Trane Technologies plc (TT) Earnings Call Transcript & Summary

Well, good morning, everyone, and welcome to Oppenenheimer's 20th Annual Industrial Growth Conference. We're continuing the day here with Trane Technologies. I'm very pleased to be welcomed by the company's CFO, Chris Kuehn. Chris, thanks so much for being with us today.

Noah, thanks. Congratulations on 20th anniversary as well. That's great.

That's -- well, we're thrilled to have you as we run it back. I think one of the through lines certainly has been the strength of commercial HVAC for several years now. And I want to follow up our question on the earnings call last week by digging in a little bit more around how to think about payback periods for commercial HVAC. You maybe contextualize for us, what does the average payback period look like for a retrofit project today versus, say, 5 years ago? And then how to understand the drivers of the better payback. I mean there's got to be a number of factors here to consider. So maybe you can speak to both of those.

Yes. Thanks, Noah. I mean, paybacks are always a little dangerous because it always starts with what are you removing when you're talking about retrofit projects. But think about these assets that probably 10, 20 years ago, you'd assume they'd be in place for 30 years. The efficiency though, around these products have only improved significantly in the last 5 to 7 years. Think of it in terms of our portfolio, providing 50% to 70% more efficiency from just the products we sold 7 years ago. But payback, it's not uncommon to see a payback in the 3-year time frame. And that's before you start looking at maybe local incentives, local laws that can ultimately with our direct sales force who are local in nature, and they know what's happening in that city and state that they're in, leveraging as many of those opportunities for the customer to get rebates or incentives. But even excluding all of that, the paybacks are very, very strong. So 3 years is not uncommon, 4 years, 5 years even, but the paybacks are very strong, excluding any type of incentive.

And I think underpinning the strength, you called out the pipeline growing sequentially in 1Q even with record bookings. Maybe it's helpful for us to understand how Trane defines its pipeline? How it's constructed within the company? And how we should think about an average conversion times from pipeline into orders?

I mean I'll start with commercial HVAC. With our direct sales force, they're spending tons of time with the end customer, understanding what their specific project could be. But in many cases, it's a multiyear journey to look at all of the assets that our customers have or buildings that they have and working with them on a multiyear journey to decarbonize and upgrade equipment and drive that energy efficiency that drives the financial payback. But we'd start with an unfactored pipeline, right? All the projects that we know that we're involved in from a bidding perspective, then ultimately to a factored pipeline that would be based on a combination of probability and also timing and that's what we kind of measure throughout the business is the unfactored and the factored pipeline. And as Dave Regnery, our CEO described last week on our earnings call, we're seeing very strong pipelines remain through the end of April in our largest verticals and many of our broad verticals within commercial HVAC in the Americas. So whether we saw growth across the majority of verticals in the first quarter, we're seeing a number of those pipelines being very, very strong. And this is a multiyear effort, especially when you're talking about applied systems, right? It's not a very rare you having a conversation within 30, 60 days, all of a sudden there's an order. These are large projects that get negotiated over time, and having a direct sales force with the local knowledge, with the tie-ins globally to our direct sales force globally, you're able to call on the end user, the architect, the GC, the construction firm, ultimately, all the players in that space to stay connected to that project. So it gives us a lot of opportunity to improve that factored pipeline that then is driving into our bookings growth.

Can we understand a little bit more how that regionalized direct sales force works? I mean how does it map to -- does it map to specific areas? Does this map also to specific verticals, maybe that will help us understand how you get a strong visibility into the pipeline and get these win rates. Just to understand how you deploy the sales force to all these different opportunities within your purview?

Yes, I'll start in the Americas. And it's not dissimilar, say, for Europe. It really starts from a local city region perspective, direct sales force, they know what the local rules and local players are in that region, in that city. They know buildings by addresses, they know what that decarbonization plan can be for a building over many years. So that's really where it starts, okay? And they can jump across verticals and they do that all the time. Having a direct sales force and they know where the opportunities are, if Class B and C office space continues to remain fairly weak, which is what we see in office, they're going to pivot to another partner, a different vertical that ultimately is going to drive their commissions as well. The majority of our sales force is 100% commissioned in commercial HVAC. But then they're going to spend their time really in Class A office space. They're going to spend their time in data centers that are within many metropolitan cities that we may not know, but multiple floors of buildings could be data centers, they'll spend their time there as well. So there are some teams that could be a little more bespoke, like a data center team that we've had for years inside the company. But they can pivot from office to education to ultimately selling what is a solution. That's the key for us. It isn't necessarily a team that is only unitary or only applied. It's funny. We don't really talk about it always in those terms anymore. It's a solution that we're providing to our customer and what's the best product for them. And I see what happened in Europe as well, very regionally focused, country-focused and understands what the local needs and regulations are, building codes, for example, and then ultimately working with the customer to deliver.

And you mentioned kind of the shift from B and C office. I think the majority of verticals in Americas have reported growth in 1Q. Maybe you can talk a little bit about which verticals were a little bit softer. And what your sales force is saying about when they might return to growth?

Yes. I mean there's aspects of the office vertical that were softer, as I mentioned. But I was on a phone call last week with someone from the investor community that's looking at new office space. And they're looking at Class A office space, and they were talking about how tight the market is. And then the marketing for each of the buildings they're looking at was very much inclusive of HVAC, comfort around the space, air quality. We think that's a winning proposition when you're investing in Class A office space for your tenants, for the employees that work there to make sure that they're working in a safe and comfortable environment. Life Sciences was another vertical that we called out as being a little bit weaker. We've seen that for a couple of quarters. But as Dave said last week, we saw growth across the majority of our verticals. And again, that direct sales force, the ability to pivot to where the opportunities are is really part of the secret sauce of Trane Technologies.

And I think you messaged continued growth in data center and higher ed last week. And obviously, there's been a lot of noise from investors in those verticals. So a question around hyperscaler activity at data center, a question around the impact of federal funding cuts on universities. What do you look for as sort of the real demand signals in these verticals as you look through the balance of the year?

Yes. I mean we've, for years, done scenario planning with all of our business units, and we look at what are those early signs of red flags or even green flags and what we're seeing around various key performance indicators and different verticals, right? The order pipeline would certainly be an area that we'd look at, what's happening with conversion from orders from the pipeline unfactored ultimately to a booking, right? A couple of examples there. . But data centers, we -- through the end of the first quarter through the end of April, we didn't see any change in terms of the need for growth. A lot of external reports have talked about that being well over 10%, maybe mid-teens growth for the next several years. We don't disagree with that in terms of the growth in that space. So we didn't see any slowdown in that space. Education, some of the questions we've received over the last year or so has been with the end of ESSER funding. Does that change or have a dramatic impact on the pipeline, and we've not seen that through the end of April. Yes, the funding mechanism concludes in the first quarter of 2026 and you had to have your order in by September of last year to qualify for the ESSER funding. But what it gave with that ESSER funding was a lot of visibility to where schools are in terms of their upgrades and their need to upgrade. And not everything was solved and upgraded in schools with the first round of ESSER funding. So we see things are traditionally going back to the municipal bond market. You're seeing it even in my home state here in North Carolina and Charlotte where recent bond passages and part of that is going to school upgrades. That's where Trane Technologies really can win because we work with those administrators. We work with those school districts. And again, a perfect example of a multiyear plan you want to have with your customers to go upgrade facilities. So we hadn't seen any change in the demand appetite for those verticals.

Okay. And maybe talk a little bit about competitive dynamics in EMEA and APAC. Any change in the outlook for those markets since early April. I think in response to a question last week, Dave said, "Yes, China specifically has been soft, but it's moderately improving sequentially." So maybe talk to the competitive dynamics overall? And then I have a few follow-ups.

Sure. Yes, let me start with Asia. The Asia segment represents less than 8% of our enterprise revenues half of that would be China, half of that would be rest of Asia. And no different for Asia, EMEA or the Americas. We really have a spouse or in region for region model for well over a decade now. So our manufacturing plants in Asia largely supply the Asia market, same in Europe, same in the Americas. But if I stick with Asia, yes, China, we are in the third quarter now since we put in -- our team locally put in more tightened credit controls and credit policies, just making sure that we had down payments for orders and when those come through, making sure that there's proper payments throughout the life cycle of the project. That will anniversary really in the third quarter. So what I would say is a little bit easier comps coming to the second half of the year. But I would tell you that then China, just market-wise, has been down. It's been challenging markets here in China for a while. So we're not expecting much growth in China for 2025, but we have a great team locally, and they'll find the right opportunities where they exist. Rest of Asia has been very strong for us. So when you balance the 2 of them, we're seeing 2025 as being a flattish year for the Asia segment, but a lot of strength in rest of Asia. So that could be anywhere outside of China, including India and think again about them 50-50 from a mix perspective. EMEA, a really strong quarter, performed as expected in terms of revenue and margins. We can talk about great order growth in commercial HVAC up in the double digits, strong order growth in Thermo King with up high single digits for the quarter. And that's all about innovation. The markets there haven't necessarily grown in years, whether it be commercial markets or transport markets. We're expecting the transport market to probably be down maybe low singles this year, and we'll outperform because of the fact of the innovation that we've introduced into that market over the last 5-plus years. Commercial HVAC markets in Europe, we're creating the demand in those markets with the paybacks on the projects that we have. It's really a retrofit market, of course, in EMEA, just given the build out there. But we're able to convert and create demand based on the energy efficiency and products that we have within that portfolio. But we're very pleased with the EMEA performance in the first quarter, a lot of confidence in their growth and plans for the full year.

Okay. Can you just touch on what happened with pricing in EMEA in 1Q? Was what we saw a function of mix and seasonality or how should we think about kind of price in EMEA for the balance of the year?

Yes. The impact on the negative price in the first quarter was really in our transport business, our Thermo King business. And think of it as a mix of customer, customer mix in the first quarter, okay? Some large customers where pricing would be a little bit different than, say, on average. So I look at that as a 1-quarter impact. That's a region that's been able to get positive price for many years in a row. And also, we also focus on making sure we get cost out of our products to make sure we can be more competitive and maybe not as much of a price increase. But no, the dynamic in the first quarter was really entirely transport and customer mix.

That's super helpful, Chris. I want to ask you about resi HVAC before we get to margins and the tariff discussion. So you reiterated normalization to GDP-plus growth, mid-single-digit growth for '25. But you also called out, I believe it was $75 million to $100 million of elevated channel inventory at the end of the quarter. Do you have a sense of how much of that inventory is kind of 410A versus 454B? And really, how do you assess the readiness of the distributor and the contractor to support the 454B transition at this point?

Yes. I think for us, the transition with 454B and with our dealers, whether it be company-owned or independent wholesale distributors, we're roughly 50-50, Noah, in terms of how the sell-in works between those 2 channels. That's gotten relatively smooth. I think the ability for us to get last buy orders for the 410A product in the fourth quarter last year and then have a pretty quick switch over to 454B, we estimated around 80% of the volume in the first quarter was 454B product, really less so in the 410A. I think on the $75 million to $100 million of a little bit elevated channel inventory, it's probably mostly 454B. I mean the distributors and dealers have until the end of this calendar year to sell 410A as a system. After that, it's components. So I think those dealers are really trying to bleed down the inventory levels of 410A. No one wants to get stuck with the older product by the end of the year. But we saw 80% of our volume being 454B sell-in into the IWDs for the start of the year. But it's been a fairly smooth process and a lot of confidence on the mid-single-digit growth for the year. When we started the first quarter was up high teens revenue growth in residential and to get to mid-singles for the rest of the year, the average growth rate is low single digit Q2 to Q4. So I think we've derisked residential in our guidance that we gave out last week, just ultimately thinking that it's a mid-single-digit growth for the year. We'll see how that kind of plays out though.

Chris, thanks. I want to talk about some other markets and also about the cost structure. And we actually got this question, I think it's a great one. The 25% plus incremental framework for margins, it's a good place to be in as a company. But if we think about long-term margin trajectory, where could margins, whether it's operating margin or even gross margin go to? And what would be the drivers for higher levels, whether you want to think about it from a mix dynamic perspective? Anything that could lift margins outside of kind of productivity and operating leverage.

Well, the 3 immediately come to mind. And the first is going to be that productivity and making sure that we're taking cost out of our production processes and think of it as every year going in with productivity targets to offset other inflation. We want to make sure that we've got a positive spread price versus cost and then ultimately allowing us to invest back in the business. So first thing is there's always opportunities within our business operating system to take cost out, whether that's in the manufacturing plants or in the back office, we're always making sure that we're optimizing that type of spend. That being said, what gives us even more confidence on 25% or greater incrementals, and we say or greater because the last couple of years, acknowledge it's been stronger. But think about our services business. It's 1/3 of the enterprise revenues. It's predominantly linked to commercial HVAC applied systems. And with all the growth that we've seen in Applied Systems, which Dave called out last week, the 4-year revenue CAGR for Applied Systems in the Americas is 200% growth. So with 3x the level of revenue, what we saw just 4 years ago, that brings with it a very strong service tail. Complex systems need OEM service and services on average, have stronger margins than the average margin in each of our 3 regions. So services growth has been low double digits the last 4 years. It's been high single in the last 7 years, and we have a lot of confidence that service business can continue to grow, and that's a margin tailwind. And then third, I'd actually go to digital. The digital connectedness that we have with our products, a recent acquisition of BrainBox AI, which we have partnered with them for several years as well gives us a lot of confidence that we can provide digital solutions, more digital solutions to our customers to remain connected. And you want to be connected, Noah. The reason being is we know from the birth date, the commissioning date of a unit within a year, that unit can drift by 30% off of its intended use. And so keeping that unit back to its optimal commissioning date structure allows for less waste of energy, less cost being wasted by the customer. Let's bring that back to its intended use. And that's where a great service technician group works, but also remote connectivity, digital connectivity to diagnose problems before someone even shows up. And that remote monitoring allows us to do that with subscription-based revenues over time.

And Chris, just in this public forum, make sure that we're understanding your comment right. That's sort of up to 30% degradation, I mean I've worked in the industry myself. So I know it's -- that is an industry-wide phenomenon, right? There also has to be some element here of taking the data from the field and using it to refine product development to ensure that, that doesn't happen. So can you speak to that as well in terms of the learning cycles you're getting, whether it's from the connectedness or now BrainBox or any of the other investments you've made?

Yes. I think you're hitting the nail on the head, Noah. It's by being connected on a remote monitoring, it allows you to avoid that drift. If you're not connected, the chances are it will drift. And some buildings change with its purpose over time, right? What you thought the ground floor, second floor, third floor were going to be, they change, and you're not necessarily adjusting in some cases, what the equipment needs to do to keep up with that change. If you're -- if you have restaurants on the base level or if that's going to change in terms of their usage of energy, if you have a different tenant that's in there. So that's some of the examples of where it helps contribute to the drift. But I think that makes the point exactly why you want to be remote connected, customers that are multiple buildings in their portfolio like to see all of their buildings on a single pane of glass, and we have that opportunity to do that and have remote monitoring before even rolling a technician out into the field.

Cool. On cost planning and tariffs, I think your customers have to appreciate that you're prioritizing minimizing the tariff impacts via supply chain before turning to price. I think Dave emphasized that several times on the earnings call last week, so we all heard it. Maybe just walk us through the sequencing of that process. How do you go about determining when you've exhausted all possible supply chain measures and are going to pivot to pricing? And kind of how to think about how much mitigation versus pricing where we should assume for the projects in the pipeline?

Yes. It's an estimate for sure because the -- as we know, there's -- the rules continue to change as we kind of go week to week. So that's where we just need to remain nimble. And we've been here before in terms of dealing with inflation. Think about 2022, post 2021 with supply chain challenges and really significant inflation, Trane Technologies as an enterprise, we delivered 10 points of price that year. In 2023, we delivered 5 points of price. So we have the ability to price and surgically price here. We're leveraging our business operating system to do that, while at the same time, working with our suppliers, Noah, to then defray that initial cost. And the $250 million to $275 million is an estimate, right? It's a 2025 estimate based on the tariffs in place as of April 30, when we gave our guidance, right? So things may change. But the goal is to, right, get that cost down and then surgically price with think of it as up to price increases, up to x percent price increases that allows us to adjust that to really not make this a profit center. We just talked a lot about Applied Systems and long road maps with customers. We like having customers for life, and we don't think this is the right time to turn it into a profit center to ultimately stay gross margin percentage neutral. We're going to be gross margin dollar neutral is the plan and you'll see that more impact in the second half of the year. There's a little bit of impact in Q2 on tariffs, but we'll see if we can update the investor community in July with more insight on what that pricing contribution needs to be. But it's going to be surgical. And I think our customers appreciate that. They appreciate that where we can offset it. We'll work with our supply base. And think of it as changing the source of supply, where the location is. Think of that as trade roots and ultimately taking advantage of trade-free zones to reduce the cost of tariffs as you're moving things across different jurisdictions. And then, of course, I'd say, last but not least, will be the surgical pricing.

Given your COGS as primarily components, and I think you source most of your raws, as you said, last week from the U.S. It sounds like more of that kind of movement of supply would be done, therefore on the components side. So how do you approach sort of the second order cost pressures when raw material commodity prices have risen sharply since January?

Yes. So we think of our Tier 1 commodity spend in that $750 million to $800 million range, Noah, and we source 100% of steel and 100% of copper from the U.S. and over 90% of aluminum from the U.S. And we've got great relationships with those suppliers. So the dollar impact of tariffs is fairly minimal when you think about Tier 1. What we've been able to do within our operations teams and leveraging our business operating system is to get into our suppliers' suppliers cost structure. And so our estimate of that dollar amount, the $250 million to $275 million, it's inclusive of looking at the Tier 2 and Tier 3 and where they're sourcing their products from. Again, it's an estimate. It's not perfect, but it gives us a lot more visibility then into what the true cost is, how do we mitigate that through other ways through source of supply and transport and then ultimately, it gives us a lot of insight on how to surgically price. So we are managing this inflation broadly, whether it be tariffs, whether it be inflation in general, but we've had this in region, for region strategy for a couple of decades now. And I mentioned at the beginning, our factories and what we deliver for Asia is really for Asia, In Europe, really -- or in EMEA for EMEA and the same for the Americas. We've got over 20 manufacturing plants in the U.S. with 1 in Mexico. And we love the plant in Mexico. It's a great team. It's a component supplier, really for parts of the U.S. But we've been in region for region many years. And I think it does make that tariff impact maybe smaller relatively to other companies and you'd expect that from Trane Technologies.

Well, it does. And I wonder if it implies going forward, any kind of structural cost advantage versus the industry average. We've always thought of you as a price leader, and you play in more premium parts of the market. But to what extent could you start to see some share gains, whether it's on commercial or in resi if competitors have to start raising prices for tariffs and you're somewhat more protective.

I think it would put us in a better position being in region for region and having our manufacturing plants based in the regions where they're supporting. So I think it is a nice opportunity. But we're going to stay close to our customers and make sure that we're doing the best thing for them long term, and that is to really offset this tariff impact on a dollar-per-dollar basis and they'll make it a profit center. But we would like that opportunity, Noah. Yes.

Yes. Can I just ask, to go back to your prior point, a lot of times companies talk about lessons learned from supply chain crisis and just getting improved abilities and capabilities, your comments around more visibility into Tier 2 supply base. Did that materially change as a result of the process you have to go over the last couple of years. Is that like a good example of lessons learned?

We certainly have more visibility to the supply chain with going through the supply chain challenges, right, coming out of COVID and working with our suppliers to really figure out who were partners and in some rare instances, there is more transactional players there. So the partners you're able to get a lot of insight on where their source of supply is, the pain that they were seeing. And then let's work with the engineering groups with both teams to figure out okay, we've got this challenge. Now let's get to yes. Let's get to can we make an alternative source of supply. Can we change what we're ultimately requesting today because it doesn't need to be at that level of specificity. And that's where we did get a lot more information around our suppliers' suppliers in that space. But every inflationary cycle, we're getting better information around what that cost structure is. But certainly, we've taken those learnings from 3, 4 years ago and working with our partners today, right? This is not the first time we've had these conversations with our partners. It's okay, maybe it's a different catalyst for what we're talking about today. But the fact is remains, we've got to go find a way to offset this cost. Let's work together to do that. And I think that's the power of being Trane Technologies and making sure we have partners there in our ecosystem.

As I was going to say, it's the power of being a company full of engineers that are built to solve problems. So maybe you have it.

We do like engineers. That's true. That's true.

So just -- we didn't touch on transport, but obviously, we've gotten a fair number of questions around that. And you consistently outperformed an end market looking at, I think, a third consecutive year now contraction. Maybe help us understand the outperformance, the share gain dynamics here and how much you think you can maintain in terms of the share gain as volumes recover over the next -- hopefully, recover over the next couple of years?

Yes. I mean 2026 and 2027 look like very strong years, the way that ACT has projected the Americas refrigerated transport markets, both of those years up 20% is what they're calling for right now. So that will be a nice adder to our growth profile as we think about 2026 and 2027. Certainly, markets both in Europe and in the Americas in transport are a little bit worse than we thought even 3 months ago. Americas looking like the year could be down 20% to 25%. We've factored in, in the Americas a lower volume than even what ACT is projecting for the year. They would put volumes down or the markets, I would say, down around 25%. But your point was around how do we outgrow, how do we do better than markets and it is the consistent investments that we're making around innovation. It's the flywheel and why we like that 25% or better incrementals. Could we do better? Absolutely. Can we do better for a few years? We absolutely could, but I think we would shorten -- I know we would shorten that innovation pipeline for our products. And the transport markets are a great example to see how you take existing diesel fuel products and make them more efficient where they consume less. And that's some of the innovation we've put into this market for many years. Then moving to hybrid systems, so you're depending on electricity and a fuel source, a fossil fuel source, and also having full electric capability for those customers that want to move to full electric power. And in Europe, you have a number of cities that you need to shift to full electric power when you're in city centers. So it's staying close to the customers on what they need and providing them optionality. And it really comes down to energy efficiency, lower usage of fuel and we know where those prices have gone, energy prices in general have gone up over time. The paybacks on those systems start to become much like the commercial HVAC paybacks. We're talking about 3-year paybacks on these fuel system or these trailer refrigeration units from savings of fuel or energy, those are strong reasons where you can outperform the market. So keep investing while we're in that third year of a 2-year cycle, that's the key for us. And then you've got nice resale value for those units when they ultimately 6 or 7 years of life and they want to be resold. You've got better resale. That makes a nice equation for our transport customers.

Very good, Chris. I think I'll ask 1 last question, and it's really around capital allocation. You mentioned the BrainBox acquisition earlier. Maybe talk to us about how the pipeline of opportunities has evolved since then comment on private valuations? And what opportunities might you be more interested in pursuing in the current environment?

Yes. I mean, it's a big HVAC/R player. We get to really see everything that comes across the gamut from an M&A perspective. We like being a pure play. We like ultimately providing reductions to energy intensity and increasing energy savings. So that's our sweet spot as a company in driving sustainability and green for green, that can be green for the environment, but it's green for the pocketbook as well for the financial and income statement. But let me just say, we've liked doing channel deals, getting closer to the customer. We like taking early-stage technology and bringing it closer to our direct sales force. BrainBox AI and Trane have had a partnership for several years. And we're really encouraged with the opportunities even just with 4 months of them being part of the Trane Technologies family have seen those opportunities grow. Our direct sales force is right in a perfect spot to go sell those remote connected solutions that BrainBox brings and taking the power of structured data and unstructured data together to come up with a more optimized solution for how you're building can reduce energy intensity and usage 10%, 15%, 20% real cost savings that customers can prove out. So we like those early-stage technologies and where we can take something early stage or in a market that they're, let's say, like in Europe, we've done a couple of acquisitions a few years ago, very strong in 2 or 3 markets in Europe. We're strong in 30 markets in Europe. So let's go ahead and take that product that's got strong revenues today. Let's bring it to the other 27 markets where we have direct sales force. And that's some of the contributions you're also seeing in our EMEA region for their revenue growth is the performance of those acquisitions. So we think that, that's been a hallmark from the company, we're not going to let excess cash sit on the balance sheet and let's deploy it to the best returns for shareholders.

We look forward to seeing that continue. And with that, I think we're going to pause here, and thank you, Chris, and thank everyone, for joining this discussion. We appreciate everyone's time. We hope you have a great day at the conference, and this has been a good one. So Chris, Trane team, thank you.

Thanks, Noah. Thanks, everyone.