Trane Technologies Chugs Along, Strong Backlog Increasingly Derisk The Short Term (TT)

Industrials have done alright over the past three months, with a lot of relief rallies coming out of fourth quarter earnings that not only beat expectations, but also included better order numbers than the Street expected and better guidance for 2023. So too with Trane Technologies (NYSE:TT), as commercial HVAC demand has remained quite healthy and management is confident that the company will exit 2023 with still-elevated backlogs.

Trane has continued to outperform since my last update on the company, and along with Daikin (OTCPK:DKILY) these two HVAC companies have outperformed the industrial group over the past year, while Carrier (CARR) and Lennox (LII) have modestly underperformed. At this point I still like the long-term drivers for HVAC, including increased emphasis on energy efficiency in the U.S. and electrification in Europe, but I still see elevated shorter-term risk as underlying residential and commercial activity slows. Valuation remains “challenging”, though Trane’s above-average longer-term growth prospects mitigate that to some extent. In a market where there are fewer clear bargains in the industrial space, Trane does at least merit consideration as a company worth paying up to own.

Strong Results Pretty Much Across The Board

There was a lot to like Trane’s fourth quarter between the reported results and a confident guide for the year ahead (in terms of both revenue/earnings and orders). With beats at the top line and operating income line, maybe some could quibble that the upside was driven more by Europe and Asia than by the U.S. (where there is more end-market uncertainty), but again I’d call that a “quibble”.

Revenue rose 14% as reported and 16% in organic terms, beating by 4% and coming in as one of the strongest industrial revenue growth numbers I’ve seen so far. Growth was well-balanced, with sales in the Americas up 14%, in EMEA up 23%, and in Asia up 19% (all organic); Americas revenue was slightly better than expected, while EMEA beat by about 19% and Asia by 4%.

Regrettably, Trane management doesn’t disclose line-item revenue drivers in the most relevant or easily comparable way. Revenue in the U.S. residential market was up “ low single-digits” (Lennox reported 14% growth), while U.S. commercial revenue was up “low teens” (up 20% at Lennox) and transportation (refrigeration) was up 30% (up 10% at Lennox).

Gross margin improved 70bp yoy and fell 270bp qoq to 30.1%. EBITDA rose 22% (with margin up a point to 15.7%), while operating income rose 25% (with margin up 120bp to 13.7%). Segment-level profit improved 24%, with margin up 120bp to 15.3%. Trane beat sell-side expectations by about $0.07/share at the operating profit line, with other below-the-line items (namely a lower tax rate), providing the remainder of the upside.

Orders Are Slowing, But There’s A Lot Of Backlog To Carry The Company Through

Orders were flat year over year on an organic basis, with flat results in the Americas, 2% growth in EMEA, and a 6% contraction in Asia. Residential bookings in the U.S. were down at a mid-20%’s rate against a high single-digit decline in Q3’22 and a year-ago comp of over 30% growth. Commercial bookings largely kept pace with revenue (up “low teens”), with applied orders up more than 30% and unitary orders up at a high single-digit rate. Transportation orders in the Americas region “normalized” and the company has not yet opened its order book for the second half of 2023.

Commercial bookings were also healthy in the EMEA region, up low-teens, while orders in Asia declined. Transportation orders were down in both EMEA and Asia.

Trane ended the year with around $7 billion in its backlog, enough to cover around five months of revenue, and remain well above average. In the Americas business, backlog is still more than 3x historical norms (relative to sales), as supply chain issues and healthy orders have reinforced the backlog. While not quite as impressive, the EMEA backlog is 1.4x above normal levels, with healthy regulatory tailwinds pushing commercial HVAC demand.

Management called for 6% to 8% revenue growth in FY’23, suggesting modest volume declines in the year, but expects to exit 2023 with over $6 billion in backlog after a mid-single-digit decline in bookings.

This is where I think guidance could be too aggressive. Supply and labor constraints have definitely pushed out deliveries in commercial HVAC (as seen with the strong differential between applied and unitary booking growth), but commercial building activity has started to slow more noticeably. That healthy backlog should drive healthy revenue and profits through at least the first half of the year, but I do have some concerns that booking activity could slow more significantly. Likewise, I think the U.S. residential market could see a sharper correction. Along those lines, I would note that Honeywell (HON) did say they’re seeing evidence of slowing private investment in its shorter-cycle Building Technology portfolio.

Incentives (financial and regulatory) could counterbalance this. The Inflation Reduction Act does provide financial incentives to adopt new, more energy-efficient HVAC technologies for both residential and commercial building owners, and I think more impact from that will be seen in 2024 versus 2023. Likewise, there are ongoing incentives in Europe to electrify HVAC (including reduced reliance on Russian gas). It is possible, then, that growth from energy efficiency retrofits/replacements could largely patch over underlying weakness in residential and commercial markets.

The Outlook

I’m still looking for 5% long-term revenue growth from Trane, so it’s not as though my concern about underlying demand over the next 12-18 months has longer-term repercussions. I do expect some further improvements in margins as well, with around one point of EBITDA margin improvement over the next three years and long-term free cash flow margins growing from the 10%-11% range toward 14%-15%. That translates into about 7% long-term FCF growth, and I’d expect further returns of capital to shareholders (and/or some M&A activity; I believe there are opportunities for Trane to acquire in areas like heat pumps and controls).

Discounting those cash flows back suggests a total long-term annualized potential return on the low end of the high single-digits, which honestly isn’t that bad for a high-quality industrial (let alone one with some ongoing growth tailwinds). Multiple-based valuation is more challenging, as Trane continues to enjoy a premium beyond what it would normally deserve on the basis of its margins/returns, but in the context of an above-average growth outlook I’m not too concerned about it.

The Bottom Line

If you believe the energy efficiency retrofit theme in HVAC (particularly commercial HVAC) has legs, and you’re not that concerned about valuation or near-term risks to bookings, Trane could still work for you. My issues are mostly around relative valuation – there are equal or better growth stories with better valuations, so it’s not at the top of my list, but it’s also a name worth keeping an eye on in case it drifts toward a better price.

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