Trane Technologies plc (TT) — Q4 2020 Earnings Call Transcript

Thanks, operator. Good morning, and thank you for joining us for Trane Technologies fourth quarter 2020 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 Mike Lamach, Chairman and CEO; Dave Regnery, President and COO; and Chris Kuehn, Senior Vice President and CFO. With that, please go to Slide 3, and I'll turn the call over to Mike.

Thanks, Zac, and everyone for joining us on today's call. I think we can all agree that 2020 was an extraordinary year. Around the world we saw the impact of the global pandemic intensify and endangered people, communities, businesses and economies. We saw climate change manifest in several floods, wildfires, and droughts. Even as we responded to these major global challenges, we stayed true to our long-term strategy. Our team launched Trane Technologies as a focused global climate innovator to boldly challenge what's possible for a sustainable world, solving the most pressing and complex challenges facing our customers. We put our purpose into action from day one, taking immediate steps to take care of each other and continue serving the essential needs of our customers in the world. I want to thank our global team members for their resilience, tenacity, and commitment to rise to the many challenges we faced. At present, COVID-19 continues to present risks. The vaccine development, production, and distribution is underway, and our Thermo King business is there to provide full end-to-end cold chain solutions. Our intent is to enable efficient, equitable delivery and administration of the vaccine to as many people as possible to contain and eventually eliminate the spread of the virus. We are also acutely focused on indoor environmental quality to improve the health and safety of indoor spaces. We believe this is another long-term secular mega trend impacting our industry, laid bare and amplified by the pandemic. This is especially critical in education, where many children rely on schools for access to technology and food. Virtual learning is broadening the digital divide and having a disproportionate impact on Indigenous students and students of color. It's vital that we open our schools and address inequities in our educational systems. We are applying our expertise and solutions to improve indoor air quality in commercial and residential spaces while balancing that with strategies to improve energy efficiency and reduce emissions. All of this is part of our drive to create a new better normal. At Trane Technologies, we are challenging the status quo to create a sustainable future where communities thrive, where quality is foundational, and where the environment is protected for future generations. We're putting a stake in the ground with historic and aggressive commitments like our Gigaton Challenge, which we launched in 2019 to reduce our customers' carbon emissions by one gigaton by the year 2030, and our commitment to reach gender parity in leadership. We are also a founding member of OneTen, a coalition to hire one million Black Americans over the next 10 years. We are executing against our transformation plans and blueprint for the future that we discussed at our Investor Day in December to fund ongoing innovation investments in our business aligned to global sustainability trends. We have a responsibility and opportunity for Trane Technologies to be a positive force to change the industry and ultimately change the world. Fundamentally tying all these elements together, we have a business model that delivers sustainable top quartile financial performance and powerful free cash flow. Combined with our balanced capital allocation strategy, we expect to continue to deliver differentiated returns for shareholders over time. Moving to Slide 4. We delivered resilient financial performance throughout 2020, demonstrating the strength of our sustainability strategy and the power of our business operating system. In the fourth quarter, we delivered broad-based market outgrowth globally. We also delivered strong productivity improvement with a 140 basis points of EBITDA margin expansion and 12% adjusted EPS growth in the quarter. We ended tumultuous fiscal 2020 with positive organic bookings growth despite significant declines in the majority of our end markets globally. While significantly investing in our business and people, deleverage was just 13% for 2020, which was significantly favorable to our gross margin deleverage target and adjusted EBITDA margins actually increased by 20 basis points on a full-year basis. We also delivered exceptional free cash flow of $1.7 billion for the full year, adding to our capital allocation capacity and optionality and extending our track record of delivering free cash flow conversion in excess of 100%. In fact, through 2020, our five-year average free cash flow to earnings conversion is 116%. And I know many investors realize how focused we are on cash flow ROIC. So, I'm pleased to report that 2020 was an outstanding year for us with an adjusted cash flow ROIC for the year of 34.5% and an adjusted three-year average of 26.5%. Since the onset of the pandemic, we've been playing aggressive offense to emerge stronger on the other side. We've invested heavily in our people, our business operating system, and in innovation for our customers to further advance our leading competitive positions and to outgrow our end markets. In early 2020, we closed on the RMT transaction that would formally launch Trane Technologies. We committed to deliver $100 million in annualized cost savings by 2021, but we didn't stop there. We continued to work on business transformation initiatives in order to fundamentally lower our cost structure and to triple our initial commitment from $100 million to $300 million annualized savings by 2023. These savings bolster our ability to continue delivering leading innovation that both solves complex problems and provides premium value to our customers. It feels continued market outgrowth while also delivering strong leverage. The pandemic will continue to present significant challenges in 2021, including limiting our visibility on how end markets will perform over a relatively short window of time. However, our guidance reflects optimism for improving end market conditions based on continued progress on vaccine development and approvals, sufficient production and supply, efficient distribution, and ultimately mass vaccinations globally. At this early stage, we're targeting strong organic revenue growth of between 5% and 7% and strong organic leverage of approximately 30%. We will also see the benefit of three key channel acquisitions we made in Q4, which are proven high return on investments for us. We have a proven track record of acquiring strong channel and technology partners over many years and delivering excellent returns. Just to give you a sense for the kinds of returns we're targeting, recent acquisitions have yielded cash flow ROIC in excess of 40%. We discussed two of these at our recent Investor Day. Including acquisitions, which are expected to add about 1.5 points in growth, we're guiding to revenue growth of between 6.5% and 8.5% and adjusted EPS of $5.30 to $5.50 a share. Our strong balance sheet and liquidity profile provide excellent capital allocation capacity and optionality as we look to deploy 100% of excess cash over time. Lastly, our core strategy remains unchanged. Secular megatrends of energy efficiency and sustainability are becoming more pressing every day, and we excel at addressing these megatrends and challenging what's possible for a sustainable world. This passion powers us forward to deliver top-tier financial performance and differentiated returns for our shareholders. Please go to Slide 5. Strong execution and resilient performance throughout 2020 enabled us to consistently improve our outlook as the year progressed. Each quarter we raised our outlook and advanced our competitive positioning as the leading climate-focused innovator to deliver strong 2020 financial results in a challenging environment. We're extremely pleased with what our global team delivered. In the final analysis, we delivered a modest revenue decline significantly better than gross margin deleverage and exceptional free cash flow during a global crisis. There's a lot to be proud of. Now, I'd like to turn the call over to Dave to discuss our bookings and revenue performance in the quarter.

Thanks, Mike. Please turn to Slide number 6. We continue to face pandemic-related headwinds in the fourth quarter. Despite these headwinds, our global teams remain focused and responsive to our customers, delivering 3% bookings growth and flat revenue in the quarter. Our Americas segment delivered growth in both bookings and revenue, up 2% and 1% respectively. Our Americas Commercial HVAC business has remained resilient throughout 2020, with Q4 bookings down mid-single digits against approximately 25% growth on a two-year stack versus 2017 related to large lumpy contracting bookings in 2018 and to a lesser extent 2019. Revenues were also down mid-single digits against high teens comps in Q4 2019 in North America. Services continue to outperform equipment and remain challenged by low building occupancy rates and building closures related to ongoing health and safety concerns. However, our teams remain adaptable, adjusting to the changing landscape and seizing opportunities to outgrow market conditions in areas such as contracting, digital connectedness, and indoor air quality assessments and services. The Residential HVAC markets remain robust, and our Residential HVAC team delivered revenue growth of more than 20% in the quarter. Backlog also remains strong entering 2021. Our Americas Transport Refrigeration business outperformed North America Truck and Trailer markets, which were down in the quarter. The team delivered solid revenue growth up low-single digits and strong bookings growth, up over 40%, as the transport markets gradually come out of a prolonged down cycle accelerated by the COVID-19 pandemic. Turning to EMEA, the overall markets continue to be challenged by significant pandemic issues and lockdowns that vary by region and country, but our teams continue to execute well. EMEA delivered 9% bookings growth in the quarter, with growth in both Commercial HVAC and Transport Refrigeration. Revenues lagged orders down 6% overall, but outgrew underlying market conditions. Commercial HVAC bookings were up high teens, while revenues were down mid-single digits. EMEA Transport bookings were positive in the quarter and revenues were down high single-digits, outperforming the broader transport markets, which were down mid-teens. Asia-Pacific results continue to be mixed, with overall bookings up 2% and revenues down 6%. China continues to show signs of improvement; however, growth in China was more than offset by declines in the rest of Asia, where a number of economies are still challenged by the pandemic. Now I'd like to turn the call over to Chris to discuss our operating performance and margins.

Thanks, Dave. Please turn to Slide number 7. Dave provided a good overview of our revenues on the prior slide, so I'll focus my comments on margins. Adjusted EBITDA margins were strong despite a slight revenue decline, up 140 basis points, driving adjusted EPS growth of 12%. Productivity and cost containment were strong, reflecting solid execution across the board. Our team has also delivered positive price-cost in every region during the quarter. In addition, we maintained high levels of business reinvestment and employee safety measures, innovation, and technology. Please turn to Slide number 8. In the Americas region, market outgrowth, cost containment, productivity, and price drove solid EBITDA margin expansion of 130 basis points. Likewise, the EMEA and Asia-Pacific regions delivered strong productivity and cost containment to improve EBITDA margins by 110 basis points and 200 basis points respectively versus 2019. Strong productivity is being fueled by our robust pipeline of projects, combined with structural transformation initiatives that Mike referred to earlier, which we shared at our December industrial event. Now I'd like to turn the call back over to Dave to provide our market outlook.

Thanks, Chris. Please turn to Slide number 9. Commercial HVAC Americas has significantly outperformed the broader markets throughout 2020 through strong focus, agility, and execution. Our service revenue remained resilient, growing low-single digits in the fourth quarter despite continued low building occupancy. Interest remains high for comprehensive indoor air quality assessments, and we anticipate indoor air quality providing a tailwind not only in 2021 but over the longer term. Market indicators remain soft, and despite limited visibility due to the pandemic, we expect demand improvement in the second half of 2021 with improved vaccine distribution and administration. Turning to Residential, we saw record bookings and revenue in the fourth quarter, which puts us in a strong backlog position entering 2021. Overall, we expect more normalized growth for 2021, with tough comps in the back half of the year given record bookings in revenue in the second half of 2020. Turning to Americas Transport; we expect strong growth in 2021 with markets emerging from deep down cycles that began in the fourth quarter of 2019. Orders were very strong in the quarter, with some customers placing orders for the year. We see market demand ramping through the year with market growth in the mid to high single-digit range in the first quarter. I'll talk more about Transport Refrigeration in our topics of interest. Turning to EMEA, the recovery continues to be country-dependent, with some countries in additional rounds of lockdowns. It's early to call the recovery broadly in Europe, but we expect improvements heading into 2021 with improved vaccine distribution in the region. Transport markets in particular are expected to emerge from the 2020 down cycle with approximately 8% market growth projection given the current rate of economic improvement. Turning to Asia, we expect continued growth in China in 2021. However, the rest of Asia has been slow to curb the virus and is still largely on the path to recovery. On balance, we see a mixed picture for Asia in 2021.

Thanks, Dave. Please turn to Slide number 10. Based on the market backdrop Dave just outlined, and the expectation for an improving pace of global vaccine production and administration, we expect to deliver strong financial performance in 2021. As Mike indicated earlier, we expect to deliver strong organic financial performance with organic revenue growth between 5% and 7%, organic leverage of approximately 30%, and adjusted EPS of between $5.25 and $5.45. We also expect to see about 1.5 points of revenue growth from the three channel acquisitions which Mike discussed at the outset, which will carry about 5 points of operating margin and deliver EPS accretion of about $0.05. All in, total revenue growth is expected to be between 6.5% and 8.5%, and EPS is expected to be between $5.30 and $5.50, which translates to a 19% to 23% earnings growth. We expect free cash flow to remain strong at equal to or greater than 100% of adjusted net income. If we project current FX rates out to the end of the year, FX would likely be a tailwind, albeit too early to call, given the global uncertainty and volatility. Our FX exposure is largely translational in nature, and each point of revenue we translate at approximately transitional operating income rates. Each point from FX would translate into about a $0.05 impact on EPS. Please go to Slide number 11. We don't provide quarterly guidance, but given the level of uncertainty and wide range of estimates across the investment community, we believe it may be constructive to provide a high-level outlook for the quarter, given what we see today. Based on orders, backlog, our pipeline, and visibility, we currently expect organic revenues to be up approximately 5% in Q1 with strong leverage of between 30% and 35%. Acquisitions are expected to add about 1.5 points of growth, and if FX holds the current rates, FX would add about another point of growth. All in, total revenues are expected to be up about 7.5%. As discussed earlier, M&A carries about 5 points of operating margin in the first year post-integration-related costs, and each point of FX translates at approximately operating margin rates. Combined, these will add about $0.02 of EPS in the first quarter. There are a couple of items for Q1 that I also want to highlight to help with your models. We're currently expecting corporate costs to be approximately $70 million in Q1. Q1 is primarily impacted by stock-based compensation, which is heaviest in the first quarter due to annual investing and the timing of 2021 corporate expenses, which were more heavily weighted in Q1 than in other quarters. Our transformation activities continue to drive corporate costs lower, estimated at $220 million in 2021. So, Q1 has no adverse impact on the full year. However, you may want to incorporate this outlook for modeling purposes. The other item I want to highlight is the estimated Q1 adjusted effective tax rate of approximately 15%. The Q1 tax rate is traditionally low, impacted again by stock-based compensation due to annual investing in Q1. The rate in Q1 2020 was roughly 12% as a reference point. The full year 2021 guidance remains 19% to 20%. So, there is no impact on the full year from a seasonally low Q1, but you may want to use this as a guide for modeling purposes.

As we outlined during our investor event in December, by transforming Trane Technologies, we initially identified $100 million of fixed cost reductions by 2021. We've exceeded our initial cost reduction expectations, delivering $100 million of savings in 2020, a full year early, and we expect to deliver $140 million in savings in 2021. We are now targeting and are on track to deliver $300 million of run rate savings by 2023.

Our balanced capital allocation strategy is focused on consistently deploying excess cash to the opportunities with the highest returns for shareholders. Despite challenging economic conditions in 2020, we continue to strengthen our core business with high levels of business reinvestment, high ROI technology innovation, and operational excellence projects, which are vital to our continued growth, product leadership, and margin expansion. We remain committed to maintaining a strong balance sheet that provides us with continued optionality as our markets evolve. We have a longstanding commitment to a reliable, strong, and growing dividend that increases at or above the rate of earnings growth over time. We continue to pursue strategic M&A and further improve long-term shareholder returns, and we continue to see value in share repurchases as the stock trades below our calculated intrinsic value. All in, we expect to consistently deploy 100% of excess cash over time. Please turn to Slide 14. And I'll discuss how we deployed excess cash in 2020 and our plans for 2021. Through the third quarter of 2020, we paused on certain elements of our balanced capital allocation strategy in favor of capital preservation and optionality given the COVID-19 pandemic. However, we did not pause on paying a strong dividend, maintaining our dividend rate and paying over $500 million to shareholders during the year. We also did not pause on paying down $300 million of debt, which matured during the year consistent with expectations upon completion of the RMT. Entering into the fourth quarter, we resumed all elements of our balanced capital allocation strategy based on our strong free cash flow generation and improved visibility to our end markets from earlier in the year. On the M&A front, we invested $183 million in value-accretive channel acquisitions that Mike has previously discussed. We also deployed $250 million in share repurchases during the quarter and have repurchased an additional $100 million to date in the first quarter of 2021 for a total of $350 million. Looking at 2021 as a fully reinvesting in the business, we plan to continue executing our full balanced capital allocation strategy. This week, we announced that we've increased our quarterly dividend by 11% to $2.36 per share annualized, starting with the payment this March. We also announced a new $2 billion share repurchase program, which adds significant capacity to the existing authorization, which is approximately $400 million remaining. These announcements reflect our strong balance sheet and liquidity position, our commitment to deploying 100% of excess cash over time, and our continued confidence in our ability to deliver powerful free cash flow to execute our balanced capital allocation strategy. We anticipate deploying $1 billion between value-accretive M&A and share repurchases. Additionally, we plan to retire $425 million in debt as it reaches maturity in 2021. As I stated earlier, all elements of our balanced capital allocation strategy are in play, and we are focused on consistently deploying excess cash to the opportunities with the highest returns for shareholders.

Thanks, Chris. Please go to Slide number 16. As we've discussed throughout the presentation, we recently completed three channel acquisitions, which have been a proven track to profitable growth for us over the past decade. We've discussed why we're so excited about these acquisitions earlier in the presentation. So I won't spend any more time now. However, we have the slide in the deck for your reference. We'll break out organic versus total revenue each quarter, but for modeling purposes, we'd highlight that 80% of the M&A is in the Americas Commercial HVAC and the other 20% is in EMEA HVAC. We've covered this slide earlier in the presentation, so I won't spend a lot of additional time on it now. The objective of this slide is to lay out how you should think about organic growth and leverage and the impact of the acquisitions. It also provides some helpful modeling guidance elements at the bottom. The key takeaways are that we're expecting strong organic growth, leverage, and EPS, and that M&A adds additional revenues and modest EPS accretion in 2021.

We continue to see strong demand for what we do in a growing movement around what we stand for. Energy efficiency and sustainability megatrends are only growing stronger, and we are uniquely positioned to deliver innovation that intersects with these trends and accelerates the world's progress. Even as we responded to market challenges and uncertainty caused by the global pandemic, we leveraged our strong financial position and continued to invest in our businesses, launching more than 50 new solutions in 2020 to meet the needs of our customers. We're not only focused on investments in innovation and growth, but also on investments in business transformation. We are on track to deliver savings that improve the cost structure of the company and enable additional reinvestment to expand margins and further strengthen our ability to outgrow our end markets. When combined with the long-term sustainability megatrends underpinning our end markets, our exceptional ability to generate free cash flow, and balanced capital deployment of 100% of excess cash over time, we are well positioned to continue to drive differentiated shareholder returns. I've said that Trane Technologies has the essence of a startup with the credibility of a market leader, and that unique profile fosters a culture of inclusion, ingenuity, and performance. It's this type of passion and purpose that sets Trane Technologies apart; it is how we will change the industry and ultimately change the world.

Thank you, operator. I'd like to thank everyone for joining today's call and especially for staying on for a few minutes after our typical scheduled time to hear more questions and answers. So, we appreciate your time. Jen and I will be around for questions as always over the next few days and weeks, and we look forward to seeing you all hopefully on the road live at some point in 2021. Thanks, and have a great day.