Trane Technologies plc (TT) — Q4 2018 Earnings Call Transcript

Thanks, operator. Good morning, and thank you for joining us for Ingersoll-Rand's Fourth Quarter and Full Year 2018 Earnings Conference Call. This call is being webcast on our website at ingersollrand.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 Mike Lamach, Chairman and CEO; and Sue Carter, Senior Vice President and CFO. With that, please go to Slide 3, and I'll turn the call over to Mike. Mike?

Thanks, Zac, and thanks to everyone for joining us on the call today. Please go to Slide 3. Before discussing our fourth quarter and full year 2018 results, I'd like to begin with a brief review of the fundamental elements of our business strategy that underpin our financial performance and create value for our shareholders. First, our global business strategy is at the nexus of environmental sustainability and impact. The world is continuing to urbanize while becoming warmer and more resource-constrained as time passes. We excel at reducing the energy intensity in buildings and industrial processes, reducing greenhouse gas emissions, reducing waste of food and other perishable goods, and we excel in our ability to generate productivity for our customers, all enabled by technology. Our business portfolio creates the platform for the company to consistently grow above-average global economic conditions aided by the strong secular tailwinds I've outlined. Second, our business operating system is designed to excel at consistently delivering strong top line growth, incremental margins and free cash flow. And lastly, over the years, we've built an experienced management team and a high-performance winning culture that makes our performance sustainable. When combined with our dynamic capital allocation strategy, we have a differentiated business model that drives strong shareholder returns over the long term. Turning to Slide 4. Focused and consistent execution of our business strategy enabled us to deliver top-tier financial performance in 2018. We delivered top quartile organic bookings and revenue growth in each quarter and closed out full year 2018 with 13% organic bookings growth and 9% organic revenue growth for the enterprise. Adjusted earnings per share growth was also top quartile, up 24% for the year and up 29% in quarter 4. Despite persistent material and other inflation and tariff-related headwinds, our team successfully developed and delivered pricing and productivity actions that enabled us to effectively manage these costs and drive improved leverage and solid margin expansion throughout the year. Importantly, at the end of quarter 2, we set out to achieve significantly improved leverage of 25% in the second half of 2018. And the team delivered against that objective, while at the same time, delivering record organic bookings and record revenues. Additionally, we achieved 10 basis points positive price/cost for full year 2018 with 60 basis points of enterprise adjusted operating margin expansion while at the same time continuing our healthy pace of incremental business investment, which is core to our ongoing differentiated operational and financial performance. Free cash flow for the year was 82% of net income, which lagged our 100% conversion target. The largest component of the shortfall is related to funding working capital above-normal levels through the end of the year to meet growing customer demand for our products and services. We also funded additional CapEx for high-ROI projects beyond what we expected when we entered the fourth quarter. We've delivered an average of 110% free cash flow to net income conversion over the past 4 years, and we expect to return greater than 100% in 2019. Lastly, in 2018, we also continued to execute our balanced capital deployment strategy. After investing in the business, including $366 million in capital expenditures, largely related to footprint optimization and plant consolidation, we deployed approximately $1.7 billion between dividends, share repurchases and mergers and acquisitions. Turning to Slide 5. Our performance against our initial guidance expectations was strong with the exception of free cash flow, which I discussed earlier. We significantly beat on both the top and bottom lines and delivered strong margin expansion while managing inflation and tariff-related headwinds and making healthy investments in the business. Turning to Slide 6. Focused execution of our business strategy is delivering differentiated results in the marketplace and for shareholders, and we will maintain this focus going forward. Looking at 2019, we see the fundamental ingredients for another strong year. First, our end markets generally remain healthy, and I'll address that in more detail over the next couple of slides. Second, we're entering 2019 with record backlog in multiple business units after achieving exceptional bookings throughout 2018. This provides us with improved visibility into what to expect for 2019 revenues relative to where we'd have traditionally been at this stage in the year. Third, in 2018, we demonstrated our ability to effectively manage inflationary and tariff-related headwinds through pricing and productivity. Combined with higher expected volumes, we expect this to enable us to continue to deliver solid leverage, improving margins and strong EPS growth in 2019 as we did in 2018. For 2019, we're expecting free cash flow to exceed adjusted net income. We will continue to execute a dynamic capital allocation strategy that deploys capital where it earns the best returns. This includes organic investments, dividends, mergers and acquisitions, and share repurchases. On the M&A side, we have an active pipeline of attractive opportunities that will be a strong fit with our core business strategy. If or when these become actionable and affordable, we're in a strong position to execute any transactions. We also continue to see value in our own shares, which are trading well below calculated intrinsic value. Lastly, based on our performance in 2018 and our guidance for 2019, we're firmly outpacing the glide path to achieving our 2020 Investor Day revenue growth, EPS and free cash flow guidance that we laid out during our midyear 2017 Investor Day. Given the tremendous amount of inflation and tariffs the industry has endured over the last 2 years, we're moving along that glide path a bit differently than what we expected in 2017, but we're well ahead of the curve nonetheless. Turning to Slide 7. Our end markets continued to show strength throughout the fourth quarter, and 2019 appears to be shaping up as another solid year. In Commercial HVAC, the markets remained strong in virtually all geographies, and we delivered strong bookings growth and revenue growth across the product portfolio. Europe has shown mixed economic signals over the past few months, but HVAC activity remains healthy there as well. China had a solid quarter in HVAC with good growth in both equipment and services. Our direct sales strategy in China continues to progress well against our expectations, and we're making good inroads in a number of verticals, including infrastructure, which has been a key focus for us and continues to be one of the strongest verticals. The situation remains fluid with trade war uncertainty. But at this point in the year, we're still expecting to see modest market growth and market share expansion opportunities in China. Outside of China, the Asian markets are mixed. In total, our global outlook for the Commercial HVAC market continues to be positive with low single-digit to mid-single-digit market growth expected. Turning to residential. Quarter 4 was a very strong quarter for us with continued share gains, primarily driven by replacement demand, and we expect the majority of the market growth to come from the replacement market in 2019 as well. This plays well into our business mix, which is about 85% replacement. Economic indicators have softened modestly but are still healthy and supportive of growth for the year. Turning to Slide 8. Our Transport business continues to be a globally diversified and resilient business with good growth opportunities across multiple areas. In 2018, we saw exceptional order growth for North American trailers and auxiliary power units, and we built a healthy backlog as a result. In 2019, our strong backlog position for these businesses gives us solid visibility into revenue growth for the year as we work to convert this backlog to revenue over time. The European transport markets are mixed with trailer a bit weaker and truck a bit stronger as Brexit uncertainty is impacting these markets. We think additional clarity around this topic would be a positive catalyst. Overall, we're expecting low single-digit to mid-single-digit market growth for transport refrigeration in 2019. Our Compression Technologies business had good growth globally in the fourth quarter with North America and Europe healthy. We continue to see trade war uncertainty impacting projects in China. Global services growth continued to outpace equipment growth in the fourth quarter, which is a positive, and is well supported by multiple service initiatives focused on increasing attachment rates of services to equipment and increasing our share of wallet of total services provided within accounts. All things considered, we expect to see low single-digit to mid-single-digit growth in the Compression Technologies market in 2019 with China being the main area to watch closely. Small electric vehicle growth continues to be powered, primarily by our consumer and utility businesses. We expect to see healthy growth in 2019. Our Industrial Products businesses, including Fluid Management, Tools and Material Handling markets, remained healthy and expect to see continued solid growth in these businesses in 2019. And now I'd like to turn it over to Sue to provide more details on the quarter and discuss our 2019 guidance. Sue?

Thank you, Mike. Please go to Slide #9. I'll begin with a summary of a few main points to take away from today's call. As Mike discussed, we drove solid operating and financial results in the fourth quarter with adjusted earnings per share of $1.32, an increase of 29% versus the year-ago period. Our earnings growth in Q4 closed out a strong year in which we delivered adjusted earnings per share growth in excess of 20% in each quarter. Organic bookings and revenue growth was strong in both our Climate and Industrial segments. In our Industrial segment, we delivered 6% organic bookings and revenue growth. Organic bookings growth was healthy in the fourth quarter despite a difficult comparison of 12% organic growth in the fourth quarter of 2017. On the Climate side, organic bookings were exceptional, up 20%, including a large Commercial HVAC order that will provide revenue over the next 3 to 4 years. Excluding this order, organic bookings growth was still outstanding, up 13%. These exceptional organic growth rates accelerated despite difficult comparisons with very strong growth rates of 7% in the fourth quarter of 2017 and 10% in the fourth quarter of 2016. Organic revenue growth was also exceptional, up 9%, and was broad-based across all of our Climate businesses and across both equipment and services. As Mike discussed, free cash flow was 82% of adjusted net income, primarily due to funding higher working capital to support our exceptional bookings and revenue growth and funding additional CapEx for strong projects in the fourth quarter. We continue to drive high-quality earnings and expect to deliver free cash flow in excess of 100% of adjusted net income in 2019. Leveraging our business operating system for operational excellence across the enterprise, we continued to manage direct material, tariff-related, and other inflationary headwinds in the quarter. During Q4, we delivered our targeted 25% operating leverage and expanded adjusted operating margins by 90 basis points. For the year, our 60 basis point adjusted operating margin improvement was towards the higher-end of initial guidance. Importantly, we also delivered on our dynamic capital allocation strategy in 2018. We deployed $480 million in dividends and increased the dividend by 18% during the year, consistent with our commitment to maintaining a strong and growing dividend over the long term. We deployed $900 million on share buybacks as the shares continued to trade below our calculated intrinsic value. We also deployed $285 million on strategic mergers and acquisitions in 2018, the majority of which was committed to spend in 2017. Looking forward, we expect to consistently deploy 100% of excess cash over time. Please go to Slide #10. As we discussed on the previous slide, the fourth quarter was highlighted by continued strong organic bookings and revenue growth in both of our segments as indicated by the positive signs on the chart. These results reflect continued strong execution of our strategy, capitalizing on healthy end markets. The minus sign on the chart was a revenue decline in Commercial HVAC in the Middle East where orders and accompanying revenues can be lumpy. Last quarter, we highlighted that there were a couple of large orders in the third quarter of 2017. These orders shipped in the fourth quarter of 2017, creating a difficult comparison for us in the fourth quarter of 2018. European HVAC orders and revenues showed continued strength in the quarter. Please go to Slide #11. We delivered organic revenue growth of 8%, adjusted operating margin improvement of 90 basis points and adjusted earnings per share growth of 29%. Strong gains in volume from ongoing investments in new products, panel, and system controls are delivering results in virtually every business and geography where we compete. Consistent disciplined focus on productivity and pricing actions enabled us to effectively manage inflation and tariff-related headwinds and drive margin expansion across the enterprise. Please go to Slide #12. The focused execution of our business strategy, underpinned by our business operating system, enabled us to drive solid year-over-year earnings per share growth in the quarter. Our Climate segment delivered another strong quarter of operating income growth. Our Industrial segment delivered solid results with our Compression Technologies business, in particular, leveraging over 40% in the quarter. Corporate productivity initiatives drove $0.05 of earnings per share growth year-over-year. Below the operating income line, other expenses related to legacy legal matters negatively impacted results by approximately $0.04. All in, we delivered 29% earnings per share growth with strong results across the enterprise. Please go to Slide #13. Strong execution drove 90 basis points of adjusted operating margin improvement in the quarter. Price versus material inflation was positive by 40 basis points in the quarter and positive by 10 basis points for the full year, reflecting strong pricing efficiency and a return to more normal price/cost despite the extraordinary inflation we were up against in 2018. Productivity versus other inflation was notably stronger in Q4, improving margins by 30 basis points. For the full year, productivity fully offset other inflation. We also continued to reinvest heavily in our business with incremental Q4 investments of approximately 60 basis points, pretty evenly weighted between operating expense reduction projects to drive further productivity, footprint optimization, plant consolidation projects for Commercial HVAC and Compression Technologies, and new product development and information technology investments. All of these investments work in concert to make Ingersoll-Rand a stronger and more resilient business. Please go to Slide 14. Our Climate segment delivered another strong quarter with 9% organic revenue growth and adjusted operating margin expansion of 40 basis points. Consistent with our expectations, results were strong across the segment. Please go to Slide 15. Our Industrial business also delivered strong results with 6% organic revenue growth and 40 basis points of adjusted operating margin expansion with Compression Technologies leveraged up more than 40%. Outside of Compression Technologies, the overall Industrial segment leverage was negatively impacted by discrete accrual adjustments and a legal settlement, totaling approximately $5 million. We expect Industrial segment leverage will be strong moving into 2019 as it has been over the past several quarters. Please go to Slide 16. In 2018, we executed a dynamic and balanced capital allocation plan, deploying capital where it earns the highest returns for our shareholders. We maintain a healthy level of business investments in high-ROI projects to help customers solve their most complex challenges. These investments helped drive our strong growth in both segments during 2018. Beyond that, we invested $366 million in CapEx, largely on footprint optimization and cost-out programs which build a stronger, more resilient Ingersoll-Rand. We maintained a strong balance sheet that provides us with good optionality as our markets evolve. We executed against our long-standing commitment to a reliable, strong and growing dividend. During 2018, we've raised the dividend by 18%. Additionally, we deployed approximately $900 million on share repurchases as the shares continued to trade below intrinsic value. As we look forward to 2019, we remain committed to a dynamic capital allocation strategy that consistently deploys excess cash to the best return on investment opportunities. We're enthusiastic about the future and the opportunities ahead to deploy excess capital to the best ROI investments, whether that be investment in the business, raising the dividend, repurchasing shares, or making value-accretive strategic acquisitions. Please go to Slide 18. I'll spend a few minutes walking you through the details of our 2019 guidance. Given the market backdrop Mike outlined earlier, we expect total reported revenues to be up 4% to 5% in 2019 with the Climate segment growing slightly faster than Industrial. The difference between our reported and organic revenue contemplates about 1 percentage point of negative foreign exchange impact year-over-year. For the enterprise, we delivered solid leverage and margin expansion in the back half of 2018. In 2019, we expect further margin expansion in each segment and enterprise adjusted operating margin expansion of between 30 and 80 basis points. Please go to Slide 19. We expect continuing adjusted earnings per share for 2019 to be in the range of $6.15 to $6.35, excluding about $0.25 of restructuring. We've modeled approximately $500 million in share repurchases into our guidance, which translates into approximately 244 million diluted shares for 2019. As I outlined earlier, we're committed to a dynamic and balanced capital allocation strategy that consistently deploys excess cash over time. Net, the actual allocation of excess cash will depend on where we see the highest ROI opportunities over the coming quarters. We're targeting free cash flow to be greater than 100% of net income. The adjusted effective tax rate is estimated to be between 21% and 22%. And for your modeling purposes, we also offer the following guidance: corporate expenses are expected to be approximately $250 million; capital expenditures are expected to be approximately $300 million, primarily driven by footprint optimization, factory consolidation and new product development initiatives. Below operating income, we estimate interest expense to be approximately $200 million, reflecting the debt refinancing we did in early 2018. Additionally, we estimate that pension-related expenses that are classified within the other income and expense line will be approximately $40 million for 2019. We do not plan other income or expense line items outside of pension. These items are truly other and not estimable in advance. I would like to cover 2 topics of interest with you. Please go to Slide 21. It's hard to keep track of what's happening with tariffs relative to what's in and what's out of guidance, so we thought it might be useful if we laid out the assumptions that we're using. The guidance I just laid out includes the known direct and indirect impacts we expect from the Section 232 tariffs, the Section 301 tariffs, including Lists 1, 2, and 3, which is the full $200 billion and the expected China retaliatory tariffs. Relative to the Section 301 tariffs, we have included a planned step-up from 10% to 25% on March 1, 2019, at the conclusion of the 90-day negotiation period. As we've said a number of times during this call, we expect to be able to effectively manage the inflationary and tariff-related impacts in 2019 as we managed these types of costs in 2018. To be clear, however, if the step-up from 10% and 25% does not occur, you should not anticipate we'll see a windfall gain. We will implement the pricing actions necessary to cover the actual inflation we see. The next topic, which is on the same slide, is on 2019 restructuring costs. We thought it would be helpful to provide a little extra content beyond what we included in the main presentation. The restructuring we're doing in 2019 is largely aimed at proactively taking steps to build stronger, more resilient businesses in both our Climate and Industrial segments. Of the estimated $0.25 of restructuring in 2019, more than 80% relates to our ongoing footprint optimization and plant consolidation efforts. Each optimization project is expected to reduce our fixed cost base and improve operational efficiencies, which benefits us no matter the economic conditions we encounter going forward.

And with that, I'll turn the call back to Mike. Thanks, Sue. Please go to Slide 22. We believe the company is extremely well positioned to deliver strong shareholder returns over the next several years, and our 2018 financial results bolstered our confidence. We'll be the first to recognize that 2018 was, by no means, a perfect year, and that we have room for further improvement. However, our ability to solve complex problems and overcome escalating headwinds to drive continuous improvement in our results through 2018 is encouraging and gives us confidence our business operating system and high-performing teams are prepared to successfully navigate the evolving landscape ahead. I want to extend my full appreciation to our talented people throughout the world that are committed to delivering excellent results for our customers and shareholders. Our strategy is firmly tied to attractive end markets that are healthy and growing profitably. Our products and services portfolio is at the nexus of global energy efficiency and sustainability mega trends, which provides a tailwind for growth, above-average economic conditions over the long term. Unless you believe the world is getting less populated, cooler and less resource-constrained, these secular mega trends will continue to create growth opportunities for Ingersoll-Rand. Successful execution of this strategy enabled us to deliver exceptional bookings and profitable revenue growth in every quarter of 2018. We have an experienced management team and a high-performing team culture that incorporates operational excellence into everything we do. Our business operating system and our culture are a differentiated and sustainable competitive advantage. And lastly, our business model generates powerful cash flow, and we are committed to dynamic deployment of capital. We have a strong track record of generating free cash flow and deploying excess cash to shareholders over the years.

I'd like to thank everyone for joining today's call. As always, Shane and I will be available over the coming days and weeks to take any questions you may have. So certainly reach out to us if you'd like to chat. And we look forward to seeing you all at the upcoming conferences in February, and we'll be on the road in March as well. Thank you.