Trane Technologies plc (NYSE:TT) Q4 2022 Earnings Call Transcript

Trane Technologies plc (NYSE:TT) Q4 2022 Earnings Call Transcript February 2, 2023

Operator: Good morning. Welcome to the Trane Technologies Q4 2022 Earnings Conference Call. My name is Lisa, 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. 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 fourth quarter 2022 earnings conference call. This call is being webcast on our website at, 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?

David Regnery: Thanks, Zac, and everyone, for joining us on today's call. Let's turn to Slide 3. Before I dive in, I'd like to spend a few minutes on our purpose-driven strategy, which is drives our differentiated financial results and long-term shareholder value. Our strategy is aligned to powerful megatrends, like climate change which has serious and far-reaching effects on the environment, the economy and human health. 2022 was again one of the warmest years on record, and we continue to see extreme weather events. Urgent action is needed to accelerate our transition to a low carbon green economy. That's where Trane Technologies is uniquely positioned to lead. Our innovation is transforming the industry and accelerating decarbonization of commercial buildings, homes and transport.

We're helping our customers advance their own sustainability goals. While contributing to our gigaton challenge, a pledge to reduce customers emissions by 1 billion metric tons by 2030. Our purpose driven strategy, relentless innovation and strong customer focus enables us to deliver a superior growth profile, strong margins and powerful free cash flow. The end result is strong value creation across the board, for our team, our customers, our shareholders, and for the planet. Moving to slide 4, our global team delivered strong performance in 2022. As we compare our results to peers and the broader industrials, we're confident organic revenue and adjusted EPS growth will again rank in the top quartile for both the fourth quarter and for the full year.

Our global teams have demonstrated resiliency and tenacity navigating persistent inflation, supply chain and a myriad of other macro related challenges globally. They've executed our business operating system which is designed for operational excellence, and delivered record results across virtually all key metrics. Throughout 2022, and building on extraordinary strength in 2021. We are continuing to see our relentless year in year out rain or shine, reinvestment and innovation paid dividends through unprecedented levels of customer demand. While this demand has been broad based, we're seeing particular strengths in our nonresidential businesses led by commercial HVAC, global commercial HVAC, organic bookings were up nearly 40% in 2022 on a two-year stack.

Americas commercial HVAC bookings were up more than 40% on a two-year stack. The tremendous growth we've delivered over the past two years has driven absolute bookings to record levels. We continue to encourage investors to look at absolute bookings levels, in addition to growth rates to gain a more complete understanding of the strength of our businesses and our backlog. As an example, our commercial HVAC organic revenues were up more than 20% in the fourth quarter, while organic bookings were higher by about half that level up 11%. Still the book-to-bill was over 105% further adding to already record backlog. Likewise, while enterprise organic revenues were up 16% in the quarter, and organic bookings were flat total book-to-bill was still 100%.

Customer demand, absolute bookings and absolute backlog have never been higher. We disclose absolute bookings and revenues each quarter by segment in our earnings release. 2022 bookings of $17.5 billion exceeded 2022 revenues by $1.5 billion for our book-to-bill 109%. Backlog entering 2023 is $7 billion well over 2x historical norms. Further, we expect backlog to remain elevated throughout 2023 and anticipate entering 2024 with backlog in excess of $6 billion. At our guidance midpoint revenue growth rate of 7%, 2023 revenues would be approximately $17.2 billion when compared to bookings of $17.5 billion in 2022, bookings would need to decline by over $1.1 billion in order for backlog to fall to the $6 billion number that I referenced heading into 2024.

That would equate to a decline of about $275 million per quarter. For backlog to return to more normal levels of approximately $3 billion, bookings would need to decline by over $4 billion or more than $1 billion per quarter. While we recognize that we have difficult comps in 2023, we have a high degree of confidence that bookings will remain robust, and that we will enter 2024 with backlog of $6 billion or more. Turning to our guidance for 2023. We expect continued strong revenue growth, EPS growth and free cash flow. We have a proven strategy to outperform end markets and our business operating system enables us to deliver consistent strong execution despite challenging macro environments. We have a multiyear track record of delivering differentiated financial performance for shareholders and are well positioned to deliver strong shareholder returns over the long term.

Please turn to slide number 5. As I discussed at the outset, I am proud of our global teams for delivering strong performance in 2022 despite persistent macro challenges, we significantly exceeded our revenue and EPS growth targets while delivering solid leverage and free cash flow and returning significant cash to shareholders through dividends and share repurchases. While free cash flow was strong at 91% of adjusted net earnings for the year, we fell short of our target of 100% free cash flow conversion. We drove an exceptional volume of shipments in the month of December in our commercial HVAC and Thermo King businesses to meet customer demand, which shifted the timing of approximately $150 million in receivables into the first quarter 2023.

We also invested about $40 million in safety stock inventory in the fourth quarter to ensure continuity of supply in this dynamic environment. Net of these two areas free cash flow would have been 100%. Please turn to slide number 6. One of the most important elements of our long-term strategy is fueling our high-performance Flywheel through relentless investments and innovation to solve our customers most complex problems. Leading customer innovation drives consistent and profitable market our growth, which in turn drives more cash to reinvest back into the business to further accelerate growth. This Flywheel as we refer to it is one of the key differentiators between Trane Technologies and our competition. We are unwavering in our commitment to invest heavily in our business, year after year, in good times and in bad.

It's this ongoing focus that has enabled us to drive differentiated financial performance for shareholders over time. Over the past five years, including the pandemic in 2020, we delivered a 7% revenue compound annual growth rate, 250 basis points of margin expansion and free cash flow conversion well in excess of 100% and since 2017, we've deployed more than $13 billion in capital, with $8.3 billion return to shareholders in the form of dividends and share repurchases. Looking forward, you can expect us to continue to consistently reinvest in our business. And we'll talk later in the presentation about some of the ways in which we are accelerating investments in 2023, leveraging the strong outlook we see entering the year. Overall, we are exceptionally well positioned to continue our strong track record of performance and capital deployment over the long term.

Please turn to slide number 7. As I discussed earlier in the presentation, customer demand for innovative products and services is at record levels, with particular strength in our nonresidential businesses, which comprise approximately 80% of our portfolio. Americas commercial HVAC was again a standout with low teens bookings growth and mid-teens revenue growth, including another quarter of high single digit services revenue growth. Bookings were up nearly 40% on a two-year stack, resulting in high absolute dollar bookings. And a book-to-bill ratio of over 110%, backlog continued to grow from an already high base and is now at levels that are 3x historical norms further adding to our visibility and confidence in our guidance for 2023. In residential, bookings continue to normalize, and we're down mid 20s in the quarter.

The decline was expected against a very high prior year comp, as two year stock bookings were still up double digits. Residential revenues were up low single digits in the quarter and sell-through is up mid-single digits reflecting healthy end market demand. We continue to have historically high backlog in our residential business. And in the fourth quarter we work closely with our Independent Wholesale Distributors or IWDS to help them manage their inventory positions and mix as they entered 2023. Our goal was to mitigate the risk of stranded inventory across the channel. I'm pleased with the approach we took and the partnership with our channel. We believe our IWDS are in a good inventory position, entering 2023 as a result. Our America Thermo King business had another very strong quarter with 30% revenue growth.

This follows growth of more than 60% in Q3. We've included our traditional transport refrigeration market overview slide near the back of the presentation, which shows the strong share gains for our Thermo King businesses globally in 2021 and 2022. Bookings were down modestly as expected, but still up more than 40% on a two-year stack. Backlog in this business remains at historically high levels, providing good visibility into future revenues. Overall, Americas backlog is unprecedented at 3x historical levels. Turning to EMEA, results in the quarter were also very strong. In our commercial HVAC business, we've highlighted acute supply chain challenges that have been impacting revenues and more importantly leveraged throughout 2022. We were able to overcome many of these challenges in the fourth quarter and delivered revenue growth in excess of 40% with strong leverage.

Services growth was once again robust up double digits. Bookings were also robust up low teens with two-year stack bookings up more than 20%. We're seeing tremendous demand for Thermal management systems which are three to four times more efficient than conventional heating and cooling. Our transport refrigeration business in EMEA also delivers strong performance with low single digits organic revenue growth in the quarter in a market that was down double digits. We discussed the transport refrigeration business in detail on slide 16 of the presentation. Overall EMEA backlog remains elevated 40% higher than historical norms. Turning to Asia Pacific, the commercial HVAC team delivered another very strong quarter in Q4 with revenues up more than 20%.

And services up mid-teens. Asia bookings were down as expected related to tough prior year comps and large bookings in the high-tech sector outside of China. Two-year stack bookings were still up high teens. China was resilient in the quarter with bookings up high single digits and revenue up double digits. Overall, Asia backlog remains elevated approximately 50% above historical norms. Now, I'd like to turn the call over to Chris. Chris?

Christopher Kuehn: Thanks, Dave. Please turn to slide number 8. This slide does a nice job encompassing our overall performance in the quarter, which was strong across the board. Organic revenues were up 16%, adjusted EBITDA margins were up 100 basis points and adjusted EPS was up 34% versus prior year. We delivered strong organic enterprise growth in both equipment and services of high teens and low teens respectively. Services growth was consistently strong throughout 2022. And our services mix is approximately 32% of enterprise revenues. Strong services mix bolsters the company's resiliency in virtually all market conditions. Please turn to slide number 9 to discuss the key revenue dynamics for the quarter. So I'll focus my comments on margins.

Technology, Ventilation, Air conditioning
Technology, Ventilation, Air conditioning

Photo by Immo Wegmann on Unsplash

We delivered strong margin expansion in each of our business segments. The key margin drivers are the same for each of our businesses. So we've consolidated the highlights on the right side of the page, robust volume growth, positive price realization, and modestly positive productivity more than offset persistent material and other inflation in the quarter. We also leverage strong margin expansion across the businesses to accelerate investments in innovation across a number of key initiatives. As mentioned previously, we are pleased with the significant progress we've made over the past two quarters, mitigating acute supply chain challenges in our EMEA businesses, which led to strong volume growth coupled with significant margin expansion in the quarter.

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

David Regnery: Thanks, Chris. Please turn to slide number 10. As we discussed throughout the call, underlying demand for innovative products and services has never been higher, with historically high levels of bookings and backlog across our businesses. Relentless innovation, leading brands with strong market positions, customer focus and operational excellence are hallmarks of our market out growth over time. In the Americas, our commercial HVAC business is driving strong demand and share gains as demonstrated by our full year 2022 order growth that is more than 40% on a two-year stack. And we've exited the fourth quarter with elevated backlog that is 3x historical norms, providing us significant visibility into future revenues.

The nonresidential markets remain strong and we are bullish on the outlook for commercial HVAC. Demand continues to be robust in datacenters, education, healthcare, and the high-tech industrial verticals, where we have strong customer relationships and market positions. Our commercial HVAC business is underpinned by long term secular tailwinds of energy efficiency, decarbonization and indoor environmental quality which are only growing stronger. We also see tailwinds from new and ongoing regulatory and policy related drivers such as the Inflation Reduction Act, Education, Stimulus, and the CHIPS and Science Act. Our commercial HVAC business is well positioned as the premier franchise to capitalize on the significant market opportunities that lie ahead.

The residential market outlook remains dynamic. Near term we see the market continuing to normalize across bookings and revenue and the process is well underway. As we saw in the third and fourth quarters. For 2023, we believe this normalization process results in market units likely down in the mid-single digit range. With tailwinds from elevated backlog, pricing, supportive regulatory and policy initiatives and share gains, we believe our revenues will be relatively flat. Our guidance encompasses scenarios for residential in the plus or minus low single digits range. We don't see a cliff scenario and residential is about 20% of our business. So a 10% decline would present a 2% headwind to the enterprise. Longer term, we continue to see residential as a GDP plus business for us.

Turning to Americas transport refrigeration, our diversified portfolio of products and aftermarket significantly outperform the end markets in 2021 and 2022. Act is calling for low single digit growth in trailer in 2023. And for weighted average transport refrigeration growth to be flattish. Consistent with our strong track record, we expect to outperform the end markets in 2023. Longer term, we continue to see transport refrigeration as a GDP plus, plus business. We'll talk more about the transport refrigeration outlook in our topics of interest section. Turning to EMEA, commercial HVAC, the market growth picture remains muted with macroeconomic and geopolitical challenges weighing. Given our innovative and leading sustainability solutions, we've been able to significantly outgrow the EMEA HVAC markets over a long period of time.

We see continued opportunities for market out growth going forward, aided by thermal management systems, which are three to four times more efficient than traditional heating and cooling solutions and are gaining momentum in the market. Turning to EMEA transport refrigeration, the removal of the Russian market was a key driver of the market decline in 2022. Thermo King EMEA outgrew the end markets up high single digits for the year. As return to 2023, we expect the market to be down low single digits to mid-single digits, mainly related to economic uncertainty in the region. Our innovative products and solutions continue to provide us with strong platform to outgrow our end markets, which we expect to do again in 2023. Turning to Asia, the environment remains dynamic and COVID continues to add complexity and unpredictability to the market forecasts.

We see continued strength in datacenter, electronics, pharmaceutical, and healthcare verticals. And if these markets continue to perform well, we could continue to see relatively stable growth in 2023. Asia continues to be one of the more dynamic markets. So we're cautiously optimistic on this segment, which represents about 10% of our portfolio. Now, I'd like to turn the call back over to Chris. Chris?

Christopher Kuehn: Thanks, Dave. Please turn to slide number 11. Dave provided a good framework for how we're looking at our key end markets for 2023 and our guidance reflects these views. Embedded in our guidance is our philosophy around our value creation Flywheel, which builds in high levels of business reinvestment in innovation out growth across our end markets, and strong leverage. Regarding 2023, to 6% to 8%, organic revenue growth, and $8.20 to $8.50 in adjusted earnings per share, or approximately 11% to 15% EPS growth. Through the back half of last year, we talked about ending 2022 with $6 billion or more in backlog. And we're sitting at a record level of $7 billion as of the beginning of 2023. This gives us good visibility into 2023 revenues.

We have approximately 1% of growth from M&A in 2023 from bolt-on acquisitions completed in 2022. And we expect FX to be neutral on a full year basis. We're targeting organic leverage of 25% plus for the year. There are a few key factors that play into our organic leverage target. So I'll spend a couple of minutes covering these factors to help frame the guidance. First, we're expecting modest incremental price and solid volumes to offset material and other inflation and drive strong incremental margins. Second, while we're expecting slow and steady improvement in a supply chain, as we've seen throughout 2022, we're not expecting it to be fully normalized until well into 2023 at the earliest. This will continue to put pressure on the realization of strong productivity, which is where our business operating system really thrives.

Third, the environment around prices for Tier 1 metals remains dynamic. In the third quarter and early part of the fourth quarter last year, we saw a deflationary trend for base metal prices. However, pricing has increased over the last two months on copper, aluminum and steel, negating much of the potential deflationary benefit in 2023. To update you in a question from our earnings call last quarter, our Tier 1 spend on these metals is approximately $750 million split roughly a third each for copper, aluminum and steel. We are seeing modest deflation in freight and logistics costs. We're also seeing inflation from Tier 2 suppliers, as they incur higher than normal wage increases and energy costs. Net we're not baking in significant inflation or deflation into our guidance at this early stage in the year.

Fourth, we're using the favorable environment we see in 2023 as an opportunity to double down on key investments across the business in advanced manufacturing and automation, digital and electrification platforms, among other key programs. We are targeting 20 to 30 basis points of incremental spend across these areas, which will be embedded in a segment P&L. This is above and beyond our average incremental spend of approximately 40 basis points per year. So we're targeting 60 to 70 basis points of incremental spend in total. We've highlighted that business reinvestment is how we win over the long term. And we're confident we can make these investments in 2023 while hitting our guidance range. We have additional investments earmarked in our corporate and CapEx guidance as well.

Lastly, while our M&A transactions I referenced earlier will have a strong payout over the next several years, they will add about 1% to our revenue at approximately 3% leverage in the first year, inclusive of integration costs. The net effect cuts about two percentage points off of our enterprise reported leverage versus our organic leverage that excludes M&A. It's not a huge amount, but it's something we wanted to highlight as a factor to consider in our guidance, as organic leverage will be stronger than reported leverage simply on the math related to M&A. We'll highlight organic leverage each quarter to provide transparency. Turning to cash, we expect 2023 to be a strong cash collection year, we have about $150 million in receivables that shifted from December into early Q1.

And barring persistent supply chain issues all year, which we do not anticipate, we expect to bring working capital levels down specifically around inventory. Net free cash flow conversion should be 100% or better. Please go to slide number 12. We remain on track to deliver $300 million of run rate savings from business transformation, including an incremental $60 million in 2023. We continue to invest these cost savings into high ROI projects to further fuel innovation and other investments across the portfolio. And I discussed a number of targeted investments for 2023. To be clear, our continuous improvement mindset is an integral part of our business operating system and continues well beyond the transformation program that we started in 2020 when we launched Trane technologies, our business operating system is designed to drive gross productivity each year to offset other inflation.

While it's been impossible to realize that level of gross productivity over the past three years, given the tumultuous macroeconomic backdrop, productivity has been improving as supply chain slowly recover and is contributing to our 25% plus organic leverage target in 2023. Please go to slide number 13. We remain committed to our balanced capital allocation strategy focused on consistently deploying excess cash 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. 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 number 14. And I'll provide an update on our capital deployment in 2022 and our outlook for 2023. In 2022, we executed strong and balanced capital allocation of $2.1 billion, including approximately $1.2 billion to share repurchases, $620 million to dividends, and approximately $250 million to M&A. We are targeting $2.5 billion in capital deployment in 2023, and expect to deploy 100% of excess cash over time. Our M&A pipeline remains active and we continue to exercise discipline in our approach. Our shares remain attractive trading below our calculated intrinsic value, and we have approximately $3.2 billion remaining under current share repurchase authorizations.

Our strong free cash, flow liquidity and balance sheet, continue to give us excellent capital allocation optionality and dry powder moving forward. Now I'd like to turn the call back over to Dave. Dave?

David Regnery: Thanks, Chris. Please turn to slide number 16, our Thermo King businesses have significantly outperform their end markets in both 2021 and 2022 as illustrated on the table on the right-hand side of the page. In 2022, the North America transport refrigeration markets were up 12% while Thermo King Americas was up more than 20% The EMEA transport refrigeration markets were down 9% in 2022 while Thermo King EMEA was up high single digits. We are very pleased with the share gains we've achieved over the past two years. In 2023, we expect the markets to be flat to modestly down and for Thermo King to once again outperform consistent with our strong track record. We also added additional information to the slide this quarter to help investors and analysts gain a better understanding of the size of the businesses.

We've included a footnote that global Thermo King has approximately 50% of our enterprise revenue and the split between the Thermo King segments is roughly 60%, Americas 35%, EMEA and 5% Asia. Please turn to slide number 17, Act has updated their long term forecast for refrigerated trailers through 2027. The data supports the view we've been highlighting for some time. Now that this is a mid-40,000-unit market plus or minus about 10%. The chart plots the actual and forecast but the key takeaways is that the market is expected to be flat at 45,000 units in 2023. Dip to 40,000 units in 2024 rebound back to 45,000 units in 2025. And to continue growing low single digits from that point forward to 2027. Additionally, our transport refrigeration businesses are a diversified portfolio with a healthy aftermarket business.

We have strong positions in large and small trucks, APUS, bus, air, and rail and a proven track record to outperform the transport refrigeration markets. We believe this is a GDP plus, plus business for us over the long term. Please go to slide number 18. In summary, we are positioned to outperform consistently, energy efficiency, decarbonization and sustainability mega trends continue to intensify, driving increased demand for innovative products and services. We are delivering leading technologies and innovation to address these trends and accelerate the world's progress underpinned by our engaging uplifting culture. The strength of our business operating system, the power of our global team, unprecedented backlog and continued high levels of customer demand, give us confidence in our full year revenue and EPS guidance.

We believe we have the right strategy, the best team and a solid foundation in place 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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