Trane Technologies plc (TT) Earnings Call Transcript & Summary

The 14th Annual Laguna Conference. To start off, for any important disclosures, please see the Morgan Stanley research disclosures website at morganstanley.com/researchdisclosures. And if you have any questions, please reach out to your Morgan Stanley representatives. We're happy to have Trane Technologies here with CEO, Dave Regnery; and CFO, Chris Kuehn.

So to start off, I mean, service is about 1/3 of the business. It's been performing very well. I think this is going to be, what, the fifth straight year of double-digit growth. How long can you sustain this? And looking at the kind of lag it has versus equipment and how equipment has ramped over the past few years, what kind of opportunity do you see for some acceleration?

Well, first of all, thanks, everyone, for coming today. Thanks for your interest in Trane Technologies. It's a great time to buy, so double down. I don't know what the news was today, but it's a great time to buy. Look, I always tell everyone that Trane Technologies is a great company for several different reasons, right? It's not one, it's many. And one of those reasons is the fact that our service business is so strong. And Toby, as you said, it's 1/3 of the company. It's had a double-digit growth rate since 2020, okay? And that includes COVID year. So just think about the durability and the resiliency of this business. I would also tell you that it doesn't happen by accident, right? We invest heavily in our service business, whether it's how we train our technicians. We have about 7,500 technicians all Trane technology employees, all trained by Trane Technologies. It's how we recruit our technicians. It's the apprenticeship programs that we have that we are constantly looking to attract and build new talent in that space. It's pretty obvious. Our service business is built around our applied business. And our backlog, which is at record levels of $12.1 billion, is over 90% applied. As your installed base grows, the tether to your service business is going to continue to expand. So we don't forecast what the growth rate is going to be in the future. But look, we've demonstrated for a long period of time that this is a very, very sustainable and competitive advantage that we have as Trane Technologies. So expect more in the future.

And I guess without forecasting, kind of following along there and data center has clearly been a strong driver. You've highlighted that 8 to 10x revenue tail you can get on service. How is that augmented as systems have become more complex and especially with data centers?

Yes. I mean we've said that applied systems and our conventional verticals or our core verticals typically carry about 8 to 10x the original price over the life of that asset. That number is probably a bit different in data centers for a variety of reasons. Look, we don't -- how the chiller is actually being used is different in a data center than what you would see in a core vertical, the renewal process or how you retrofit that will probably be different. So we don't believe it's going to be 8 to 10. We think it's going to be a little bit lower. But at the end of the day, if you look at all of the chillers that we're installing in data centers, which is a lot, this is going to be a great upside for the future.

And kind of staying on that AI theme, how have some of your investments in digital, such as like BrainBox augmented your service offering?

Yes. We love being connected to assets. So in the past, we've been connected to assets and buildings for a long time now for decades. But today, we have over 70,000 buildings connected. We probably have 2 million to 3 million assets connected. And what BrainBox has done is in the past, we would always think of things like -- think of it as machine learning, so we were connected, but it was always about how do you make sure the asset or the building is performing the way it was designed. With BrainBox, we now can take unstructured data and add that to the equation. So now all of a sudden, you have buildings that are performing not only the way they were designed, but also how they're being used, and that's a difference. And we're able to get 15%, 20% savings by putting algorithms or agentic algorithms in place, in buildings. So if you think about it, and most people don't know this, but buildings waste about 30% of the energy that they pay for, 30%, and that's a very conservative number. And what we can do is we have the technology today with BrainBox and our portfolio of products to not only eliminate that 30%, but actually drive it negative, so think about the savings that we're able to drive for our customers and the buildings. And if you think the cost of energy is going to be less in the future, I don't think that's the case. I think it's going to continue to improve. And I think our paybacks to customers is going to continue to increase. We have this -- our strategy is, think of it as we think buildings are going to get smarter, more resilient in the future. And what that means smarter, they're going to start using more sophisticated controls, using structured and unstructured data to ensure that they operate at the most efficient level. Resilient, they're going to start using different sources of power at different times. So for example, you may use electricity, you may use fossil fuel or you may use storage. And our controls will know what to do at what time to optimize the return for our customer. We had our Chief Digital Officer, we're running a pilot in Minneapolis. And in February, he came in and he was like, "Dave, let me show you the pilot." He's all excited. I said, "This is great." And I'm looking at the screen, and I'm like, "What the heck are we running the heat pump for?" Which is electric, and it's minus 5 degrees F, in Minnesota. Now it was 5 in the morning, Minnesota time, when I was looking at this, and he quickly pointed to the bottom of the screen, and he said, "Well, the cost of a kilowatt is $0.02. That's why we're doing that." So think of it as almost free. Think about that at scale, and that's what we're talking about what we're doing right now. It's really, really exciting. I know everyone wants to talk about data centers. We're very strong in data centers. We're going to continue to be very strong in data centers in the future. Smart, resilient buildings is as big or a bigger opportunity in the future.

And to that point on bringing the resiliency and savings of the building, could you speak on the longer-term tailwinds that surround the equipment business in commercial HVAC?

Look, I think the pipeline of activity that we're seeing right now in our business is probably the most I've seen in my career in this industry. And I've been in it a long time. So we're going to continue to accelerate our growth rates, and I can tell you our pipelines are very, very strong. In the second quarter, we had order growth in the Commercial HVAC Americas business of 50%. And we track 14 different verticals in a lot of detail. And I would tell you the majority of those verticals had growth of over 20%. So look, we see a lot of demand not only today, but well into the future and the breadth of our portfolio, our service business, the way we go to market with the direct sales force, those are all things that make Trane Technologies as a great company.

And kind of digging in there, could you speak on like which of the verticals outside of data centers have really been the most attractive?

Go ahead, Chris, I'll let you speak.

Thanks. I mean, look, in the second quarter, we said 11% to 14%, we saw growth. Actually, year-to-date 11% or 14% growth in the second quarter, all of them we saw growth. So look, we're seeing a lot of continued support and higher education. Office is turning positive, and we're seeing growth there. But let me step back and think about the direct sales force, you go to any one of our commercial sales offices, we have over 100 of them in the U.S., and you sit down with those teams and you look at the pipelines that they're working on, it's not data center pipelines, it's office, it's higher ed, it's K-12, it's federal government. It's -- gosh, there's so many different verticals. But I think about what they're working on in their pipeline, sure, data centers as a line item. But for them, over 95% of our sales force is focused on verticals other than data centers.

And speaking to that direct sales force, how is that -- how does that create a competitive advantage for Trane? And how do you communicate the value proposition to your customers?

Yes. What people don't realize is a direct sales force, we have the optionality on calling on all the influencers in a job, right? So I think if you're going to go sell to a hospital, who's involved in that decision making, right? That could be a mechanical contract or it could be a general contractor, it could be an architect, it could be the engineer or it could be the end user. The reality of it is, it's all five. And with the direct sales force, we have the appetite, okay, to call on all of them to make sure that we could show our value proposition. If you're going through someone who's representing you or what they call a rep agency, they may not have that appetite, right? They may want to just call the mechanical contractor, which is fine. But we're calling on all to be able to explain the value proposition. And when you talk to the engineers, do you know how much product engineers buy? Not quite zero, but close to zero, right? What you're doing is you're calling on them to explain the value proposition of your products. And when you do that, you become the basis of design. And if you're a mechanical contractor, you may or may not want to start changing the basis of design because once you start changing that, you start taking on liability that you may or may not know of. And what we do is we call on all those influencers, and that's the competitive advantage that we have as Trane Technologies. We love this, we love talking to customers, we love getting their feedback, and we love being able to help our customers save a whole bunch of money.

And Toby, the direct sales force, they're local, so they know the local laws, right? So in a city level or state level, they understand if there's incentives that come from the states or from the cities. They understand incentives that can cover utilities, and they're bundling these incentives and making sure with that local knowledge, bringing it to the customer, and then it's an even stronger payback from the customer when you have that understanding locally. We've talked in the past about New York City where it's not just -- right now, it's maybe some carrots to move to decarbonization, but it becomes sticks in 2030 and 2035, and so on. So how do you get your customers on that decarbonization journey so they don't pay penalties in the future? Having that local knowledge of those laws, that helps out a lot.

And kind of with that value proposition, I believe a lot of that is captured in the margin premium you get on the service business. And as this business kind of mixes towards services, that continues to grow, how does that augment your incremental margin outlook? I know you've previously spoken to like 25% plus. Is there any room to push that higher?

Well, that's why we have the plus on the back end of that, right? And so we had some conversations this morning and we typically do about price versus inflation and then incrementals on volumes. And that altogether, you get you to the 25% plus. Making sure you have a customer for life, as Dave said earlier, we want a broad relationship. Many of our customers have multiple assets that you want to be on a journey with them for multiple years for CapEx upgrades, okay? But at the same time, it's a plus because we have a very robust pipeline of investments. And the way to get the top line revenue growth, and it's been a double-digit CAGR for the last 5 years, as Dave called out, is to keep investing in the product, having new products out there, more energy-efficient products. So that's the governor, but at the same time, we look at it is we're always going to bias to accelerating investments where we can.

We're always looking at long-term growth, Okay? I know it's -- as a CEO, you could get boxed into trying to manage the short term. I would tell you, as soon as that happens, you're probably going to fail. So as you always look out, right, we're interested in top quartile growth on the top line. We're interested in top quartile growth on the bottom line. And we're looking for free cash flow which we've been able to have, what, over 100% over the last 6 years on average, right, conversion because that tells you the quality of your earnings. I think you all know that. But look, this is a long-term view that we're always going to take, and you saw in the second quarter, Toby, we were a bit below the 25%. No excuse, right? No excuse from Trane Technologies. Yes, we're investing heavily. We bought a new business, Stellar. We're making sure we're implementing our operating system. We have some investments that we pulled in to make sure we get the fundamentals correct so that we could start taking these solutions to other verticals other than just data centers. And again, that's a long-term view that we have as to how we're going to continue to be top quartile growth.

You mentioned Stellar there. Why is that such a good strategic fit with that long...

I think if you could take skilled labor and variability out of the job site, that's a good thing, right? If you could take -- if you think about a job site, there's so much variability that happens there, right, whether it be weather or whether it be being able to have the proper skills on the job site at a particular time. If you take all that and you move it to your factory, a lot of that work, and then you basically just deploy it and it's like literally assembling LEGOs on a job site, that's a much better solution. And by the way, the quality level becomes so much greater. So look, we think this is a trend not only in the data center space, it's exaggerated in the data center space because of the speed at which we're trying to build data centers, but it's going to be very, very applicable in all verticals. And I think the key, though, is we need to make sure that we get our fundamentals correct before we start deploying it to the other verticals. And by the way, Stellar, think of it as a $1 billion business, think of it -- in a couple of years, think of it as mid-teens EBITDA, and we are well on our way to make sure that, that will become reality.

And kind of to that line of thinking of investing to support these changes in the market, are there any other adjacencies that could be interesting as you see these changes, especially with like data center infrastructure moving forward?

Look, I mean we always get asked the question about what's the M&A you're looking at. And I always say that's a great question that I can't answer. Look, we love being a pure play. It took us a long time to become a pure play. We're going to continue to be a pure play, so if you're wondering about that, don't wonder about that. But we're always looking at technologies, and we're always looking at how we could scale those technologies within our strong channels. We have the advantage of having the strongest channels in the industry, right? And when you do that, you could take technologies and deploy it relatively quickly through your channels. And whether that be Stellar on a modular design or whether that be thermal management systems in Europe that we're scaling or whether it be an air handling system in Europe that we scale through the rest of our distribution.

And then kind of thinking to the fact that you're a pure play. And when you think about the pitch that you give to customers, how is the partnership with Eaton kind of helped bring to...

Eaton, first of all, a great company, great leadership team. We work with them relatively a lot in reference designs for data centers, so they're on the same team we are with one of the larger chip manufacturers to develop what the data center is going to look like of the future. And think of it as speed, think of it as efficiency, think of it as cost, and all three, and that's what we work on together. It's just amazing to me when you take a whole bunch of really smart people and put them in the room together, the solutions that can be developed. And I'm super excited about the reference designs that we've developed with this particular chip manufacturer. But I would also tell you that we're doing that same work with the majority of the hyperscalers. And just to be fair, we work with Eaton, but we also work with others in that space as well like ABB.

And kind of to that point, why does Trane's portfolio resonate so well with the hyperscalers and chip vendors? What gives you that right to win?

I think it's not a lot different than what we'd say in other verticals, right? It's about our domain expertise, right? We have some of the most technical experts in the industry, and they want to be able to work with us. We have this system mindset, right? Think about how we go to market in our core verticals, right? We have a breadth of a portfolio that's broader than anyone else in the industry. We don't get -- we're not selling a product. We're selling a solution. We're selling a system. What are you selling in a data center, right? You're selling a thermal management system, right? It's not about the chiller. It's not about the CDU. It's not about the cold plate. It's about how that system works together, including the electrical infrastructure with Eaton, so you can come up with a solution that's more efficient. And that's what we do really, really well.

And kind of to that point, how do those relationships help drive your innovation engine?

Yes. I mean I think the innovation is why we're at the table, right? Because we're able to think differently. We're okay disrupting ourselves. I know that sounds odd, but it's true, right? I always tell our team, what are we doing to disrupt ourselves. If you're the incumbent and you disrupt yourself, go look in history, those are the companies that survive well into the future. And we're not afraid to do that, right? We pride ourselves on disrupting ourselves, thinking differently. Look at the thermal management system that we developed in Europe, right? You had a cooling system on this vertical, you had a heating system, a boiler over here. They didn't even talk together, right? We combined them into one system, thought differently about how to solve the problem. And all of a sudden now, we have the most efficient systems in the world, at least today. And by the way, we keep pushing the envelope on that. So look, we're okay disrupting ourselves. We're okay pushing the innovation. I would tell you that what we are seeing is, especially in the data center vertical, as we're developing next-generation product, that product is making it into other verticals. So we talk about chillers being smarter in data centers. That's happened, right? So the majority of what we're doing in data centers right now are air-cooled systems or basically closed loop systems. The water is not using evaporative cooling. It's using free cooling or -- and what we've done is we've designed the chiller, so the chiller is smart enough to know what's the receiving water temperature, what's the leaving water temperature have to be regardless of what it is, and it will optimize that, whether it will take into account the math associated with the area, the temperature that it's operating in and being able to optimize at what point do you use compressor versus when you just use free cooling. That same technology is being deployed right now, not only in data centers, in schools, in hospitals, wherever it's applicable. It's all about efficiency. It's all about how you generate a system that's different and more competitive for our customers.

And kind of on that point of chillers, there was some news earlier this year in conversation on what the content for chillers can be in data centers going forward. Any kind of commentary on your orders have still been strong, so how does that kind of factor in your outlook there?

What I told you a couple of years ago, we're doing all the reference designs, right? We're working on the reference side, I have yet to see in a reference design that doesn't have a chiller in it. But look, I think that we don't -- we optimize to what the customer needs. If the water temperature needs to be at 45 C at the plate, we'll have it at 45 C. It's going to leave the plate at a level that's higher than 45 C, right, at about 7, and you'll be pretty close, that's what has to be removed, right? Because it's got to go back at 45 C. And we're really good at optimizing that. So look, chiller aren't going to go away. I think what you're going to find is chillers are going to get smarter, right? They're going to know when to operate in a free cooling mode versus when to operate in a vapor compression mode. I think you'll see a lot more creativity on heat recovery within data centers. We're working on a really cool project right now up in the Nordic area, where in the Nordic area, they already have a lot of district heating loops in place. So what we're doing is we're taking the data center and we know when to augment the heating, the district heating loops. So you're recapturing the heat rather than wasting the heat or putting the heat back out into the environment so that it becomes an efficiency gain for the district heating loop. And it's going to be really breakthrough thinking as to how data centers of the future start to become an asset to the community versus all the rhetoric you may be reading about in the news right now. But more to come on that. But it's really exciting.

And as you kind of think about the chiller evolution, though, there's been kind of debate on the future of water versus air cooled and kind of to that community impact, what kind of impacts are there from these water-cooled chillers?

I mean at the end of the day, we're using predominantly air cooled right now. And by the way, just be cognizant of the fact that you could sit there and say the data center isn't using water because it's a closed loop system, and when you're using air-cooled chillers, that's a true statement or where you're using dry coolers with the centrifugal that's a true statement. Remember to ask the next question, right, which is where is the power coming from because that's a very important question to ask because if the power is coming from coal, there's a lot of water being used. If the power is coming from nuclear, there's a lot of water being used. If the power is coming from natural gas, it's about 10% that of coal. So there is a knock-on effect that you all need to be cognizant of that we certainly are aware of as well. So even though we may be out there saying, look, our data centers that we're doing, we're not using water. We may be using water if you look one step removed, which is very, very important. In fact, I have to go to a meeting actually on Thursday, where we'll be talking about that at a very high level with many of these influencers about let's not be naive to just think of the data center as a -- it's a whole ecosystem there and the data center is part of it, but the power is coming from somewhere that you need to make sure that that's in a sustainable way as well.

And then I know it's still like a smaller piece of the portfolio, but how have the investments in CDUs kind of augmented those data centers?

We're very happy with our CDU business. Very happy. We acquired Stellar, how long ago Chris?