Trane Technologies: Multipart Puzzle Between Industry Drivers, Macro Risk & Valuation

I described Trane‘s (NYSE:TT) valuation as “interesting” earlier this year, as the HVAC sector had weakened on a slowing outlook and what I believed to be sector rotation. While I wasn’t fully comfortable with the valuation, I thought growth prospects were stronger in the near term than the Street was appreciating, and that has been borne out this year by the company’s results.

The shares have appreciated close to 10% since that last article, outperforming not only the broader industrial space, but other HVAC and refrigeration companies like Carrier (CARR), Johnson Controls (JCI), and Lennox (LII). On the positive side, I like Trane’s leverage to what I believe can be a multiyear trend of efficiency-driven upgrades, but on the negative side, I have some concerns about 2023 expectations and the valuation.

Robust Pricing Helps Drive Another Beat

Trane’s third quarter results were good relative to sell-side expectations, and strong pricing power is clearly playing a positive role in the story.

Revenue rose 19% in organic terms to $4.4B, beating by almost 6%. That growth stands out as one of the best results among the industrials I’ve seen, and while Trane had been a price leader since early in 2021 (generating more revenue growth from pricing than its peers), and remained so in Q3’22 with over 10% growth from pricing (above a sector average closer to 9%), volume picked up nicely (up 9%), albeit off somewhat easier comps (flat last year, and down 0.5% in Q3’20).

Overall 19% organic growth compares strongly to 11% growth at Carrier, 17% growth at Lennox, and 10% growth at Johnson Controls, though Building Products was up 23% at Honeywell (HON) – not really a true comparable but still a good read on building electrification, automation, and retrofit. Residential HVAC (or R-HVAC) grew “mid-teens” in the Americas region, beating the high-single-digit growth at Carrier and lagging the 18% growth at Lennox. Commercial HVAC (or C-HVAC) was up “low-teens” in the Americas, lagging Carrier (light commercial up 20%-plus and aftermarket up “double-digits”) and Lennox (up 19%).

Refrigeration was quite strong (up 30% adjusted), well ahead of Carrier (down 1%), as Trane benefited from its greater exposure to the faster-growing ground transportation market and lower exposure to containers and commercial refrigeration.

Gross margin improved 40bp to 32.8% (beating by 60bp), as strong pricing has started to overcome input cost inflation, and operating income rose 22%, with margin improving 60bp to 16.7%. Operating income beat expectations by almost 8%, adding $0.17/share versus sell-side expectations (and a bottom-line beat of $0.15/share).

Segment profits rose 21%, with margin up 50bp to 18.1%; Trane’s margins continue to compare favorably to Carrier and Lennox. By segment, Americas profits grew 24% with margin up 140bp to 18.1%; EMEA profits fell 6% with margin down 170bp to 16.8%; and Asia-Pacific profits rose 42% with margin up 310bp to 20.2%.

Commercial Orders Remain Strong, While Residential Falls Off

Relative to my expectations for Trane at the start of the year, residential has performed as well (if not better) than I expected. Still, the business is clearly slowing in the face of a slowing housing market and weaker renovation demand. Orders declined at a high single-digit rate in the quarter, with the book-to-bill falling to 0.92x. I don’t think 2023 will be a particularly good year for this business, even if strong pricing helps offset volume declines to some extent.

The C-HVAC market is pretty interesting. Orders were up 20% in the Americas and up low-teens in Europe, and I’ve been impressed by the strength of the business. I do have a weaker/lower outlook for new non-residential construction activity in 2023 than the Street, but the impact on companies like Trane isn’t so clear-cut.

New-build activity is only a part of the commercial picture, and the industry continues to see strong demand for retrofits/replacements driven by energy efficiency, as well as indoor air quality. The Inflation Reduction Act should boost this trend, albeit not likely in 2023, and the payback on efficiency-driven upgrades is now less than three years in many cases. In a potentially weaker market for real estate, those low paybacks could spur even more retrofits as building owners look for ways to make their properties more appealing to prospective tenants.

European demand for new systems as part of an effort to drive the electrification of heating (and adding air conditioning capabilities) is another multiyear driver to consider, though I think Carrier may be better-placed here given its strength in heat pumps.

The Outlook

Better pricing has led me to boost my 2022 revenue estimate by about 4% relative to my model at the time of my last article, but a weaker outlook for residential, commercial, and transport markets in Europe does lead me to reduce my growth rate for 2023; all told, it nets out to a slightly higher revenue outlook than before. Long term, I’m still looking for over 5% revenue growth as Trane continues to ride demand for more efficient commercial systems and growing demand for refrigerated transport.

I’ve also made minor adjustments to my margin assumptions, with slightly lower margins and FCF margins in the near term, but I still expect long-term EBITDA margins to approach 20%, taking FCF margins toward the mid-teens and driving high single-digit FCF growth.

Using a discounted cash flow approach, I see mid-to-high single-digit total annualized return potential (around 7%), and I don’t find that particularly compelling. Likewise, while Trane has respectable margins and relatively strong ROIC compared to other industrials (though a more in-line ROTA), the 14.25x forward EBITDA multiple that comes from that process/analysis doesn’t support a compelling fair value right now.

The Bottom Line

Given Trane’s exposure to what I believe are attractive secular growth opportunities (efficiency-driven building retrofits, as well as transportation refrigeration), I don’t have a problem with Trane getting some premium to its valuation. I simply think the premium in place renders the return potential more “fair” or “reasonable” than compelling. There are worse things than owning a good company with above-average growth prospects at a fair price, but I’d prefer to pick up shares at a bigger discount to fair value if possible.