Trane Technologies plc (TT) Earnings Call Transcript & Summary

Good morning, everyone. We're going to keep things rolling here with Trane Technologies. I have Chairman and CEO, David Regnery as well as EVP and CFO, Chris Kuehn, joining me up on stage. Guys, always a pleasure. Looking forward to our conversation here. Obviously, HVAC space has got a lot going on, on multiple fronts. Hopefully, we have time to explore it all. Dave, maybe just leave us off with a few comments, what you're seeing, what you're focused on, how do you prioritize when you got a lot of different things going on in the world across the markets and we'll take in some questions after that.

Okay. Great. Well, first of all, thanks for having us here, Josh. You always did a great job with this conference. And thank you, everyone, for attending today. Glad to see all the interest in Trane Technologies. I must admit that I was having a great day until I woke up this morning and read the headlines "Some of the big New York Jets fan" and maybe next year. But anyway, in business, look, we've seen our second quarter with very strong results. I think you saw it published. But revenue growth, very strong, 11% organic, EPS growth of 24%, strong free cash flow. Our business continues to execute at a very high level. If you look at our commercial HVAC businesses, think of it as in the Americas, up high teens on a revenue basis, think of Europe, up high teens, and in Asia, it was a number that was up over 40%. And despite that significant revenue growth, our book-to-bill was over 101%. So we actually built backlog in our commercial HVAC business as you see the tailwinds behind that business. In the residential space, look, we -- as we said on the second quarter call, it's normalizing. And you have inventory in the channel that's normalizing. We think that normalization will continue into the third quarter. We think it will be complete by the end of the year. We're very confident in saying that our backlog, which we ended the second quarter at $7 billion, will be north of $6 billion going into 2024, which gives us just tremendous visibility into the future. So we're very bullish on the future. We increased our guide for the year, and we're very confident with the midpoint of our guide, which by the way, will be EPS growth of north of 20% for the third consecutive year.

Excellent. Maybe just to dive into some of the macro elements that you're seeing out there. I guess on the business unit level, inventory levels in resi are something that people have been watching, interest rates as it pertains to commercial real estate and how commercial folks are thinking about their business, anything on the macro side that kind of stands out that you feel we should be aware of?

Yes. I mean I think on the resi side, yes, inventory levels in the field, that would be independent wholesale distributor, inventory is normalizing. And we saw that normalize in the second quarter. We'll continue to third. And again, as I said previously, it will be complete by the end of the year. I think the big macro that's out there, okay, we could talk about policy and certainly, that's a tailwind, but if you think about what's happening in the world with sustainability and decarbonization and the fact that the planet continues to get warmer, I mean it was just announced a couple of weeks ago that it will go down as the warmest summer on record. And the mega trends around that and the tailwinds that, that's creating, that's really what's propelling our business. Certainly that -- and that's well into the future, what has to happen.

Got it. And then just from a regional perspective, I think there's been probably more uneven performance from a lot of industrial companies in Europe and Asia, particularly China. Obviously, you guys have performed better than that. I think there's a lot of nuance there in terms of HVAC, but what are you seeing on the ground in each just from a macro perspective? And is basically all the outperformance, just the secular elements of your business? Or do you think there's something else we need to know?

We'll start in China. China represents about 5% of the enterprise revenue. Look, you're going to read a lot of headlines in China that the economy is slowing. When you peel that onion back a little bit, you're going to realize that it's in the residential space and retail. And that's not really where we play in China. We're in the applied space, and we're in the industrial segments, okay? So think of semiconductors, think of pharmaceutical, think of data centers, they're very, very strong, and that's really where we win. And about -- I guess, it's about 7 years ago now, we made an investment in our direct sales force in China. We built that out over several years, and that's paying tremendous dividends right now. We're able to meet with end customers. We're able to meet with architects, engineers and have them understand the value proposition that Trane Technologies brings, and you see it in our results. In Europe, you could call Europe markets a lot of different ways, but I think of them as flattish over really an extended period of time. And you see our results, and we're winning there with innovation. And on the commercial side, we've really kind of changed the game as to how conventional heating and cooling happens in a building. And I know [indiscernible] you probably heard me say this before, but a conventional way of heating and cooling of building is you would have a cooling side, right? We'll call that a chiller, you'd have a heating side, we call that a boiler. Those two systems would -- in the history, would just operate independently. And what we did was we rethought that. We said, let's combine it into one system. And we basically took a heat pump. I think we all know how a heat pump works. But when you're heating a space, you're actually removing -- and when you're cooling a space, you're actually moving heat from it. What do you do with that heat? You vent it out into the atmosphere. At least that's the way it was done in the past. If you want heat, you go to the ambient air outside and you bring it in, right? That's the way a heat pump works. So we started with a heat pump, then we went and said, "What about simultaneous heating and cooling?" Many times in a building like a building like this, you often need heating and cooling at the same time. I've been in thousands of mechanical rooms in my career, and you often see the boiler running and the chiller running. Oh my gosh, right, what a waste, right? Why don't you reuse that heat that's being created, don't vent it out into the atmosphere, use it where it's needed. So we took simultaneous heating and cooling and combined that in the system. We have a cascade technology, which is a little bit more complicated, but it allows these systems to operate anywhere in any geography, whether it's very cold or very warm, they're very efficient, and then we have sophisticated controls. We call that a Thermal Management System. It operates as a system, 3 to 5x more efficient than the conventional way of heating and cooling a building. That's one of the reasons why we're winning in Europe, right? We have a technology that's -- it's a competitive advantage for us.

So I think this is a good dovetail into the next question I have, certainly something we've been thinking about a lot the last few years is just how much the commercial retrofit market has changed. I mean we used to be sort of slavishly devoted to like what is the ABI doing or what are Dubstarts doing? And those things haven't seemed like they've mattered for commercial HVAC for, I don't know, maybe like 4 or 5 years now. Maybe just talk through some of the different elements. I mean the things that kind of come to mind for me are digitization, IoT. You talked about the electrification of heat, you got indoor air quality. I mean, where are you really seeing sort of that torque on the payback periods? What of this is maybe a little bit more fluff and overblown, something that could still be on the come, like it's sort of open-ended deliberately. But the market changed a lot, and you guys are in a position to say, like, here's what really matters, here's what's still coming.

Yes. I think I'd start at a high level and say, what does the replacement look like in the commercial space? And in the Americas, think of it as 65% to 75% of revenue. I think in Europe, it's a higher number. Think of it more in the 80% to 85%. And in Asia, it's actually a lower number as that is a newer infrastructure. Yes, you're right. Efficiencies have certainly improved. I think at the list -- one of the things that I think I'd add to your list is just the efficiencies in the products today versus what was manufactured just a very short period of time ago. The products today -- many of the products we're producing today are anywhere between 60% and 70% more efficient than they were 7 years ago. So think about that. When you want to look at total cost of ownership, you should look at the amount of energy that's being consumed by the product that's in place. And that's all tailwinds for this replacement process, right? And if you couple that with the mega trends around sustainability and decarbonization and the journey that many leading companies are on, those are all adding and becoming even greater tailwinds for our business.

So I want to pivot that into service, because I think importantly, you guys don't talk about service in the context of backlog, not in there. I think with all the things that we just went through in terms of drivers, the service intensity gets higher, just sounds more complicated, right? Like you can't go to the local garage to get your oil changed. You got to go to the dealership where they charge you 4x as much, like...

Well, I don't think they charge that much.

But I think like there's -- certainly, this digitization element that crowds out some of the smaller players. Like how do you see that evolving? How big are these sort of the independent guys today that you see in the service market? Like I'm assuming they go much lower over time in terms of share. But how do you guys characterize that?

Yes. I mean it's a great question, and I love our service business. It's a big part of what makes us different as Trane Technologies. I'll start there. And by the way, our Service business has had exceptional growth over a long period of time. So think of it as our Service business has grown at high single-digit rates on a compound annual growth rate for 6 consecutive years, and that includes a pandemic year. So your question on digitalization and how that's impacted, we love to be connected to our assets, right? We love to be able to understand how the building is performing, how our particular asset within the building is being -- is performing. And I would tell you what's transforming in that is something is now not working properly when it's using too much energy. So it's a different concept. 7 years ago, we used to think about being connected, so we could be more optimal on dispatch of our service technicians. So they know what's happening in the building before they get there. That's all goodness, and that still happens. But today, the mindset is the asset may be using more energy than is required, why? And we have sophisticated algorithms or AI tools for structured data that we've been using for years now that really allow us to fine-tune that. So we know building X is operating inefficiently. We probably even know the why, we'll then go to the customer, we'll proactively help get that building operating more in an efficient manner. So that's one on service. The other is, is I explained that heating and cooling, right? We don't do a lot, we don't do any service work really on boilers. Well, when you combine that now into a system where the boiler is no longer part of it, we now have our service technicians being leveraged 360 days a year, right, in both, heating -- peak heating season as well as peak cooling season. So it really allows us to expand our Service business to even a greater extent and our Service business is -- and I know I don't talk a lot about it for a lot of reasons. But we have a very sophisticated business operating system that we use around our Service business; how we hire technicians, how we train technicians, how we educate them on new products that are coming to the field, how we get their input on new products that are in the pipeline, so that we can make sure they're more applicable to the problems that are real in the world. So our Service business is a big part of what makes Trane Technologies a success, and we're going to continue to leverage it as we do today. And remember, our Service business and our commercial HVAC space in the Americas, thinking about 50% of the total revenue is Services. And in Europe, it's about the same. Middle East is a bit less and in Asia Pacific, it's a bit less. But these are -- this is a big business for Trane Technologies, all in, 1/3 of the revenues, right? All in, it's 1/3 of our revenues as a company.

So you mentioned backlog and sort of the confidence with exiting backlog still being at super high levels. Obviously, supply chain and sort of the desire to make sure people were in line, supported a lot of backlog growth. But a lot of things have happened since then. Has there been any complexion change underneath the surface? We're seeing more mega projects. Is there more bidding intensity, more competition? Are projects getting bigger? Anything you could sort of tell us to be able to, I guess, qualify backlog a little bit more rather than just say, hey, the numbers are big.

Sure, want me to start?

Sure, go ahead.

Well, first off, look, it's growing, right? And it's really from a complexion perspective where we ended the end of 2022 at $6.9 billion of revenue. At the end of June, it was $7 billion of -- the $6.9 billion of backlog, $7 billion of backlog at the end of June. So it's up $100 million, but it's really all the growth is in commercial HVAC. We're seeing the normalization of residential HVAC, and we haven't opened up the order books for the Thermo King business yet for 2024. So you're actually seeing growth in the backlog really from a commercial HVAC perspective. And Dave mentioned before, we had high teens revenue growth in the Americas and in Europe in the second quarter. Over 40% growth in Asia in the second quarter, and we're still able to deliver at a very high level, absolute bookings levels that are very, very strong, really driven by the commercial HVAC business. At the end of the second quarter, $7 billion of revenue, 2 -- I keep saying revenue, $7 billion of backlog. $2 billion of that is setting up for revenue in 2024. And that's 5x normal that we would have middle of the year to have backlog build already for the subsequent year. So it's already starting to give us, Josh, a lot of visibility into 2024. It should be very healthy growth. The makeup of the backlog, it really has always been very strong in commercial HVAC. Now at the end of the second quarter, think of that as 95% plus of that backlog is really coming from commercial HVAC and a bit from the Thermo King business. So yes, you're starting to see some of the mega projects come into the backlog. That's really not impacting revenues this year. That will be in the future. But I think we're very early innings in terms of the mega projects, in terms of what's hitting our backlog through the second quarter.

Yes. The only thing I would add is on the mega projects, and by the way, I'm not necessarily sure what a mega project is but we've defined it as any project that's $1 billion or greater. So we'll set the standard on how to define it. But look, and these are complex projects, right? So you asked the question: Are they more competitive? They are more dynamic, right? So you often have, and I think on the second quarter earnings call, I used it as an example, a fab plant that was being built in Texas, the owner was in Korea, the engineering firm was in Seattle, Washington and the GC is in Texas. You need to be able to be nimble enough to make sure that you're calling on all those influencers and to be able to explain the value proposition that Trane Technologies brings to the solution. And we have a global direct sales force that is a competitive weapon when you start thinking about how do you close mega projects. We have what we call, it's part of our operating system, it's called critical to close process. And it used to be it was designed, and I know this because I ran the Americas business at one time, it was designed in the Americas. I was like, no, let's expand that. We're a global business. And these mega projects often touch many different influencers around the globe. So you'll often -- if you ever went to one of our sales offices, you'd often find these critical to close [ wall ] rooms where they're working on different projects, and it would be people dialing in from around the globe and understanding what the dynamics are and what's happening in a fab plant or in an EV battery plant. And how do you -- who's doing what, who are the influencers, and how do you be able to make sure that your value proposition is known? It's a very -- it's a great competitive advantage we have as a company, having a direct global sales force.

Got it. I want to pivot over to resi for a little bit, because there's a lot of different pieces going on here, maybe hard to isolate some of them. But you mentioned normalization. I think zooming out a little bit, the next 2 years seemed to be like pretty big tailwinds. I guess from the regulatory side, the big refrigerant production curtailment next year probably has some virtuous impact on price, probably has some virtuous impact on replacement just given that repair is expensive. And then we have the R454B in 2025. I mean we heard from someone else earlier today, it sounds like each of those are maybe double-digit tailwinds in each year. I mean, maybe premature to thread the needle on the exact points. But what's the context that people should have for what leaks out of that? Because it seems like there's some pretty powerful drivers.

Yes. I think the Residential business, you've kind of hit on the points there. It's pretty dynamic as far as what's going to happen and what's going to happen over a transition. I think everyone is aware of the fact that we're going to be transitioning away from the predominant refrigerant that's used today, which is 410A into a new refrigerant that's a lower global warming potential. The majority of the industry will be using 454. It is classified as a slightly flammable. I know that sounds like an oxymoron refrigerant. But when you do that, obviously, you need to put different sensors around the equipment to make sure that it stays safe. So if there's ever a leak, the system will shut down. So it will prevent any catastrophic event from occurring. With that said, there are several elements that fall into place. One is you need to be ready as a manufacturer, okay? How do you charge these units? How do you apply 454 in your manufacturing locations? There's a lot of safety that's required there. There's a change in the product in most cases to accept the new refrigerants. And then you get into the: How do you train the channel to make sure it's ready? How do you make sure you manage the phase in, phase out of the activity that's going to happen. You mentioned the refrigerant, yes, 410A is going to go up in price, right? And that price will be passed on to the consumer. I would assume it to be margin neutral, it will happen in 2024. And then when you get into 2025, you now have all these sensors and other parts of the equipment that need to be embedded. That will be another pricing, because we don't have that dialed in as to what that's going to exactly be, but it will be a price increase. The product will be more expensive to manufacture. So there's a lot going on there. But if we just take a step back, I don't -- I think last year when I was here, we were talking about Residential business. And people were asking me, well, what do you think of Residential? Could it go down? And I kept telling people that, look, Residential is 20% of Trane Technologies, right? And if it went down by 10%, it's a 2% tailwind for the enterprise. And I think I had a lot of people that were a little bit suspect on that. Well, look what happened in the second quarter with our Residential business. Our revenue was down high -- low teens, and our EPS growth as an enterprise was 24%. So we're not just a Residential business, okay? We're a big commercial business, a big service business and -- which were really a balanced diversified portfolio in the HVAC world. And you hit on what are the tailwinds behind Residential? Yes, we certainly have these regulatory changes that are happening that we're more than ready for, we'll lead some of that. You also have some policy that's going to be taking effect, IRA. I wish I could quantify that for you. I don't know all the rules yet, so it's very difficult, but it will be a tailwind for our business. With the breadth of our portfolio, regardless of what the final rules are by state, we'll have product in our portfolio to fulfill the needs for the IRA, the rebates that will come.

So you anticipated my next question on the IRA front. And maybe resi is a fine place to start with that, because we're still on topic. It looks like at the low end, the $2,000 tax credit I think pretty much everybody can get. Does that cover most of the difference from what you've seen so far and the rule making between kind of straight cooling and the heat pump equivalent?

It will cover some. I mean there's a whole -- there's a lot of dynamics associated with putting heat pump -- if you don't have a heat pump -- say, you have a conventional split system in your home, you want to go to a heat pump, that's great. There's a lot of benefit there from an efficiency standpoint, there's a lot of benefit there from a carbon footprint standpoint. It also requires a different way of energy, electricity in your home. So there could be some rewiring that has to take place, and that's a cost, okay? You have the cost of the system that's been more. You have the cost of the wiring in your home depending on how you're -- the amperage that your home kind of want to get to detected, but the amperage that you could accept in your home. I gave an example earlier. Remember when you were -- at least me, I was a kid, and my mom used to send me out to put the Christmas lights out and you'd say, go put the Christmas lights on. And I would always say to take shortcuts, and I plug them all together, so I didn't have to run different extension cords. And guess what happens when you plug them in? They all go out, right? Because the amperage makes the fuse blow. Well, it's the same concept in your home, right? A lot of homes are built with 100-amp panels. So if you have a dryer, which most people do, you have an electric vehicle, which a growing number of us have. And then you all of a sudden have an electric makeup unit that you use for your heat pump, you could start to be above 100 amps, if they all go on at the same time. So there's a lot of infrastructure stuff that happens -- that has to happen there. But at the end of the day, it's going to be a tailwind for us, IRA. There's lots of different products in the portfolio. There's lots of different ways to solve the problem that I just discussed. But it's also going to be an opportunity in our commercial business. And I know the headline always goes to Residential. But in the Commercial space, it's going to be the extension and enhancement of a tax credit called 179D. So that will happen. And there's also some talk there about potentially including thermal storage systems. So this is where you have ice storage, which we're -- we have a lot of systems where we use thermal storage capability. So there's going to be potentially a rebate for that. And I always say potentially, because the rules aren't final. We're working with many up in Washington, D.C. to try to get this right for, not only for us, but for everyone in the United States to make sure that we can have the biggest impact and the most desired impact that we want to help us decarbonize the homes around the world.

When you talk about the commercial incentives for IRA, I think there was like a tripling of the tax credit per square foot. I think for those of us who don't do a lot of HVAC spec work in our own lives, what is $5 a square foot relative to $1.88 or whatever like? Is that a big move? Does that cover a lot of what you guys provide?

It's -- the square foot, it's basically saying that from a baseline, if you can improve the energy per square foot, you're going to qualify for different portions of this rebate. Again, we don't have the final detail on how that's going to work. But it's a tax credit that they call 179D, okay? So it's been around for a while. What they did is they enhance that. So think of it as doubling the prior enhancement. It's not quite double, at least from what I understand right now. So that's what it is. And yes, it's meaningful, for sure. I mean, look, the systems that we're producing today, by definition, are significantly more efficient than they were 5, 7 years ago. So it's -- you're going to be able to hit those hurdle rates, and it will be a catalyst to help grow some of the commercial -- another catalyst in our commercial business.

And maybe just putting the policy context that we just talked about in the context of what we've already seen with things like ESR, is there going to be a transition that folks noticed that, okay, ESR rolls off and ships. And you've worked through that opportunity and then transition into IRA or into something else. Is there -- is that a step down? Is that a step up? Or is it just, hey, there's so many policy tailwinds that disaggregating them is academic like...

It's a great question. I guess first of all, ESR funding is going to be around for a while, right? We have another -- there'll be at least another 1.5 years of ESR funding that's going to be available. So that will continue. I always tell people ESR is in the middle innings, okay, of being used. And I think it's a great program to really increase the efficiency and the health of schools around the country, okay? And it was a great program that we certainly -- I've seen a lot of benefit from and more importantly, students have seen a lot of benefit from. Yes, 179D or the IRA, it will be -- it won't be as large as ESR. So don't assume that, but it will be an additional tailwind. And I do believe that there'll be other policies that will help us decarbonize as a country and as a world. I mean these policies that are becoming tailwinds for our business are not just here in the United States, they exist in Europe, and they exist in Asia. And it's just another one of those tailwinds that people always ask me, well, how do you continue to deliver such high results? Well, that's one of it, right? The tailwinds on policy is one, a direct sales force is another, having a service organization that's robust, that's vibrant, that's growing is another. So it's a great time to be the CEO of Trane Technologies.

Education is 1 of 14 verticals we track Josh, right? So as one is accelerating or multiple are accelerating and we're fairly diversified across that group, it gives us an opportunity to direct sales force for them to go pivot. Commercial real estate, well understood that it's maybe not the biggest inflection point, but we track, and we are well diversified across other 13 as well. And that's where we're just seeing that balance of strength.

So I want to pick up on 1 of the other 13 that's rising and important lately, data centers. Obviously, the cooling load and some of these high-performance data centers are just significantly higher than certainly a commercial building, but even kind of a traditional data center. Maybe [ reinforce ] for me what that opportunity looks like for Trane, to the extent that you guys know, I know it's still early days.

Well, I think data centers are -- is a very strong vertical for us and by the way, it's actually included in the office vertical. But we love working with data center customers, okay? They're very innovative. They're very well -- they have lots of great ideas and they like working with us, because we're very creative, and we come up with solutions that are different than maybe what we've had in the past. There'll be a lot of innovative thinking that has to go into data centers when you start thinking about graphic process units or GPUs, right? They do -- the way their boards are designed, there's a lot -- there's a higher concentration of heat. And we're looking at different technologies that are novel in this space, that can really help transform and become an efficient way of cooling these data centers, that are going to have, as you said, significantly more heat than traditional data centers. So we made an investment in a company called LiquidStack in the first quarter. It's basically -- it's -- we submerged the racks actually into a dielectric, which is a liquid that doesn't conduct electricity, and it becomes a very efficient way of cooling. It's a two-phase process and that go into a lot of details. But look, it's early innings on those types of technologies, but that's where we, Trane Technologies, love to make investments to understand and get our scientists working with their scientists. And we think there's a lot of opportunities. And we actually have some of our data center customers looking at that technologies with us as well, because it's the solutions that exist today, we need to innovate for tomorrow and this high heat requirement is really kind of becoming a factor that's kind of expediting that innovation that has to happen in data centers. And we've been a leader in this space for a long time, and we'll be a leader, well into the future.

Excellent. Well, I see we're at time. Dave, Chris.

Yes. Thanks for coming, everyone. Appreciate it, and look forward to talking to you many as the conference continues. Thanks, Josh.