Trane Technologies plc (NYSE:TT) Q3 2023 Earnings Call Transcript

Trane Technologies plc (NYSE:TT) Q3 2023 Earnings Call Transcript November 1, 2023

Trane Technologies plc beats earnings expectations. Reported EPS is $2.79, expectations were $2.66.

Operator: Good morning, and welcome to the Trane Technologies Q3 2023 Earnings Conference Call. My name is Cheryl, and I will be your operator for the call. The call will begin in a few moments with the speaker remarks and the Q&A session. [Operator Instructions]. I will now turn the call over to Zac Nagle, Vice President of Investor Relations.

Zachary Nagle: Thanks, operator. Good morning, and thank you for joining us for Trane Technologies’ Third Quarter 2023 Earnings Conference Call. This call is being webcast on our website at tranetechnologies.com where you’ll find the accompanying presentation. We are also recording and archiving this call on our website. Please go to Slide 2. Statements made in today’s call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. Please see our SEC filings for a description of some of the factors that may cause our actual results to differ materially from anticipated results. This presentation also includes non-GAAP measures, which are explained in the financial tables attached to our news release. Joining me on today’s call are Dave Regnery, Chair and CEO; and Chris Kuehn, Executive Vice President and CFO. With that, I’ll turn the call over to Dave. Dave?

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David Regnery: Thanks, Zac and everyone, for joining us on today’s call. I’d like to begin with a few comments on our purpose: to boldly challenge what’s possible for a sustainable world. Our purpose is at the heart of our strategy, which is aligned to powerful mega trends like energy efficiency, decarbonization and digital transformation. Coming off the hottest summer on record, we see policies aimed at decarbonizing the built environment continuing to expand. We see growing sustainability commitments for our customers, our suppliers and for our investors. We see corporations not only setting goals but taking action. We are their partner of choice. And we have the technology to help bend the curve on climate change, and that’s exactly what we’re doing.

We are scaling today’s technology and relentlessly innovating for tomorrow to meet our customers’ needs to dramatically reduce emissions. This enables us to consistently outgrow our end markets and deliver differentiated financial results. The end result is long-term value creation for our customers, our shareholders, our employees and for the planet. Moving to Slide #4. Our global team performed extremely well in the third quarter, setting us up for a strong 2023 and positioning us well for 2024. We delivered strong organic growth of 9% and leverage throughout the P&L, resulting in adjusted EPS growth of 23% and powerful free cash flow. We continue to see very strong customer demand for our products and services, with the enterprise bookings at an all-time high of nearly $5 billion in the quarter.

Bookings were exceptionally strong in our commercial HVAC businesses globally, with organic bookings growth of low to mid-teens in all segments. Our Americas commercial HVAC business was once again a standup with organic bookings up mid-teens in the quarter and up approximately 65% on a 3-year stack. Enterprise backlog ended the quarter at $6.9 billion, with the composition shifting increasingly towards commercial HVAC. Year-to-date, backlog in commercial HVAC is up approximately $800 million. Over the past 3 years, our commercial HVAC backlog has nearly tripled, up approximately 170%. As residential and Thermo King have normalized, the backlog burn in these businesses has been completely offset by growth in commercial HVAC backlog, including a large percentage of long-cycle applied systems.

We continue to drive strong demand and a healthy pipeline of projects in key growth verticals across our commercial HVAC businesses. We’re leveraging the power of our direct sales force, which brings specific expertise on how to customize solutions and leverage policy, programs and incentives to optimize customers’ paybacks, total cost of ownership and performance. Our leading innovation and unique direct go-to-market strategy enables us to quickly pivot and win in the highest growth verticals as markets evolve. We have a resilient and diverse portfolio, and our business operating system is designed to deliver consistent top quartile performance. As our residential business has normalized and transport markets have softened, our overall business has delivered strong results and is on track to deliver high single-digit organic revenue growth and 20%-plus adjusted EPS growth for the year, our third consecutive year of 20% or higher adjusted EPS growth.

We’re on pace to deliver free cash flow equal to or greater than 100% of net earnings and continue to execute our balanced capital allocation strategy with high levels of business reinvestment, a strong and growing dividend, strategic bolt-on M&A and share repurchases. Our strong execution, robust bookings and revenue growth and exceptional backlog gives us confidence in raising our 2023 guidance and confidence in our ability to deliver strong performance in 2024 as well. Please go to Slide #5. Demand for our innovative products and services continues to be broad-based across our segments, highlighting the strength of our global portfolio. Organic bookings were up 8%, led by our commercial HVAC businesses. In the Americas, commercial HVAC was very strong across the board.

We discussed booking strength on the prior slide but revenues were exceptional as well, up in the low 20s percent range with equipment up approximately 30% and services up low teens. Our residential business continues to normalize as expected with revenues up low single digit. Consistent with our prior comments, the nature of our transport refrigeration business is lumpy, and our performance in Q3 was in line with our expectations on both bookings and revenues. Revenues were a bit lower than our guidance of down 10%, driven by the timing of customer deliveries between Q2 and Q3 but remained strong against a tough 60% prior year growth comp. On a 2-year stack, revenues were up more than 40% in the quarter. Americas backlog is approximately 3x historical norms with the largest component being commercial HVAC applied systems for 2024 and beyond.

Applied systems are the most complex and innovative systems and the largest driver of our service business in commercial HVAC. Our EMEA business was right on track with our expectations. Bookings were strong in both businesses, both up low teens. Commercial HVAC revenues were robust with mid-single-digit growth on tough prior year comps. TK EMEA revenues were up versus a down market. Backlog remains strong, approximately 60% higher than historical norms and predominantly commercial HVAC. Our Asia Pacific business performed well with strong bookings growth in China and the rest of Asia. Asia revenues were slightly lower against a tough prior year comp of nearly 30% growth. Our outlook for the region continues to be positive. The verticals we play in remain strong with good opportunities for future growth.

Asia segment backlog continues to be robust as we approach 2024, approximately 70% above historical norms and predominantly commercial HVAC. Now I’d like to turn the call over to Chris. Chris?

Christopher Kuehn: Thanks, Dave. Please turn to Slide #6. The scoreboard for the quarter highlights strong execution top to bottom. Organic revenues were up 9%, adjusted operating and EBITDA margins were up 130 basis points and 100 basis points, respectively, and adjusted EPS was up 23%. At an enterprise level, we delivered strong organic revenue growth in both equipment and services, up high single digits and low teens, respectively. We continue to highlight our exceptional services growth because our services business continues to differentiate us in our industry. It makes Trane Technologies more resilient with higher recurring revenues at higher margins over time and represents about 1/3 of our enterprise revenues. Over the past 6 years, including 2020, our services business delivered a revenue growth CAGR of up high single digits, and we’re driving even stronger growth in 2023.

Our high-performance flywheel continues to deliver results with relentless investment in innovation driving strong top line growth, margin expansion and EPS growth. Please turn to Slide #7. As an enterprise, we delivered about 5 points of volume and about 4 points of price in the quarter. Strong volume growth, positive price realization and productivity combined to more than offset inflation in the quarter. The supply chain continues to stabilize, enabling improving productivity as we move throughout the year. In the Americas segment, we delivered about 7 points of volume and 4 points of price that accompanied strong leverage and margin expansion led by our commercial HVAC business, more than offsetting volume declines in transport. The EMEA segment delivered very strong organic incrementals and margin expansion, with organic revenues up low single digits in the quarter.

The segment also delivered approximately 12 points of M&A growth in the quarter, which impacted reported leverage, given year 1 integration costs. The Asia segment delivered strong margin expansion and organic leverage in the quarter on slightly down revenues. For the enterprise, we earmarked an additional 30-plus basis points for incremental business reinvestment in 2023 to accelerate the timing of key projects across the enterprise. This nearly doubles our average run rate of approximately 40 basis points annually or a total of 70-plus basis points in 2023. We’re extremely pleased we’ve been able to make these incremental investments in 2023 while driving strong leverage. We see a tight linkage between investments in innovation and market outgrowth, and we’re taking opportunities to go further and faster in 2023.

Now I’d like to turn the call back over to Dave. Dave?

David Regnery: Thanks, Chris. Please turn to Slide #8. Overall, our positive outlook for our segments and our end markets is largely unchanged from the prior quarter. And as we move into the fourth quarter with continued high levels of absolute demand, exceptional backlog and strong execution, we’re gaining additional visibility into healthy growth in 2024. Across the enterprise, there are some key themes. Strong demand for our sustainability-focused solutions remains high. While we expect the law of large numbers to kick in at some point and for order growth to decline, absolute bookings are expected to remain robust, given our new baseline is at a very high level. Across our businesses, we see the stacking effect of supportive policy and regulatory changes that play to our unique strength as a leading climate innovator.

In addition to all the tailwinds at a national level in both the U.S. and Europe, we see activity at the state and municipal levels, and our direct sales force is able to help customers leverage these programs. In Americas commercial HVAC, our business is extremely strong as we’ve outlined. We’re winning with customers and developing innovative solutions in data centers, education and high tech, just to name a few strong verticals. And we’re driving tremendous growth in our applied business, which makes up the majority of our backlog. Applied business is the most differentiated and complex and it’s where our competitive advantages shine. It’s long cycle with higher-margin service opportunities, representing a multiple of initial purchase price over the life of the system.

Additionally, this business helps to forge long-term relationships with customers as they move from project to project over a multiyear period. We have the most comprehensive portfolio of products in the industry, which enables us to compete and win across all verticals, driving leading long-term sustainable growth. There’s no change to our residential business outlook. We expect residential to continue to normalize through the fourth quarter and for the normalization process to be largely complete in 2023. Also, as expected, strength in commercial HVAC is more than offsetting the decline in residential in 2023. Our transport refrigeration business was largely in line with our expectations in the third quarter and up more than 40% on a 2-year stack.

We expect to outperform the market for the year. ACT is projecting a dip in 2024 and a bounceback in 2025 and continued growth afterwards. However, ACT’s forecast has been volatile in recent months, and we are in the process of validating assumptions versus our internal forecast and other sources. We’ll update the market when we hold our year-end earnings call. In our EMEA segment, the third quarter was also in line with our expectations for both businesses. As we highlighted in our second quarter call, EMEA HVAC has very tough comps in both the third and fourth quarters, up high 20s and low 40s, respectively, and revenue growth is expected to be more moderate in the second half. The 2-year stack for Q3 is up more than 30%. Our transport refrigeration outlook is unchanged.

Likewise, our Asia Pacific segment, our outlook for the full year is unchanged. Revenue in the second half is expected to be flattish, purely related to tough prior year comps while bookings continue to be strong. Now I’d like to turn the call back over to Chris. Chris?

Christopher Kuehn: Thanks, Dave. Please turn to Slide #9. Strong execution, record bookings and near-record backlog puts us in an excellent position as we move into the fourth quarter. We’re raising our full year revenue and EPS guidance for 2023. Organic revenue growth is expected to be between 8% and 9%, up from our prior guidance of up approximately 8%, reflecting strong Q3 performance and a largely unchanged outlook for a robust Q4. We’re raising our adjusted EPS guidance to approximately $9, up from a range of $8.80 to $8.90, mainly reflecting a flow-through of our third quarter outperformance versus our guidance and continued strong leverage of 30%-plus for the fourth quarter. We’re pleased with our free cash flow performance of approximately $1.3 billion year-to-date.

And on the full year, we continue to expect to deliver powerful free cash flow of equal to or greater than adjusted net earnings or approximately $2 billion. As we’ve highlighted before, we pay close attention to our investment peer group and consistently target top quartile financial performance, including adjusted EPS growth and adjusted free cash flow conversion. We believe our guidance places us in a strong position to deliver against that target in 2023. As we said in our last earnings call, we expect an increased M&A contribution in the second half versus the first half due to the timing of acquisitions. We had approximately 3 points of M&A in the third quarter and expect to have approximately 2 points of M&A in the fourth quarter as 1 acquisition passes the 1-year mark and is included in our base.

There is no change to our full year guidance of approximately 2 points from M&A. Please see Slide 19 of the presentation for additional details related to guidance to assist with your models. Please go to Slide #10. We remain on track to deliver $300 million of run rate savings from business transformation by 2023, including $60 million which will be realized in 2023. We continue to invest in these cost savings and high ROI projects to further fuel innovation and other investments across the portfolio. Our continuous improvement mindset is an integral part of our business operating system, and it’s designed to drive gross productivity each year to offset other inflation. While it’s been extremely difficult to realize meaningful levels of productivity in recent years, given the supply chain and other macro challenges, productivity is improving as supply chain challenges abate and is contributing to our 30%-plus organic leverage target in 2023.

Please go to Slide #11. We remain committed to our balanced capital allocation strategy focused on consistently deploying excess cash to opportunities with the highest returns for shareholders. First, we continue to strengthen our core business through relentless business reinvestment. Second, we’re committed to maintaining a strong balance sheet that provides us with continued optionality as our markets evolve. In 2023, we received upgrades to our credit ratings, which are now Baa1, BBB+, reflective of our strong balance sheet and cash flow generation. Third, we expect to consistently deploy 100% of excess cash over time. Our balanced approach includes strategic M&A that further improves long-term shareholder returns and share repurchases as the stock trades below our calculated intrinsic value.

Please turn to Slide #12, and I’ll provide an update on our capital deployment for 2023. Year-to-date, as of the end of October, we’ve deployed $1.6 billion in cash with $513 million to dividends, $535 million to M&A and $550 million to share repurchases. We have significant dry powder with over $2.6 billion remaining under the current share repurchase authorization, and our shares remain attractive, trading below our calculated intrinsic value. Our M&A pipeline remains active, and we have deployed or committed approximately $900 million year-to-date as of the end of October to bolt-on leading technology acquisitions and equity investments. Our latest acquisition, Nuvolo, was announced in early October. Nuvolo will augment our energy services, enterprise management and digital capabilities in commercial HVAC.

We expect the Nuvolo transaction to close in the fourth quarter. All in, we’re on track to deploy approximately $2.5 billion in cash in 2023. Our strong free cash flow, liquidity and balance sheet continue to give us excellent capital allocation optionality moving forward. Now I’d like to turn the call back over to Dave. Dave?

David Regnery: Thanks, Chris. Please turn to Slide #14. Transport refrigeration market forecasts for both North America and EMEA remain unchanged, and we expect to outperform each market in 2023. Our performance through the third quarter is on track to meet these expectations. The slide shows key data points on the markets and on Thermo King specifically to provide additional transparency and reference information. Please go to Slide #15. As discussed, ACT’s projections for 2024 have been volatile, and we are focused on conducting a thorough analysis of the markets. In the interim, we’ve included ACT’s most recent forecast for 2023 through 2028 for your reference. Please go to Slide #16. We expect to provide 2024 guidance on our fourth quarter earnings call.

However, given increasing visibility, we believe it may be constructive to discuss key dynamics at play that give us confidence we’ll see healthy growth in 2024. Our commercial HVAC businesses, which make up roughly 65% of our total revenues, are executing well in healthy markets, and the agility of our sales teams to quickly pivot focus to growing vertical markets is driving record bookings and backlog. Our applied backlog is a standout and provides a long higher-margin service tail that makes our business stronger and more resilient. Secular mega trends continue to support growth, and policy and regulatory stacking is amplifying these tailwinds with the majority of these programs still ahead of us. We expect to enter 2024 with our residential business largely through the normalization process and on path to our long-term target of GDP-plus growth.

We continue to lead with innovation, which yields healthy pricing opportunities, and our business operating system is primed to stay ahead of inflationary pressures. The supply chain has vastly improved and pockets of remaining challenges continue to abate. Our culture is lean-based and we’re excited about the productivity we can unlock as we move into 2024. We’ve also been heavily investing in productivity-enhancing projects such as factory automation, which we expect to unlock further value. ACT is forecasting a dip in North American trailer production in 2024, a snapback in 2025 and growth thereafter. While we’re in the process of further assessing their forecast, our North America transport refrigeration business is approximately 10% of our total revenues.

We expect to execute well, manage the business tightly, outperform the end markets and, if necessary, manage deleverage within gross margin rates. Lastly, while we don’t talk about our service business a lot, we’re quietly putting up double-digit growth in 2023 on top of a 6-year compound annual growth rate of high single-digit growth. Our service business is strong, resilient and poised for growth, and we continue to build out our energy services and digital capabilities and offerings, which represents a big current and even larger future opportunity. Please go to Slide #17. In summary, we are well positioned to drive significant value over time. We are proud to have been named one of Fortune’s Best Workplaces for Women and one of the World’s Best Companies by Time Magazine.

Our culture and people fuel our innovation and help us to fulfill our purpose every day. This steadfast focus on purpose, our leading innovation, our proven business operating system enables us to execute our strategy and stay nimble across our resilient portfolio. This, in turn, enables us to consistently deliver a leading revenue and earnings growth profile and powerful free cash flow. With our strong performance, elevated backlog and continued high levels of customer demand, we are confident in once again raising our full year revenue and EPS guidance and reaffirming our free cash flow conversion target. We have the team, the strategy and the track record to deliver strong performance in 2023 and differentiated shareholder returns over the long term.

And now we’d be happy to take your questions. Operator?

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Q&A Session

Operator: [Operator Instructions]. Your first question is from Scott Davis of Melius Research.

Scott Davis: I’m kind of getting sick of congratulating you on good quarters, but this is one of the better ones.

David Regnery: Please keep it up.

Scott Davis: You’re making Lehigh proud, Dave. All good. Guys, when you think about the backlog that you have and the demand environment in commercial, is this the type of environment where you can really be selective on projects and kind of cherry pick the stuff that as really the margin, price margin structure that you want? Or are you still — or is that not kind of how it works and you’re just out there bidding on a wider array of stuff but just bidding at a higher price? I was just trying to get a sense of that interplay between project selectivity and really just the supply-demand imbalance that’s out there right now.

David Regnery: Yes, Scott, it’s a good question. We have strong core business right now. And we spend a lot on innovation and we price our innovation to ensure that we get proper returns. So I would say it’s leading more with innovation, and we’re constantly looking for how we can improve our portfolio, how we can improve the efficiency of our products, how our products can use next-generation low-GWP refrigerant. That’s all inclusive in our business operating system when it comes to innovation. And that’s what’s really leading our markets right now. And I would also tell you that having this, and I know I’ve told you this before, but this direct sales force and being able to educate them on new innovations real time and having them take those messages to the influencers on jobs is very, very important when you go to close especially some of these large applied jobs.

Scott Davis: Yes, that’s helpful color. I have to ask this question. You have a competitor who had a ransomware issue in the quarter. Did that help you guys as it related to bidding on things and such or was that a nonevent?

David Regnery: It was not — it was a nonevent so I hope everything is okay there, but it was a nonevent.

Operator: Your next question is from Julian Mitchell of Barclays Capital.

Julian Mitchell: I think, Dave, you emphasized a couple of times the strength in applied bookings and the difference versus light commercial because of the service element. So maybe just a follow-up on that point would be around sort of what’s the rough split today of, say, the revenues in your commercial HVAC business between applied and light commercial? And just wondered when you’re looking at the revenue outlook next 12 months, do you anticipate much of a difference in revenue trends of applied versus light commercial maybe because of stimulus impacts or the scale of the respective backlogs? Any sort of perspective around that, please.

David Regnery: Yes. Julian, we don’t look at just light. We look at units are in total so it would be light and large. And historically, it’s been about 50-50 in our equipment business. But obviously, in the third quarter, we had very, very strong demand in our applied business. So think of data centers, high tech, education, we’re very strong. We had solid performance in other verticals, too, like health care, life science, government, industrial. And then there were some weaker verticals as well. Think of traditional office, warehousing and retail and those weaker verticals where you tend to see more unitary than applied systems.

Julian Mitchell: That’s very helpful. And then just my follow-up. It’s more of a sort of silly short-term one, but only 1 quarter left in the year. Your sales guide, I think your Q4 sort of construct on guidance is the same as it was back in July, and you just kind of flowed through the Q3 beat to your full year guide. But if I wanted to look at the Q4 for what that’s worth, the revenue guide implies nearly, I think, sort of 8%, 9% sequential sales decline from Q3, which seems a bit heavier than normal. Is that just kind of noise around backing out from the year? Or is there anything specific maybe in transport or something like that, that’s weighing on Q4?

Christopher Kuehn: Julian, it’s Chris. I’ll start off. The Q4 implied guide is kind of around mid-single digits organic revenue growth, and it is a little bit of a stepdown versus Q3. But if we put a few reasons behind it, one is when I think about the toughest comp of the year, our commercial HVAC businesses, this is really the toughest comp across the board going into the fourth quarter on a year-over-year basis. Second would be the contribution from price. We would expect to be a bit lower in the fourth quarter than the third quarter. We commented price delivered around 4 points of growth in Q3. You probably dialed that into about 2-ish points of growth in Q4, so there’s about 2 points right there sequentially. And then maybe just to round out another response here, really be around residential as it continues to normalize.

We did a little better in the third quarter on revenues. Our constructive view around residential for the full year hasn’t changed with revenues down around mid-single digits. So we’re very focused on making sure inventory in the channel is positioned well for the start of 2024. So we would expect that normalization to continue really into the fourth quarter. So hope that gives you a little bit of some view here on how we think about Q3 to Q4. But let’s not forget maybe the first point, the commercial HVAC on tough comps, we had 40% growth in EMEA last year, 30% growth in Asia last year, really toughest comp of the quarter.

Operator: Your next question is from Andy Kaplowitz of Citigroup.

Andrew Kaplowitz: Impressive quarter. Dave, with the understanding that orders can be lumpy, it appears that you actually had a positive inflection in orders in Americas commercial HVAC in the quarter despite concerns of higher U.S. rates. So did you see larger mega projects start to hit a little more frequently in the quarter? I know you mentioned strength in data centers. Did you see like some of your bigger verticals actually heat up a bit as the quarter went on? And would you say that, that gives you more of a probability of ending backlog at the end of this year closer to $7 billion and $6 billion as I know you’re guiding?

David Regnery: Yes. I mean, we’re still tracking a lot of “mega projects”, and we’re defining a mega project, again, as a project where the total revenue — total size of it is over $1 billion. We’re still tracking a lot of those in our pipeline. So yes, we had a little bit of activity in the third quarter but we just had some really nice growth. And as I said earlier, data centers, education continues to be very strong. And then we had like what I would call solid performance over a lot of different verticals, health care, life science, government, industrial. Those are all very solid performance in the quarter. So I think a lot of the mega projects are yet to come, which is still good news. And I think I’ve told you on our second quarter call, our ability to track these projects and to triage them on a global basis because some of these big mega projects, you have decision-makers that are in different parts of the world.