is roughly 2x normal.

Perfect. And looking at the sort of the pricing side of things, I think you've sort of guided to low single-digit price in your revenue for 2023 as a whole. Maybe that's a little bit more cautious than some of the HVAC peers. But in general, I think everyone agrees pricing tailwinds will moderate. How are you seeing pricing play out in kind of orders now? Do you expect to see any kind of pressure as you go through the year? Are your competitors behaving on price?

I like to start, Julian. It's one of the best parts of our business operating system over the last 2 years is being ahead of the highly inflationary environment we've seen. We've been ahead on price throughout all of 2021 and all of 2022. Price cost positive every quarter. Certainly, a margin headwind, but from a dollar basis, a positive on price cost. So I think we've led there in most cases. Carryover pricing we're seeing into 2023 is in that 2% to 2.5%. It does not assume any incremental price increases beyond what we've already announced in the first part of January. There will be some carryover inflation into next year, but we're not planning on anything incremental beyond what we entered January with. But we remain nimble. If markets, commodities and other costs continue to be inflationary -- in the last 60 days, we've seen more inflation in copper and aluminum than we did, say, in the third or fourth quarter -- we'll remain nimble and we'll revisit pricing again. We're targeting 20 to 30 basis points of price over cost in 2023. That's a typical year for us. And so we'll kind of report as we go throughout the year how we do. But we remain nimble. I think it's just embedded in the business operating system to take the input cost, look at the value for the customer and making sure we're going to price effectively.

And the only thing I would add is it really helps with -- if you're an account manager and you were calling on customers, if you have a pipeline of innovative products that you continuously are launching into the market, it really helps your conversation with customers as to why they'd be wanting to pay more for your product because of what you're going to be adding for them.

That makes sense. And so looking beyond the very short term, there's a lot of conversation around Inflation Reduction Act and other stimulus measures. What's your sort of best assessment of when you might start to see some impact on your orders? How significant do you think that impact could be over several years?

Yes. I think policy is a tailwind for our business today, and it will be well into the future. I think if you look today, you have the Infrastructure Act that's already -- we're into that. Certainly, ESSER funding for making our schools safer for our children. We're probably 50% into that, maybe a little bit less. And we've been very successful, by the way, in the education vertical with ESSER funding and making it easy for our customers to navigate that. Our equipment orders in the education vertical in 2022 were up 40%, 4-0. So we've been very successful there. As far as IRA, that's in front of us. We're still working through how the funds will flow from federal to states, and every state will have a framework they have to operate within. That's being defined. Some states will move faster than others. And the key is, is how do you make it simple for the end customer to understand what benefit they can receive. And we're pretty good at that. So that's in front of us. If you look a little bit further even in front of IRA, you have the CHIPS and Science Act. Again, that process has really just started. And again, that could be a big opportunity for us in the future as well. And I know we talked a little bit about North America. In Europe, we also have other policies that are out there that are helping drive and fuel some of the tailwinds that we're seeing.

That's helpful. And I guess having come from the AHR Expo a couple of weeks ago, a lot of conversation there cyclically about the residential market. Any broad thoughts on how that market is playing out, much destocking evidence? And any surprises around the SEER transition, where the date was 7 weeks ago now.

I'll start with the SEER transition. I'd say no surprises for us, okay? We are very well-planned there and we worked very closely with our channel partners in the resi space to make sure that they ended up with the correct inventory. I think everyone understands the SEER changes are a little bit different this year, where depending on where you were located, it was an install date or a manufacturer date. And if you had an installed date criteria on you, we wanted to make sure that those channel partners were really good at phase in, phase out of their inventory, which we do all the time because we're introducing so many new products. But -- so we work very closely with them. As far as transitioning in the resi space, we've seen orders for the last 2 quarters getting smaller. They're contracting, right? In the fourth quarter, our order rates were down over 20%. So some of that normalization, as we call it, has already started. And we feel as we ended the fourth quarter that our channel partners are in a good position with their inventory, at least they have the correct inventory. We didn't want to have stranded inventory, was really the concern that we had in the fourth quarter. So we took a little extra time there, but we want to make sure that they had the right stocking units in place.

And then I think there's a debate certainly in the last sort of couple of days here. If you think about residential and nonresidential markets, classically, there's a linkage trends in one show up as trends in nonresi after a lag. A debate around is this time different because of things I call the stimulus actions. So I just wondered what's your perspective on that resi to nonresi transmission. Is it something different now because of stimulus? And I guess related to that, your like commercial age factor...

Yes. At the end of the day, we haven't seen that, okay? Our commercial business continues to be very strong, as you saw with our fourth quarter results really on a global basis and really across many verticals, too. That's what I'm most impressed with is the strength that we're seeing across many verticals, not just one. We'll watch it, as you said, Julian, the whole mega trends around decarbonization. And how you improve the carbon footprint of the built environment is a little bit different than what we've seen in the past, and you certainly have a lot of policy and dollars behind those policies that are going to create tailwinds for an extended period of time. With a backlog of $7 billion, which the majority of it is in our commercial businesses, that gives us a lot of buffer to occur. And as I said before, we're going to go into 2024 with a backlog that will be 2x normal as well. So it will be $6 billion plus. So you could start to understand that there's a little bit of a buffer here that we haven't seen in the past when there's been any kind of a slowdown. As far as a slowdown, if it occurs are we ready? We -- as part of our operating system, we've always done scenario planning at a very detailed level. And it's -- if things -- and this is at a business unit within a geography, even down to a country level. We all -- we have certain triggers: "If something happens, what do you do? If it's down 5%, what are the actions? If it's down 10%, what do you do?" And it's, "What would you stop doing? What would you never stop doing," which is as important because you never want to cut investments that are for the future, especially around innovation. So we're very, very specific on, "Let's go into any problem should one rise with a detailed plan so we know how we're going to react." You never want to go into a situation and not have a plan because you're going to make decisions you're going to -- you may regret later. And we have very detailed plans. And trust me, we're not talking ourselves into a slowdown, but if one occurs, I want everyone to know we'll be ready for it because we'll have very detailed plans.

One thing that you highlight on the backlog, the $6.9 billion, that does not include service. Our definition, it's really an equipment backlog. 2022 service revenues were 32% of the enterprise. And over the last 6 years, services have grown high single-digit revenue CAGR for the last 6 years. So just to highlight there, Julian, that there different definitions of backlog depending on who you're speaking to. but 1 year, 2 year, 3 year service contracts, we don't have that in our backlog. And a very resilient business.

That's helpful. It makes sense. And one -- you mentioned the SEER transition has been smooth on your side. I know some others are running around here and there. When you look at the refrigerants change in a couple of years, do you think that's -- how substantial do you think that change is in terms of requiring extra investment, the size of the units, the education of the contractor and installer technician base? Or do you think, "No, this is a sort of part and parcel of this company's"...

I mean for us, it's -- I don't want to be overconfident here, but we've been working with next-generation refrigerants since 2014, okay? We were the first to introduce next generation and talking about lower greenhouse gas potential and not degrading the performance of our product, but enhancing the performance of our product using a greener refrigerant. So we did that back in 2014. And I can remember early on having conversations with a lot of investors. And people were saying, "Why are you doing this? Why is it important?" And I was sort of like, "No, no, no, you don't understand. This is a greener solution. This is how we're going to be able to help next generations that live on this planet." And it kind of went on: "I don't know about this. Do you have customers that are demanding it?" And to make a long story short, we became really, really good at transitioning to next-gen refrigerants. In fact, the majority of our commercial portfolio uses refrigerants that have very low GWP. And this transition that's going to take place in residential and light unitary, which is basically the 410 conversion into a different refrigerant, we'll be well ready for it from a product standpoint for sure. I think where you may run into some slowness is really around policy, and this would be: "Can you actually install the product?" Okay? "Is it going to meet the code requirements because you'll be dealing with 2L, slightly flammable refrigerants?" So that's where I would be more concerned. From a product [ standpoint ], "Bring it on." Right? "We're ready for it now." And it's not a -- we deal with this every day. In fact, we like going to lower GWP refrigerants. From an investment standpoint, yes, it's an investment, but considered part of our run rate because we've been doing this for so long.

And when you look at the commercial business, do you see much changing in terms of speed of, say, equipment replacement rates because of energy efficiency or climate change or policy stimulus? Or are those holding pretty steady? And I guess there's another angle to this, where, as buildings are digitizing and upgrading, does that benefit those who can cross-sell a range of products within the building? Or -- no reason, actually, why that could be the case and it could be opposite.

With your first question, as far as are we seeing acceleration of replacement, I guess the short answer is no. I mean, I would look at it as 65%, 35% as far as replacement versus new. That number can move around a little. It could be 70-30, could be 60-40. But it's still in that band. What we do is, is we work with customers on how to enhance their -- the efficiency of their building. And that doesn't always necessarily have to be a binary change overnight. So there's lots of things you could do, especially in applied systems to make a building run more efficiently. Your last question there about do you need a whole basket of goods to sell. I mean, one of the advantages that we have as Trane Technologies is we always think of things at a system level. So we're never thinking at it just at a product level. That's why we're so good at the applied side of our business. We're always looking at a system and how we can improve the system whether it's a building, whether it's a campus. And I'll give you a great example. Our business in Europe, right, we used to -- the traditional way of heating and cooling a building is a chiller plant and a boiler plant. And our clever leaders basically said it's HVAC heating, ventilation and cooling. How about we combine the 2 into one system? And when you do that, we're calling it a thermal management system, but it basically eliminates the need for that boiler. It eliminates the need for that fossil fuel to be used for heating. And that's where you start making dramatic changes to the carbon footprint of a building. Most of the time, we're the incumbent, right? So you never find -- you rarely find incumbents that become disruptors because they like what they're doing. We became the disruptor here. We're disrupting the industry. We're combining these 2 plants that were independent into one. And this technology exists. We're deploying it. We need to get more people to deploy it. I mean, this -- why would you ever want to put fossil fuel in your building? I don't understand it, and you don't have to do that. So it's one of those things where -- I was talking to a group yesterday, and they were asking, "Why don't more people deploy this?" And I was thinking, I was like, "Well, if your" -- "if you're a maintenance leader for a building and your boiler breaks, do you think they're going to call Trane to say, 'Can you come fix my boiler?'" They're going to call the boiler manufacturer. And that's where this education process has to happen at all levels so people can understand what's possible so we can really have an impact on the decarbonization that has to occur on our planet.

And that's a good, I think, a lead into -- we always get this question around heat pump exposure, size of the business that Trane -- the positioning in sort of resi versus commercial in Europe versus the Americas? Any broad color you can give on that?

Yes. I mean, if you think about resi, I mean, the industry is probably -- it's around 30% heat pump or north of that. We tend to be on the higher end. So we're very well-served there. If you think about on the commercial applied systems, I think people are still grappling with the heat pump is. I mean this is something that started 7, 8 years ago. Julian, you know this. We were talking about heat recovery, right? And then we started talking about full heat recovery. And then we started talking about simultaneous heating and cooling. And I think you remember we were calling it 4-pipe chillers, which confused everyone. And then -- but it's evolved from there, right? It's simultaneous heating and cooling, but it's at a different level now. It's a system. We call it a thermal management system, where it's just so much more efficient than what it was in the past, so much more, 3 to 4x more efficient. It's just -- we just need to deploy this technology everywhere.

Understood. And transport refrigeration doesn't get a huge focus. I think a couple of quick questions. I guess one is around how you see that market playing out. Clearly, it's a very good industry structure with you and another major rival in Europe and North America. And then also sort of secularly, how does that electrification theme play out in the sort of rig side and the re-fer side? And what are you doing to sort of stay abreast of that change?

Yes. I mean Thermo King is a business that we invest heavily in, like all of our business. And certainly, a theme there is the electrification of that portfolio. And over time -- a lot of that fleet is running on diesel today. A lot of that fleet will switch to an electric or a renewable type solution. I wouldn't necessarily get fixated on whether it's battery, whether it's hydrogen. It will be a greener solution than diesel. We'll be ready for it. I think the transition will happen with smaller first and then move up to larger. I think long haul or what we call long haul, which is traditionally served by trailers today, that will take some time before it evolves. But we have demonstration products out there today. We're working with some of our major customers. And you may have -- if you're in California, you may have seen them going down the road. And companies like Walmart are very, very boastful about what they're doing as far as all electric vehicles. And we're working with them. So it will happen. It will happen over time. Think of it more as the -- obviously, home delivery as a vehicle is electric. We'll have an electric unit for that. Think about Class 5 to 7. Those units will be -- probably start as hybrid and then go to electric. We have electric today. In fact, in California, they have legislation out there now that basically says if you're going to purchase a refrigeration unit for Class 5 to Class 7, a percentage of that has to be fully electric, not the truck, but the unit. So we have applications there that we're deploying today and selling to customers. And other states are looking to adopt that. So this will start to transition over time. You will have some policy that will drive it like you've seen with CARB in California. Other states will start to adopt that as well.

And cyclically, I suppose you have a good backlog. It's an industry that tends to have big ups and downs.

Yes. I mean I think in the past, it was big ups and downs. If I look at the trailer market in North America, which tends to be the bellwether for Thermo King -- people look at that -- that market has been above 40,000 trailers for 7 of the last 9 years. And one of them was a pandemic year and next year was coming out of a pandemic. So I mean, think about it. That's pretty -- that's a very robust market in the trailer space for our Thermo King business. And if you look at the forward-looking forecast from ACT, they're saying this year is going to be flattish. It's up a couple of percentage. They say next year it will be down in the 10% range. And then they're right back up to the 45,000 range the following year. So it's, again -- they're forecasting in the next 5 years it will be at 40,000 or greater. So it's a very robust market. So I think the cyclicality that we've seen maybe back when I was running that business in the 2010 time period, we haven't seen that. And we could debate whether it's going to occur or not. Obviously, if there's a slowdown, every industry could be impacted, just some will be impacted less than others. And the Thermal King business today is much more diverse than it's ever been in the past. It's not just a trailer business or a truck business. It's auxiliary power units, it's bus, it's marine, it's air, it's intermodal. So it's a very diverse business to transport perishables.

And when we look at China specifically, you have some transport there and also a lot of applied. How is that market kind of shaping up? If we do see a reopening, do you think there'll be sort of a market share grab among companies or it's going to be pretty disciplined?

Well, I mean, our business in Asia -- like for the enterprise, we had organic growth of 15%. Our Asia business grew 12%. So it was very strong. And if you look at the obstacles that we had to overcome in Asia in 2022, there are some steep obstacles. I mean, we're in -- let's face it, we were in a lockdown situation in China for a good portion of the year. And that team performed just exceptionally well. I'm very, very proud of what that team has been able to perform and what they've been able to achieve. As far as the reopening goes, we're optimistic cautiously as to what's going to happen. In the fourth quarter, I would tell you I was a bit nervous as to what was going to happen. And we actually put more inventory in place because I was nervous that the reopening, you'd have a surge of COVID and then we'd go back into lockdowns. That did not occur, which is a good thing. I think the spread of COVID, although there's no official numbers that have come out of China, has been very rapid. If you look at our cross section of businesses, if that statistical means for China, over 70% of our employees have already had COVID. So the reopening has happened a lot faster than any of us anticipated. We're optimistic, but cautiously optimistic on China. I would tell you that the verticals that we've been strong in were strong all the way through the lockdown. So think of the bigger infrastructure type industries, fab plants, data centers, et cetera. You see the benefit of us making an investment 7 years ago in a direct sales force, where a sales force that could call on engineers, architects, mechanicals, GCs and getting them all part of that buying process is really paying dividends.

That's great. And then maybe lastly, before we go into the audience response survey. When you think about Trane's focus in the building, how comfortable do you feel that you're sort of going up high enough, if you like, in the stack? You have a very good controls business on the equipment. You've got maybe people trying to come from an IT background or building management systems background to get lower in the stack. Do you think those sort of IT penetration in buildings as it goes up, does that put pressure on you in terms of that sort of reinvestment on controls or systems?

I would tell you that I used to tell people 5 years ago or 10 years ago now because -- I'm dating myself here. When I was running the commercial business for the Americas, I used to say, "We're investing more in controls than we are equipment." And no one believed me. I would tell you that we have a very robust controls platform. And you're right, Julian, we started at a -- think of it as a unit controller for sure, right? We want to control the intelligence within our units. Go to the next level up, think of it as a system level, think of it as a chiller plant controller, for sure, we're very robust. But then think of it at a BMS level, Building Management System. We have very sophisticated controls, and we have for a number of years. And 7 years ago when we started this journey or 10 years ago when we started this journey, I said we want to be different, right? We didn't have a robust platform. And a couple of things that we kind of led with. One was we wanted to make sure we had open protocol. We wanted to make sure that we can network in with other systems. And the second is that we wanted to lead with wireless. And today, we're the leading wireless provider of BMS systems. And why would you want to run wires through the ceilings of your building if you're upgrading your controls. You don't have to. And it has to do -- the sophistication of the meshing network for repeating that we've been able to develop is -- it's very, very impressive, very impressive. So is there competition? There's competition all the way through there. There's also competition at the equipment level. But we have a very, very robust platform that we continue to invest in, and I'm very happy with the success that we had.

Great. Now if we could please switch to the audience response survey questions. Firstly, do you currently own the stock?

You want us to participate too? Yes.

I own a bit of the stock just to be fair, just a full disclosure. All right. It looks like we have -- it looks like we have 32% of the audience to do some convincing to.

Next question, please. A general bias -- quite mix. Third question is around earnings growth for Trane. And again, the peer set in this context is sort of U.S. industrials or multi-industry, it's sort of a broader group. So generally above peers. Fourth question is around capital deployment, which we didn't have time to touch on, but it's mostly been around historically buybacks and dividends, some bolt-ons.

There's no option #7, which is all of the above, Julian?

No. And I kind of put -- yes, that I've put to people's quote on one answer. And yes, both on M&A, the most popular answer. The next question I think is around valuation. What PE multiple does Trane deserve through the cycle, let's say, for the next 12 months?

We should do these questions before I talk so I know how to emphasize…

We'll do that next year.

Okay. So sort of 20x -- it looks like the penultimate question is around sort of what's the biggest thing holding people back on the stock. Why 20, not 25x? Or what letting not one own it? So full growth -- I think we have been pretty good...

Full growth?

Yes. And then the last one, this is a new question this year. Does ESG play an active role in your investment decision on Trane?

And for context for most companies, number one is about 25%. So 60% for Trane is very different from the norm.

All right. Well, thank you very much for your time today.

Thank you, Dave. Thanks, Chris.

Julian, thank you.

Thank you very much.

Appreciate it.