Trane Technologies plc (TT) Earnings Call Transcript

All right. Welcome back, everyone. We are very excited to have Trane Technologies with us today. We've got Dave Regnery, who's the Chairman and CEO; and Chris Kuehn, who is the EVP and CFO with us.

Dave, as I walk over here, maybe I'll just ask you, you've been at the helm of Trane for almost 2 years. I know time flies when you're having fun. Can you talk about what, if anything, you've changed regarding Trane strategy over the last 2 years and reflect on what maybe you're most proud of? And what if anything, Trane could still improve upon as we go into 2023?

Yes. Thanks. It's hard to believe it's 2 years. Time flies. We have fun, right? So look, when I took over as the CEO and the Chair early on, I said, look, I've been fundamental to the blueprinting of Trane Technologies as a pure-play climate innovator. And this started this transition between Michael Lamach and myself started well before it was announced. So I said I don't expect a lot of dramatic changes to our strategy. And hopefully, you haven't seen these dramatic changes that sometimes you see when a new CEO gets named. But what you have seen is consistent performance and being able to execute at a very high level. And our business operating system enables us to do that. And I always tell people it's a system of things that makes Trane Technologies a great company. And I could talk about innovation. I could talk about a lot of things, but I always start with our culture. And that's what allows us to differentiate ourselves as Trane Technologies. And I'm very proud of the performance that we've been able to demonstrate. In 2022, organic revenue was up 15%. Our EPS was -- had a growth of 21%. Our book-to-bill in the year was 109%. We exited the fourth quarter with a record backlog of close to $7 billion. We have a very strong guide for 2023. We have -- I could go on and on about how proud I am of what this team has been able to execute. But it's been a great 2 years. I am a little bit flabbergast when people remind me, it's been 2 years because it seems like it was just yesterday, but I'm having a lot of fun. It's funny. I always had a -- this is a funny story, but I was at a -- in Charlotte, we have a group of CEOs that get together periodically. And it's really all about how we could create economic mobility in the greater Charlotte area. And there's a lot of CEOs of publicly traded companies that are in Charlotte. And I was with this group, and we were having a break, and we were just talking amongst ourselves and one of the fellow CEO, said, boy, the last 2 years have been the hardest I've ever experienced as CEO. And I'm thinking of myself. I wonder if my job is going to get easier because these have been the first 2 years in my career. So anyway, it's a great job. I think the team is executing at a very high level, and hopefully, everyone here sees it in our results.

That's great to hear, Dave. So like maybe I would just ask you, you kind of mentioned this a little bit. I think Trane is one of the most innovative, if not the most innovative of the global HVAC companies. But the megatrends, the decarbonization, digitization, they're ramping up. So what's Trane doing to make sure you stay at the forefront of innovation?

Yes. I mean this is one of those -- part of that system of things that makes us a great company, right, is innovation. And we relentlessly invest in innovation. This isn't like a flash in the pan. We're not going to be episodic. We're going to be very consistent about how we execute -- how we invest and then how we execute, right? Because it's not just about the dollars you invest. It's the process that you have behind that. And we've been able to really hone that process over a long period of timing. I would tell you one of the things that I always point to that differentiates a little bit us versus some of our competitors is the fact that when we go at innovation, we're always looking at a system level. So we're not out there at a component level or a product level. We're always thinking about the system of HVAC and what's that solution look like. And if you look at -- I'll use Europe as an example, where a traditional way to heat and cool a building is that you have a chiller plant and you have a boiler plant. And our clever engineers said, wait a second, it's HVAC heating ventilation and air conditioning, let's look at that system and how could we combine that system. And now we have a thermal management system that basically eliminates the need for fossil fuel for heating in buildings. It's all electric now. You do not need fossil fuel to heat a building. You do not need it. And we have that technology. And I think about of global greenhouse gases from heating and cooling of buildings. And most of that comes from heating. If we could eliminate fossil fuel from heating, we would dramatically, dramatically change the landscape on decarbonizing the built environment. And this technology exists today. It's not like we have to wait, right, in case you didn't know the world is getting warmer. And it's just -- it's -- I'm very proud of what our team has been able to create, expect more of it in the future. It's not just on our Trane side. I can talk about Thermo King and get just as passionate about some of the inventions we have there and what we're working on with electrification and how we're continuing to push the envelope to make sure that the planet that we all live on here is better for the next generations that are going to be here.

Trust me, Dave, we're going to get to those things. So let me just step back though and ask you about the current environment for a second, if I could, and maybe Chris can chime in. You -- last quarter, you reported with all the strength, you still reported flattish bookings, which is against a very tough comparison. But you go into '23 with record backlog $7 billion you talked about ending this year with $6 billion of backlog. So are you essentially telling us that there's still a good chance you have multiyear earnings visibility here? And how resilient do you think your earnings growth will be when we start seeing these lead indicators come down like the ABI or Dodge Momentum?

Andy, why don't I start, and Dave can jump in. Look, I think it's really important to focus also on the absolute dollars because those tough comps, as you mentioned, 2021, we saw 27% bookings growth for a full year basis. Fourth quarter, we had $4 billion of bookings. We had revenue of $4.1 billion. And so while you look at the revenue growth of 15%, the backlog really didn't move much in the fourth quarter. What we try to do for 2023 is we said, okay, if we look to the end of the year, we expect backlog to be probably $6 billion or stronger, okay? We ended 2022, entering 2023 with $6.9 billion. So a little bit of context around that. if we were to have flat bookings in 2023, okay, that's $17.5 billion. Based on our revenue guide for 2023, we would actually grow backlog by the end of 2023. It'd be over $7 billion. Our guide of a ballpark and say call it $6 billion or stronger. That assumes revenue or bookings decline of around 6%. So do we think that could occur? It could. But if we end 2023, going into 2024 with $6 billion of backlog, that's still 2x the normal level of our backlog entering it in a year gives us a lot of visibility into the forward looking demand.

Helpful. So let me ask you about -- I think we talked a little bit about sort of innovation. Let's move to sort of pricing of that innovation and price versus cost. You talked about 2% to 2.5% carryover pricing into '23. What are your expectations for sort of driving additional pricing if you need to? I mean, as you know, copper has bounced a little bit, steel has bounced. So how do you think about that? And stepping back, you guided 25% organic incremental margin. How do you think about contingency in that forecast if supply chain headwinds or inflation -- worse than you thought?

Yes, I'll start. Look, we feel really confident on our 2023 guide. I'll start there. We're not planning for really any inflation, deflation. We're kind of planning on a flat basis on a year-over-year basis, Andy. There are pockets of where we've seen costs come down, certainly around logistics and freight. There have been some opportunities there. Steels were treated a little bit. But that pocket of savings or lower costs, we saw third quarter, fourth quarter, early fourth quarter last year around copper aluminum. To your point, those have bounced back, right? What we are seeing though, we're also seeing a lot of inflation around wage and energy in our Tier 2. And just order of magnitude, our Tier 1 spend, copper, aluminum, steel, it's around $750 million of annual spend. Our Tier 2 spend when you think about motors, compressors, metal fab, that's over $4 billion of spend. So when you start seeing the wage inflation, energy inflation on a much bigger base, that's where we bundled it all together, came out and said, we think it's going to be roughly flattish on inflation, deflation. We've got price increases that were put in place December, early January, and that's just based on our full year outlook for 2023, and we're targeting 20 to 30 basis points of price over cost in 2023. It's allowing us to do even further investments. We can certainly talk about that as well because we've got a great pipeline of investments and want to keep that always flowing. But I'm really proud. I know David is too, around the business operating system that we've driven for pricing every quarter in 2021, every quarter in 2022, we were price over cost on a dollar basis, and the resilience of that operating system, I think, really showed through.

Yes. And I mean don't -- the strength of our business operating system, right here, we're talking about our product growth teams, led by our product management teams, just exceptional performance that we've seen over the last several years. I mean, just think about the amount of inflation that we've seen and the fact that we've always been able to stay ahead of that. I mean they look around corners. And that's what we talk about. That's what I talk about when I talk to them is what are we seeing around the corner. So if we continue to see persistent inflation, and I know we'll see if that happens, I would -- I'm very confident that, that team will be ahead of it.

Chris, just to follow up on one thing you said it's interesting, right, because it's like you're kind of guiding to a more normalized year on price versus cost. That 230 is kind of what you usually do.

It is. It is. So I hope the viewpoint in 2023 is we don't need to have 3 rounds of price increases like we saw in 2021 and we saw in 2022. But look, the business operating system is nimble enough that if we have to react, we will react to that. We are targeting that 20 to 30 basis points and hope we get to something more normal. But it isn't just pricing for cost, right? It's pricing around innovation. And we're always making sure we're looking at the total value to the customer. And when you think about our products that are more energy efficient, more less reliant on fossil fuels and the cost of those have only gone up. That's been an area that I think has been a lot of success in driving a lot of demand.

And I know what you're going to say, but if demand were to slack and like if you look at residential, for example, like you're not going to give that price -- or you think it's pretty sticky?

We think it's sticky. And the history in the industry would suggest that it's -- our pricing holds and sticks over that environment.

Okay. So maybe just delving into some of the underlying end markets a little bit more. Obviously, North American commercial HVAC, a really, really strong market. 4Q bookings were plus low teens. Revenue was mid-teens growth. So I know you've talked about strength in a number of verticals, but how are you thinking about sustainable growth rates in sort of North America and commercial? Do you expect any difference between applied and unitary markets? And what end markets do you think will be the biggest driver of growth in North America?

I think the verticals that I called out on our fourth quarter call will continue at least in the mid to long term. I mean, data centers are going to continue to grow. What we're seeing in the education with some of the stimulus funding that's happening there with ESSER -- that will continue to be with us for the really -- I mean I think now they've extended that. So I think it's an order is accepted by September 2024, you have to 2026 to get it installed. So that will continue to be. I think we're seeing in the high-tech industrial space, we're seeing certainly nice activity there. Think about battery plants for electric vehicles, a lot of cooling capacity required. I think in front of us that we haven't yet seen is things like IRA once those funds start to move forward, and that will impact both residential and commercial. -- as well as The CHIPS and Science Act. That will be another -- that's a little bit further out, but that's all in front of us.

Dave, could I ask you like approximately how big the education vertical is for you guys now? Because, again, I think it's a little bit underrecognized how much money is out there.

Yes, I get asked the question a lot, I don't answer it, but let me do my best here. Look, if I think about our commercial HVAC business in North America, right, 50% of the business is service, 50% is equipment. If you think about the equipment, think about a 50% institutional, 50% commercial. And there's probably -- there's like 14 different verticals that fit under those 2 broad categories. And we have strengthened all of those verticals. And that's one of the strengths that we have as a company is we're not overdependent on any particular vertical. And we have expertise that exists in all those verticals. So education, -- we've had a lot of success, okay? I think I called it out in our fourth quarter call. I mean our order -- equipment order rates were up 40%, 4-0 in 2022. And a lot of that has to do with the approach that we take with our customers and the relationships that we have. If you remember, if you go back 3 years ago, and I never really want to go back 3 years ago, but in the beginning of COVID, right, we were talking about indoor air quality audits, right? And we're still doing audits today, but we are helping many of our customers in the education vertical think through how they make their school safe today and what it would look like long term. The long term was kind of a road map as to what capital improvements you would need to make over time. Well, then comes ESSER funding I'll get it wrong elementary secondary school Emergency Relief Act, and the funding became available. We pulled those road maps out and basically going back to the customer and said, "Let us help you get funding because you already know what you have to do. These were shovel-ready projects from any of the schools. And that's one of the ways that we took something a policy, ESSER funding, which on the surface is somewhat complex, made it simple for our end customers and help them through the journey -- and you could see the success we're having.

So speaking of complex, you talked about the IRA, right? I think implicit in sort of -- and maybe Chris said it on the call, like in the second half of the year, IRA might start to ramp up for you guys as sort of states to begin to set their own rules. So what if anything is in your guide for IRA? And what kind of visibility do we have to the states actually getting to act together so that money can start to come up?

Well, I mean, I think the -- the way IRA is going to work is you're going to have federal funds that will go down to the states and the states have a framework that they're going to be operating within to qualify for this funding, but that framework will be a little bit different probably by each state, okay? We don't know that, but that would be a good assumption to make. We're still actually helping clarify a lot of this, okay? We're a company that has such a broad portfolio of products that will be able to serve whatever the end solution is. We just want to make sure the end solution is optimal. So originally, this came out, and I think you may know this, Andy, but we only want certain high -- very high SEER product to qualify. Well, okay, we can do that, right? But really, if you want it to be for more lower income, well, that may not make sense, right? Maybe you want to lower that SEER requirement. And at the end of the day, heat pump is still going to have a dramatic impact on the decarbonization of the home. So we're helping people clarify that, and we're hopeful that towards the back half of the year, and it may go into the fourth quarter, we're going to start to see some of that funding be released. It will be state by state. As far as do we have it in our guide. We don't know what the impact is going to be there. So we haven't baked this in because we're not really sure what the impact would be. It would impact both residential and commercial, okay? So you could -- are we optimistic on our guide. We think we could. We have a 6% to 8% for the enterprise, and we're very confident with that number.

So Dave, maybe you could help us with the state of the North American residential market. Like I know it's not a huge portion of your business, but like I feel like between you guys and your peers, it's kind of, I don't know, all of the places may be too strong, but so what you've said to us is you think you guys market will be down mid-single digits in unit terms in '23, pricing and share gains where you guys will lead to a relatively flattish revenue. That's kind of what you guided to. But can you give any color into your visibility? I think you mentioned higher than usual backlog, you still have that. But you mentioned that your distributors, your independent wholesale distributors on a relatively good inventory position. And I feel like maybe 1 or 2 of your peers have said something different than that. So like any update on...

Yes. I mean, first of all, residential is about 20% of the enterprise. So...

After commercial, Dave. I asked it.

No, I know you did. Just to size it, okay? And if you think about our residential business, about half of that or 10% of the enterprises, we go through independent wholesale distributors. So when we're talking about what's the inventory level, we're looking at that 10%, okay, or about half of the residential business. The fourth quarter and really part of the third quarter, we were very -- we're always in touch with our channel partners, but we are very intense in helping them with the phase in, phase out of their inventory. And as the regulatory change happened, depending on where you are located -- we wanted to ensure that no one got stuck with stranded inventory. And in the south, it's an installed date. So if you have it in your inventory, you won't be able to sell it after a particular date. We did not want anyone to be stuck with inventory that they would be calling others to figure out what they're going to do with -- and that's a bad trail that, that would be down. So we spend a lot of time helping them with what we call phase in, phase out. We do it all the time with our new product introductions. Some of our channel partners needed more help than others, but that was okay. And we think their inventory is in a good position right now because of that. It wasn't about us shipping additional product to them in the fourth quarter. It was more about how do we make sure that they have the right mix and the right inventory that can set them up for success in the future. So that was the emphasis. As far as what's their inventory level, we think it's in a good position, right? We're -- we do a lot of work there on making sure that we don't want our channel partners to be set up for an unsuccessful year. So we spend a lot of time helping them with their inventory needs.

And you have reasonably good visibility to replace the markets? Obviously, we'll see what happens here...

Yes, we'll see what happens. I mean at the end of the day, we all know what's happening with interest rates, right? We'll see what -- I guess, the Fed is going to be releasing some news here if they did have it already, but soon, we'll get that commentary. As interest rates go up, obviously, new home sales will go down and existing home sales will go down. So that shouldn't be a secret to anything. So it is going to tighten. Our guide is that we believe that the unit volume will be down in that mid-single-digit range. And we feel as though we'll be flattish, plus or minus 1%, 2% is kind of what we baked into our guide for residential. And again, it's 20% of our business. So if we were -- if it was -- went down additional 10%, it would be a 2% impact to the enterprise.

So let me ask you about China. So you highlighted strong China demand in Q4. But can you talk about what you're seeing as the country moves past Zero COVID and stuff? And how are you thinking about the sustainability of growth in '23? I know a few years ago, you changed your strategy there. You went direct. So how is that helping?

Yes. China is one of those areas where -- first of all, our team in Asia had a great 2022, all right? The revenue growth was up 12%. The organic revenue growth was up 12%. And if you think about the challenges that were faced in Asia, specifically in China, right, and that's about half of our business is China for Asia. And I mean, just unbelievable obstacles that they face that they were able to overcome to achieve 12% organic growth. As far as where -- as the economy opens up, we're cautiously optimistic as to what that's going to bring. I was on the phone last -- I guess it was 2 nights ago with the China team, and it's -- they're very optimistic as a team. They have a lot of innovation that they're working on. And I think you're going to see that where we're strong in China has consistently been strong for a period of time. So think of data centers, things of these projects that take longer times to close or to influence like a longer-term infrastructure project, you tend to have to go to the engineers, the architects, become basis of design, really do more of a selling effort or making sure you sell to all the different owners of the decision. And if you're going through just a distribution model, that's very, very difficult. That's why we made the pivot probably 7 years ago to say, look, we're going to just go and develop our direct sales force in China specific, and we have, that's now 7 years. We have a very mature sales force there, and they're able to have that longer appetite to close orders. And that's why we've been so successful there for many years now with these longer-term projects to close. As far as reopening goes, I think you're going to see it more in the hospitality section immediately, right? I mean restaurants are open in China now. People are starting to go back to restaurants, malls and they're starting to go back. But remember how long it took us here in the states to kind of stop wearing our masks when we went to the grocery store, maybe some of us still do, which is okay, but it took some time, and they've been really reopened now for really only less than 3 months. So they're still in the beginning of that process. So it will take some time, but it's -- we're optimistic but cautiously optimistic in China.

If I go back, Dave, like 5, 6, 7 years ago, you were pretty small in Europe like pretty small you've grown it pretty quickly. And I know you talked about thermal management systems, so let's talk about that. But what changed in your for you guys? Like was it really just the innovation on the thermal management system side? Was it that it's become a little more of a cooling market? And where is your European business 5 years from now because it's come a long way in fact.