Trane Technologies plc (TT) Earnings Call Transcript & Summary

It's my pleasure to have up next Trane Technologies' Dave Regnery, Chairman and CEO; Chris Kuehn, CFO. So thanks very much for being here, Dave and Chris.

Maybe first question just around -- I think people would have been surprised clearly at the booking strength at Trane, particularly the last 6 months as you've seen sort of broader nonresidential starts and so on in different regions soften a bit. So maybe help people, just high level, understand some of the main drivers of that outgrowth for Trane and how do you see the sustainability of that?

Yes. Well, thanks, and thanks, everyone, for being here today. We're glad to be here. You and the team always do a great job here at Barclays. So we're always glad to be here. You have great food here, too, I wanted to let you know. Look, we ended the year with a backlog that was equal to what our backlog was at the beginning of the year, that being $6.9 billion. I will tell you that the composition of that backlog has changed over a year. And we had about $1 billion move from Residential and Thermo King into Commercial HVAC applied. And we are seeing tremendous growth within our Commercial HVAC business. It's really on a global basis, and there's some verticals that are very, very strong right now. We track about 14 different verticals. Now if you look in AHRI, if you look in Dodge, you may not find 14 verticals. We tend to subdivide some of the verticals like office. But areas where we're seeing a lot of strength, which is really helping to drive our backlog and our order rates, are in areas like data centers, high-tech industrial, education, health care, all very, very strong verticals where you are required -- the solution typically requires an applied solution. So -- and that's a sweet spot for Trane Technologies. So these are all highly engineered. Our direct sales force following up end customers helping to sell solutions, not just products, but solutions to these end customers. So this is a sophisticated sale that we do with our direct sales force. It's highly technical and can have those conversations. So that's where we're seeing the growth. And I think the advantage that we have is with the direct sales force, we're really able to run to where the opportunity is. And it's not going to be in traditional office, at least it wasn't in 2023, and we think that's going to be a tough vertical again in 2024. But we will go to where the opportunity is, and we have the opportunities to do that.

Perfect. And on that point on kind of backlog strength in applied HVAC, are you expecting kind of the year ahead to be similar book-to-bill, let's say, at least 1x? Or just give me -- again, it's very tough comps now.

Yes, we have very tough comps. And we've said for a long time now that backlog will normalize over time. We could argue about what the time is and what normal means. But I would say that our backlog is going to be high for an extended period of time. And last year, for those that remember, I was trying to signal to everyone that we were going to go into 2024 with a very strong backlog. So we said that, look, the backlog is going to be at least $6 billion plus. Now everyone forgot the beginning of that sentence, and they just remembered the $6 billion for the last -- I think it was the last 9 months of the year, I answered questions about, mathematically, how do I get to $6 billion. And I was like, I'm not saying I'm going to be at $6 billion, I'm going to be at $6 billion plus, but the concept here is we're going to have a very strong backlog going into 2024, and we obviously did. So I won't say a number, but I would tell you that we're going to have a very strong backlog going into 2025.

Yes, that's good enough. One of the areas of pressure, as you said, there's 2 areas of pressure in the backlog the last year, Residential and then Transport Refrigeration. So maybe sort of touch on Residential first as a mix of direct and distributor channels. How do you see that distributor channel inventory level today? When do you think you can sort of come out of that overhang or headwind of distributor...

Sure. Well, Residential, just to remind everyone, is about 20% of our business. And by the way, I'll start with saying that this is a great business, and we really like this business. And over time, we see our Residential business being a GDP-plus business over time. To answer your question, Julian, we're about 50% 2-step distribution, we're a 50% 3-step distribution. So with a 3-step distribution, we're selling to an independent wholesale distributor, who sells to a dealer, who sells to a homeowner. That's where we have inventory that's been in the channel. At the end of the third quarter, I told everyone that I believe that the destocking would be completed in the fourth quarter. And I was wrong, okay? I think there's more destocking to happen in that channel. I think it will continue certainly through the first quarter and probably into the second quarter, but we'll see how the year plays out. Obviously, peak season doesn't start for a while. So we'll wait to see how that -- that trend that kind of is in front of us, we'll see how that plays. But I would also tell you that the -- for the full year of 2024, we're calling Residential to be flat, okay? Could it be plus or minus 1% or 2%? Sure. But we're calling it flat, and that's what we have modeled into our guide for the year, and we're very confident in our guide.

How do you see the sort of final demand or the consumer side in Residential? Is there any kind of fatigue from paying up high prices? Or do you think that overall demand, leaving aside destock/restock, is final demand kind of very solid in resi?

It's a great question. I think there's a lot of variables there. And if you listen to the evening news, you'll hear all the bad news. Okay, I don't think it's that bad. But we always look at what we call sell-through, and that's what's actually getting to the end consumer. And it hasn't been horrible, okay? It hasn't been as strong as we thought it was going to be in the fourth quarter, just to be clear, but we'll see how it plays out. It's really -- we won't really know until we get into peak season. So let's wait until April and May. We'll see how the season starts, and we'll see what demand is. I think there was also some confusion, too, in the resi. I won't spend too much time on resi today, but there was a lot of confusion at the end of the year, right? There was this EPA ruling, which was what's the sell-through period going to be? So we had some independent wholesale distributors got a little bit nervous about that. That's been now clarified by the EPA. So you now have until the end of 2025 to sell-through 410 product or older product. So I think that's kind of a burden that's been lifted, and we support that decision by the EPA.

Perfect. And on the transport side, how are we thinking about kind of typical downturn there, duration or magnitude?

Yes. The Transport business, again, a great business, okay? We love it. I had the opportunity to run it for a long time at one time in my career. Look, it's more cyclical than HVAC. And a downturn started there, we could say, in the back half of 2023, certainly the fourth quarter, which was even weaker than we thought it could be. 2024, we've been very clear, we see the Americas, the market will be down 10%. We'll do better than that, which, by the way, we've been better in our Transport business for a number of years now. In Europe, it will be down, think of it as mid-single digits. Again, I think we'll do better than that. The good news is that in 2025, markets are projected to snap back. And we'll see. But it's a great business, and it's -- I had the opportunity right after our fourth quarter earnings call, I got on an airplane and went to the Thermo King North America dealer meeting, right? So we have all of our dealers together. And you could see that they were all very concerned about the year in front because the forecast is to be down. And it was funny because when I ran the business back in 2008, if you go back in time, what was happening in 2008? It was called the financial crisis, right, the bubble, right, real estate bubble. And you would have thought the world was ending. And I told them back in 2008, 2009, I said, look, we're going to pay attention to 3 things: we're going to pay attention to the customer; we're going to continue to invest in the business and to be innovative in our business; and we're going to make sure we have the right culture for our people. And those are the 3 things we're going to work at. So I was speaking to them, and I reminded them as to what I said in 2008 and I said, so I have 3 words to leave you with. As we go into 2024, let's pay attention to the customer, let's make sure we continue to innovate for the business, and we're going to always pay attention to our culture to make sure it's a great place to work. So look, this is a great business, it really is. I've been in it for a long time. It's more cyclical. It will snap back, and it's a great part of our portfolio.

Great. And then firm-wide, there's always discussion about sort of price versus volume, particularly in HVAC. Your price assumption for the year looks low perhaps to many people. Maybe just any sort of context around that and industry competitive discipline.

Sure. I'll let Chris get that one. Go ahead, Chris.

No, thanks, Julian. Yes, we guided to 6% to 7% organic revenue growth, 7% to 8% reported growth for 2024 and throughout an early estimate of around 1 point of price and think of that as primarily carryover from 2023, and we had some announced actions in the fourth quarter maybe through early January. Look, it's not a cap. It's a starting point on the year. We like setting targets that we can meet or exceed throughout the year. So could the price be a little bit stronger? Could it be 2 points? It could be, and we'll update investors as we work throughout the year. But what I would tell you is the business operating system at the company really has improved over the last 5 years in terms of the nimbleness around price. So as we see cost inputs today being fairly, let's call it, tame around the Tier 1 other than maybe steel, Tier 2 is inflationary, wage inflation would be a really strong example there. Refrigerant inflation would be an area there. We're making sure we're pricing effectively for cost inputs, and that's where we need to remain nimble. We're pricing for innovation. Dave talked about the transport portfolio and investing the same in the residential portfolio, investing, we're making sure we're pricing for innovation. But then last but not least, we need to make sure we got a customer for life, right? So we're going to make sure that we're pricing effectively. And as we think about Commercial HVAC systems and the backlog that Dave talked about really shifting to applied systems that have long service tails that can bring 8 to 10x the amount of revenue over the life of that service contract or agreement versus the original cost of the equipment, we want to make sure you have a customer for life there. So we're not hard capping it at 1. Let's see how we do throughout the year.

Perfect. And maybe on the commercial HVAC side, there's different definitions, I guess, of what light commercial means. But I don't know, how would you characterize that cutoff? And is there any kind of split you could give us on applied versus light?

I think in 2024, applied is going to be a lot stronger than unitary. I think we saw the same phenomenon happened in 2023. It's always different. I know that there's a lot of different definitions out there, which always makes me nervous about what you can consider light versus large. And it's always difficult to say, well, what's the compare look like in the light side versus a competitor, and there's all different variables that go in there. Some of the light product is actually stored or stocked in IWD. So it's very confusing. At the end of the day, look at light product that's less than 25 tons, look at large at greater than 25 tons in unitary. But I would tell you that we don't look at it as a product level. We don't forecast it at the product level other than through our SIOP process to make sure our manufacturing is smooth. We look at it as selling solutions to customers. And when you have that type of perspective on how you take care of a customer, you're agnostic as to the product that you're going to use for the solution. You're more interested in the outcome that the customer is going to see. And that's kind of how we approach it with our direct sales force.

When you look at the applied business, I think something that Trane did earlier than most was a lot of sensors packed into equipment, every piece leaving the factory. Have you seen kind of utilization of those sensors, that data, whether yourselves or the customers? How has that evolved the last 5, 10 years, let's say?

Yes. I mean we were probably one of the first out there with what we call at the time, I'm not going to take credit for this marketing because I didn't agree with it, but Factory Mounted Controls. I think that has a different nomenclature than what we're really doing here. But yes, we put a lot of intelligence in our product early on because we had this vision that said, look, we're going to be able to get a lot of data from our products, and we're going to be able to make the asset perform the way it was always designed over time. And 7 years ago when I made that decision, it was sort of like I didn't know exactly what it was going to be, but I knew it was going to be a big idea. And here we are in 2024 and we're connecting more assets. We hired a Chief Digital Officer, and I was saying that we had 2 million connected assets. And he came to me and says, Dave, I think your number is off by a factor of 2. We have like over 4 million connected assets on a global basis. But at the end of the day, it's not how many assets you have connected, it's the data that you're deriving from those assets, and then how do you use that data in a structured way to make the asset perform the way it was always designed and/or improve it. So it's not just about predictive to say, oh, what might happen, when will this fail? That's part of it. Sure, there's goodness that comes there. It's really about the data and then being able to compare that to others to make sure that it's, in fact, optimal. I always tell people that our service business has moved from -- 10 years ago, it used to be break/fix or we wanted to be connected to an asset so we can reduce truck rolls, right, so our service business can become more efficient. And that happens. But really, what it's about is how much energy is being consumed by the product. And that's where the -- if 40% of all the energy in a building is for heating and cooling, that's where the opportunity is. And myself as well as a lot of other people had that foresight 7, 8 years ago to really build all this intelligence in. And we're, to be fair, we're winning in the marketplace today because we have this data, and we're able to take the data and turn it into useful information for our customers.

When you look at the -- that aftermarket portion of the large commercial business or the applied business, how much of that, if it's possible to say, or what's been the increase in the portion of it that's tied to more contractual or recurring?

Yes, I mean it's a difficult question. But first of all, if we sell an applied system, these systems are under some sort of warranty for a period of time. And depending on where you are in the world or depending on if you buy an extended warranty, that could extend it. During that time, we're connected to the asset. And we want to be connected to that system because, obviously, we want to make sure it's performing the way it was designed. And as then -- as the warranty period would end, we're back with our direct sales force again showing the value of what it's like to be connected to an asset. And you might -- I was asked the question earlier like, well, these are new systems, of course, they're going to perform. You'd be surprised, right? And it's all not -- it's not all mechanical that goes wrong with the system. There's a lot of human interface. Take a building like this, think about all the people that override different programs and they don't even necessarily know what they're doing. And all of a sudden, now they've got a system out of balance. We're able to detect that now and we're able to fix it. Sometimes we could fix it remotely or sometimes we have to come out and readjust what's done. So anyways, there's a lot of value in being connected. We're going to be connected to every system that we put out there, and the customer wants us to be. And obviously, they see the value in it. A great example was during COVID, right? Remember, the health care vertical, very strong for us, connected to a lot of assets there. You couldn't even go see someone in the hospital if they were sick, right? You couldn't even get access. Well, they sure as heck didn't want HVAC technicians in the hospital. But because we were connected, number one is we were able to fix a lot remotely. Number two is we're able to diagnose what could be wrong before we got there. So it was much -- the time there was reduced. So they saw a lot of benefit in that, and that actually has helped propel us too, at least in the health care vertical.

And are there any verticals specifically where you see a stronger uptake of that contractual element or element that's more tied to connected units or it's universal, most geographies, most verticals?

I think the more sophisticated the vertical, the more -- think about the more sophisticated the applied system that's being adopted, there's a greater propensity to want to be connected. So think of a data center, right, that's a great example of, yes, of course. Think of a hospital, right? A lot of sophistication goes into those systems, a lot of different elements of a hospital, right? It's not just the room, think about the operating room, think about the fresh air exchanges that have to occur in an operating room by code. All those, they want to make sure that that's performing the way it's designed.

One vertical, I guess, that there has been seemingly a clear benefit from stimulus is education. I think that has grown very well for you and your industry peers in the U.S. the last 2 or 3 years. Do you worry that maybe some of the ESSER funding plays out, the program ends, that vertical comes under some pressure in a year or 2? Or do you think there's enough spending there?

Yes. I think we have certainly benefited from the ESSER funding, okay? And by the way, the education vertical is 1 of those 14 verticals that we track. And we've always been very, very strong in the education vertical. It's a very large vertical. ESSER funding is going to be with us now until, I think, we're going to have to install the product, the least I saw was by the first quarter of 2026. So there's still some time there. As far as if ESSER funding end, does the vertical stop growing? I think the answer is no. I think there's a lot of -- you think about municipal bonds and the appropriation of those bonds, and there's a whole mechanism there that keeps that as a very, very strong vertical, not just today, but it will certainly be strong in the future. The ESSER funding, if you remember, a long time ago, we were -- I was probably up here talking about indoor air quality audits. Remember those days when we were talking about during the height of COVID? Maybe I was talking remotely because we were probably on a Zoom call. But -- and we took those audits and then we basically created road maps for superintendents to make their schools safer for the students that were learning there. And that's why we were able to get a jump start on ESSER. We already had the road maps for many of these school districts across the country. So it was just about implementing that. I would tell you that, that work continues, and this will be a strong vertical, not just today with ESSER funding, but also into the future.

And then I think one topic of discussion among investors is HVAC, in theory, should have been the beneficiary of the Inflation Reduction Act. It's debatable how much is actually happening. But I guess, where do you think we are on the scale of that tailwind? And I guess the concern would be, if you get some dismantling of pieces of it in a year or 2, any concerns there?

Yes, I think that IRA is still alive, okay? It's still well. We are seeing benefit today. The tax credit portion of that is actually happening. So think of it as if you're a residential and you bought a high-efficient heat pump unit, you could still get a tax credit. On the commercial side, you have 179D, a tax deduct that's alive and well, and it has to do with efficiency per square foot. So that's actually -- it has always been there. They doubled it, theoretically doubled it with IRA. So that will continue, okay? Now what hasn't happened yet is the state rebates. So that's where it's been a little bit slower than anticipated, which will be a tailwind for the residential business. We're still optimistic that, that will happen. If it doesn't happen because of for whatever reason, these projects -- these products still have really good paybacks. So it's not going to -- maybe a little bit of a tailwind goes away, but it's not going to be detrimental to the business.

Great. And then maybe switching to margins. Trane has been very consistent at driving growth in operating leverage over time. You have that 25%-plus placeholder there medium term. And for this year, it's a little bit of a step-down, not meaningful versus what you saw in 2023. Is that just a function of narrower price cost tailwinds or more investment? Any of the sort of the main moving parts there aside from volume leverage?

Julian, it's a number of things, but we like the long-term framework of 25% or better incrementals. It means that we're able to invest back in the business and really drive the market outgrowth. I mean the conversations we've had so far with transport and HVAC, I think we can see a lot of the outgrowth there, especially on the order front and then on the revenue side as those orders turn into revenue. But think of it as, look, price will continue to be less of a top line benefit, right? We saw that through 2023 with the first quarter over 6 points of price, and we ended in the fourth quarter just under 3 points of price. It's still elevated, though, when you think about pre-pandemic levels. We're in a range of, call it, 30 to 50 basis points of price a year, and we're guiding to 1 point and it could be better in 2024. So look, it's still going to be a bit higher, but that contribution from price and offsetting inflation will be a little bit less. The dovetail here is really around productivity, okay? Think of that as if you're hitting 2 to 3 points of productivity, you're talking about $300-plus million a year of gross productivity that the company is driving. And we're going to be able to ramp into that as our engineers and product managers who thankfully were spending a lot of time the last couple of years solving supply chain issues, and those have been largely resolved in 2023, Dave and everyone has been really pushing their efforts back into let's get back into value add, value engineering of the product, let's make sure we're getting the right cost for the product, let's lean out the flows in the factories as well. We've talked about this in the past, but it's highly inefficient when you don't have all your components ready to go when you're building that chiller. A 70% or 80% machine that gets taken off the line sits for a couple of weeks, components come in, you put it back on the line, you add the components on, you retest it, you're now getting it out for transport, that's really expensive to do that instead of the onetime through. So for us, it's really driving to, let's call it, $300-plus million of gross productivity, and we're going to be on that path in 2024 as we get those teams geared up again. But I'll tell you, the 25% incrementals, I think it's strong. It's going to lead to the strong bottom line growth. We're calling for 11% to 15% EPS growth in 2024. And it allows us to invest back in the business, start with innovation, start with automation in the factories, sales and service investments on upfront tools and people. It's really just going to be high returns there again for the investments. And we want to start early. That's why we got into the first quarter around 25% incrementals as well. The earlier we start those investments, the earlier the payback comes.

Perfect. And then on inorganic growth, let's say, the balance sheet looks on the outside quite under-levered, I just wanted sort of your characterization of it, how you see it? And then on the acquisition front, there's some things -- we've seen some of your peers do heat pump acquisitions, how appealing is that vertical, particularly as the market has come down a lot, maybe any thoughts around that specific area.

Do you want to start with the balance sheet, then I'll check the latter?

Sure. I hear you say under-levered; I say really strong. I'd say we have tons of optionality on the balance sheet. And if we saw the right opportunity that we needed to lever up for, we would. But I would tell you, we like the ability to be disciplined. We like the ability to do bolt-on acquisitions. And you saw us, in 2023, put about $900 million to work with 4 bolt-on acquisitions. And if I go back to 2022, late 2022 with the AL-KO acquisition, they're executing above business case, right? They're driving some of the growth you're seeing in Europe and the Americas as well. So we like that bolt-on strategy, and I think we'll continue to look for opportunities there, but we have a lot of optionality with the balance sheet.

Yes. And on the M&A front, look, as a major HVACR player, we're going to get to see everything. And as I've told this many groups before, look, we don't need to do anything, we love our portfolio, and we're executing at a very high level. But we'll get a chance to look at everything. We're going to be disciplined though.

Yes. When you think about reinvesting organically, what are some of the main areas right now that you're -- like if we look at, say, heat pump sort of air-to-water technology, like how big would that become...

Yes, well, I think we have a proven track record of investing consistently within our business. It's not about taking a period off or, oh, our Thermo King business is going to be down in 2024, let's pull back investments. That's a really bad strategy, and it's not one that we execute too. So we're the company that will consistently be investing in our business. And hopefully, everyone sees the results, right? We had very strong results in 2023 on both the top line and on the bottom line. And by the way, the quality of our earnings, and if you use free cash flow as the proxy for quality of earnings, has been very strong for an extended period of time. So look, we like our model. We're going to continue to invest in the business. We like innovation. We like investing in our channel, okay? By the way, because we're a direct sales force, that means we're investing in educating on making sure that our account managers are the best in the industry. We're always adding to that field. Our service business, we're always adding to technicians. We're always training our technicians. We want to make sure that they're the smartest than anyone else in front of the customer. So we pride ourselves in that. Those are investments that we're going to continue to make. We're also doing a lot in digital. You heard me talk earlier about 7 years ago, we had this crazy vision where we're going to go out and start [ censoring ] our products in different ways than maybe some of our competitors. We know the benefit that's derived there. That will continue. And then the last area I would hit on is factory automation. And think of factory automation, I know everyone has this lens that says it's about productivity. And yes, you're right. It's also about safety. We want to make sure that every job can be performed in a safe manner, and it's also about quality. And we've had great success in all of those. And when you think of productivity, don't just think of it going to the bottom line, think about adding capacity within your 4 walls. That's a great form of productivity that we get with automation. And because of the strength that we're seeing in the workforce, don't think about people leaving the Trane organization when you automate, think about it going to another role, and we're helping to train those and creating career ladders for all parts of our organization.

Fantastic. Well, I think it's time to switch to the audience response survey questions. First one, do you currently own the stock? Please use those gray boxes. [Voting]

This is where I get a report card live.

Well, that's fine. So fairly balanced, still maybe 40% no ownership at all. Second question, what's your general bias towards Trane right now: positive, negative, neutral? [Voting]

So generally very positive. Third question, around through-cycle earnings growth versus the, call it, multi-industry average. [Voting]

So almost all above peers.

All right, we got 0 on below peers. Thank you very much. I feel like...

Fourth question, yes, very wide spread there. What should Trane do with excess cash? [Voting]

So generally, buybacks and smaller M&A. Fifth question, what P/E multiple should Trane trade out on this year's earnings? [Voting]

So generally a premium to the market. And then last question is really around what is the main sort of fundamental headwind or reason for not owning more of Trane, it should be, I don't know why Fortive is up there, but this should be about Trane and nothing to do with Fortive.

We'll share with Jim the answer, if you want us to. I just love Jim, so I'll let him know how he did.

Please. Thank you. [Voting]

Okay. So generally, margins. So I think that 25% incremental is pretty conservative, but we'll see. So thanks very much, everyone.

Well, thank you all.

Okay. Thank you, Dave and Chris.