Trane Technologies plc (TT) — Q3 2023 Earnings Call Transcript

Thanks, operator. Good morning, and thank you for joining us for Trane Technologies' Third Quarter 2023 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 Dave Regnery, Chair and CEO; and Chris Kuehn, Executive Vice President and CFO. With that, I'll turn the call over to Dave. Dave?

Thanks, Zac and everyone, for joining us on today's call. I'd like to begin with a few comments on our purpose: to boldly challenge what's possible for a sustainable world. Our purpose is at the heart of our strategy, which aligns with powerful mega trends like energy efficiency, decarbonization, and digital transformation. Coming off the hottest summer on record, we see policies aimed at decarbonizing the built environment continuing to expand. We see growing sustainability commitments from our customers, our suppliers, and our investors. We see corporations not only setting goals but also taking action. We are their partner of choice. And we have the technology to help bend the curve on climate change, and that's exactly what we're doing. We are scaling today's technology and relentlessly innovating for tomorrow to meet our customers' needs to dramatically reduce emissions. This enables us to consistently outgrow our end markets and deliver differentiated financial results. The end result is long-term value creation for our customers, our shareholders, our employees, and the planet. Moving to Slide #4. Our global team performed extremely well in the third quarter, setting us up for a strong 2023 and positioning us well for 2024. We delivered strong organic growth of 9% and leverage throughout the P&L, resulting in adjusted EPS growth of 23% and powerful free cash flow. We continue to see very strong customer demand for our products and services, with enterprise bookings at an all-time high of nearly $5 billion in the quarter. Bookings were exceptionally strong in our commercial HVAC businesses globally, with organic bookings growth in the low to mid-teens across all segments. Our Americas commercial HVAC business was once again a standout, with organic bookings up in the mid-teens in the quarter and up approximately 65% on a 3-year stack. Enterprise backlog ended the quarter at $6.9 billion, with the composition shifting increasingly towards commercial HVAC. Year-to-date, backlog in commercial HVAC is up approximately $800 million. Over the past 3 years, our commercial HVAC backlog has nearly tripled, up approximately 170%. As residential and Thermo King have normalized, the backlog burn in these businesses has been completely offset by growth in commercial HVAC backlog, including a large percentage of long-cycle applied systems. We continue to drive strong demand and a healthy pipeline of projects in key growth verticals across our commercial HVAC businesses. We're leveraging the power of our direct sales force, which brings specific expertise on how to customize solutions and leverage policy, programs, and incentives to optimize customers' paybacks, total cost of ownership, and performance. Our leading innovation and unique direct go-to-market strategy enable us to quickly pivot and win in the highest growth verticals as markets evolve. We have a resilient and diverse portfolio, and our business operating system is designed to deliver consistent top quartile performance. As our residential business has normalized and transport markets have softened, our overall business has delivered strong results and is on track to deliver high single-digit organic revenue growth and 20%-plus adjusted EPS growth for the year, our third consecutive year of 20% or higher adjusted EPS growth. We're on pace to deliver free cash flow equal to or greater than 100% of net earnings and continue to execute our balanced capital allocation strategy with high levels of business reinvestment, a strong and growing dividend, strategic bolt-on M&A, and share repurchases. Our strong execution, robust bookings and revenue growth, and exceptional backlog give us confidence in raising our 2023 guidance and our ability to deliver a strong performance in 2024 as well. Please go to Slide #5. Demand for our innovative products and services continues to be broad-based across our segments, highlighting the strength of our global portfolio. Organic bookings were up 8%, led by our commercial HVAC businesses. In the Americas, commercial HVAC was very strong across the board. We discussed booking strength on the prior slide but revenues were exceptional as well, up in the low 20s percent range with equipment up approximately 30% and services up low teens. Our residential business continues to normalize as expected with revenues up low single digits. Consistent with our prior comments, the nature of our transport refrigeration business is lumpy, and our performance in Q3 was in line with our expectations on both bookings and revenues. Revenues were a bit lower than our guidance of down 10%, driven by the timing of customer deliveries between Q2 and Q3 but remained strong against a tough 60% prior-year growth comp. On a 2-year stack, revenues were up more than 40% in the quarter. Americas backlog is approximately 3 times historical norms with the largest component being commercial HVAC applied systems for 2024 and beyond. Applied systems are the most complex and innovative systems and the largest driver of our service business in commercial HVAC. Our EMEA business was right on track with our expectations. Bookings were strong in both businesses, both up low teens. Commercial HVAC revenues were robust with mid-single-digit growth on tough prior-year comps. TK EMEA revenues were up versus a down market. Backlog remains strong, approximately 60% higher than historical norms and predominantly commercial HVAC. Our Asia Pacific business performed well with strong bookings growth in China and the rest of Asia. Asia revenues were slightly lower against a tough prior-year comp of nearly 30% growth. Our outlook for the region continues to be positive. The verticals we play in remain strong with good opportunities for future growth. Asia segment backlog continues to be robust as we approach 2024, approximately 70% above historical norms and predominantly commercial HVAC. Now I'd like to turn the call over to Chris. Chris?

Thanks, Dave. Please turn to Slide #6. The scoreboard for the quarter highlights strong execution from top to bottom. Organic revenues were up 9%, adjusted operating and EBITDA margins were up 130 basis points and 100 basis points, respectively, and adjusted EPS was up 23%. At an enterprise level, we delivered strong organic revenue growth in both equipment and services, up high single digits and low teens, respectively. We continue to highlight our exceptional services growth because our services business continues to differentiate us in our industry. It makes Trane Technologies more resilient with higher recurring revenues at higher margins over time and represents about one-third of our enterprise revenues. Over the past 6 years, including 2020, our services business delivered a revenue growth CAGR of up high single digits, and we're driving even stronger growth in 2023. Our high-performance flywheel continues to deliver results with relentless investment in innovation driving strong top-line growth, margin expansion, and EPS growth. Please turn to Slide #7. As an enterprise, we delivered about 5 points of volume and about 4 points of price in the quarter. Strong volume growth, positive price realization, and productivity combined to more than offset inflation in the quarter. The supply chain continues to stabilize, enabling improving productivity as we move throughout the year. In the Americas segment, we delivered about 7 points of volume and 4 points of price, accompanied by strong leverage and margin expansion led by our commercial HVAC business, more than offsetting volume declines in transport. The EMEA segment delivered very strong organic incrementals and margin expansion, with organic revenues up low single digits in the quarter. The segment also delivered approximately 12 points of M&A growth in the quarter, which impacted reported leverage due to year one integration costs. The Asia segment delivered strong margin expansion and organic leverage in the quarter on slightly down revenues. For the enterprise, we earmarked an additional 30-plus basis points for incremental business reinvestment in 2023 to accelerate the timing of key projects across the enterprise. This nearly doubles our average run rate of approximately 40 basis points annually or a total of 70-plus basis points in 2023. We're extremely pleased we've been able to make these incremental investments in 2023 while driving strong leverage. We see a tight linkage between investments in innovation and market outgrowth, and we're taking opportunities to go further and faster in 2023. Now I'd like to turn the call back over to Dave. Dave?

Thanks, Chris. Please turn to Slide #8. Overall, our positive outlook for our segments and our end markets is largely unchanged from the prior quarter. And as we move into the fourth quarter with continued high levels of absolute demand, exceptional backlog, and strong execution, we're gaining additional visibility into healthy growth in 2024. Across the enterprise, there are some key themes. Strong demand for our sustainability-focused solutions remains high. While we expect the law of large numbers to kick in at some point and for order growth to decline, absolute bookings are expected to remain robust, given our new baseline is at a very high level. Across our businesses, we see the stacking effect of supportive policy and regulatory changes that play to our unique strength as a leading climate innovator. In addition to all the tailwinds at a national level in both the U.S. and Europe, we see activity at the state and municipal levels, and our direct sales force is able to help customers leverage these programs. In Americas commercial HVAC, our business is extremely strong as we've outlined. We're winning with customers and developing innovative solutions in data centers, education, and high tech, just to name a few strong verticals. And we're driving tremendous growth in our applied business, which makes up the majority of our backlog. Applied business is the most differentiated and complex, and it's where our competitive advantages shine. It's long-cycle with higher-margin service opportunities, representing a multiple of the initial purchase price over the life of the system. Additionally, this business helps to forge long-term relationships with customers as they move from project to project over a multiyear period. We have the most comprehensive portfolio of products in the industry, which enables us to compete and win across all verticals, driving leading long-term sustainable growth. There's no change to our residential business outlook. We expect residential to continue to normalize through the fourth quarter and for the normalization process to be largely complete in 2023. Also, as expected, strength in commercial HVAC is more than offsetting the decline in residential in 2023. Our transport refrigeration business was largely in line with our expectations in the third quarter and up more than 40% on a 2-year stack. We expect to outperform the market for the year. ACT is projecting a dip in 2024 and a bounceback in 2025, with continued growth afterwards. However, ACT's forecast has been volatile in recent months, and we are in the process of validating assumptions versus our internal forecast and other sources. We'll update the market when we hold our year-end earnings call. In our EMEA segment, the third quarter was also in line with our expectations for both businesses. As we highlighted in our second quarter call, EMEA HVAC has very tough comps in both the third and fourth quarters, up high 20s and low 40s, respectively, and revenue growth is expected to be more moderate in the second half. The 2-year stack for Q3 is up more than 30%. Our transport refrigeration outlook is unchanged. Likewise, our Asia Pacific segment, our outlook for the full year is unchanged. Revenue in the second half is expected to be flattish, purely related to tough prior-year comps while bookings continue to be strong. Now I'd like to turn the call back over to Chris. Chris?

Thanks, Dave. Please turn to Slide #9. Strong execution, record bookings, and near-record backlog put us in an excellent position as we move into the fourth quarter. We're raising our full-year revenue and EPS guidance for 2023. Organic revenue growth is expected to be between 8% and 9%, up from our prior guidance of approximately 8%, reflecting strong Q3 performance and a largely unchanged outlook for a robust Q4. We're raising our adjusted EPS guidance to approximately $9, up from a range of $8.80 to $8.90, mainly reflecting a flow-through of our third-quarter outperformance versus our guidance and continued strong leverage of 30%-plus for the fourth quarter. We're pleased with our free cash flow performance of approximately $1.3 billion year-to-date. And for the full year, we continue to expect to deliver powerful free cash flow of equal to or greater than adjusted net earnings or approximately $2 billion. As we've highlighted before, we pay close attention to our investment peer group and consistently target top quartile financial performance, including adjusted EPS growth and adjusted free cash flow conversion. We believe our guidance places us in a strong position to deliver against that target in 2023. As we said in our last earnings call, we expect an increased M&A contribution in the second half versus the first half due to the timing of acquisitions. We had approximately 3 points of M&A in the third quarter and expect to have approximately 2 points of M&A in the fourth quarter as one acquisition passes the 1-year mark and is included in our base. There is no change to our full-year guidance of approximately 2 points from M&A. Please see Slide 19 of the presentation for additional details related to guidance to assist with your models. Please go to Slide #10. We remain on track to deliver $300 million of run-rate savings from business transformation by 2023, including $60 million which will be realized in 2023. We continue to invest in these cost savings and high ROI projects to further fuel innovation and other investments across the portfolio. Our continuous improvement mindset is an integral part of our business operating system, and it's designed to drive gross productivity each year to offset other inflation. While it's been extremely difficult to realize meaningful levels of productivity in recent years, given the supply chain and other macro challenges, productivity is improving as supply chain challenges abate and is contributing to our 30%-plus organic leverage target in 2023. Please go to Slide #11. We remain committed to our balanced capital allocation strategy focused on consistently deploying excess cash to 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. In 2023, we received upgrades to our credit ratings, which are now Baa1, BBB+, reflecting our strong balance sheet and cash flow generation. 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 #12, and I'll provide an update on our capital deployment for 2023. Year-to-date, as of the end of October, we've deployed $1.6 billion in cash with $513 million to dividends, $535 million to M&A, and $550 million to share repurchases. We have significant dry powder with over $2.6 billion remaining under the current share repurchase authorization, and our shares remain attractive, trading below our calculated intrinsic value. Our M&A pipeline remains active, and we have deployed or committed approximately $900 million year-to-date as of the end of October to bolt-on leading technology acquisitions and equity investments. Our latest acquisition, Nuvolo, was announced in early October. Nuvolo will augment our energy services, enterprise management, and digital capabilities in commercial HVAC. We expect the Nuvolo transaction to close in the fourth quarter. All in, we're on track to deploy approximately $2.5 billion in cash in 2023. Our strong free cash flow, liquidity, and balance sheet continue to give us excellent capital allocation optionality moving forward. Now I'd like to turn the call back over to Dave. Dave?

Thanks, Chris. Please turn to Slide #14. Transportation refrigeration market forecasts for both North America and EMEA remain unchanged, and we expect to outperform each market in 2023. Our performance through the third quarter is on track to meet these expectations. The slide shows key data points on the markets and on Thermo King specifically to provide additional transparency and reference information. Please go to Slide #15. As discussed, ACT's projections for 2024 have been volatile, and we are focused on conducting a thorough analysis of the markets. In the interim, we've included ACT's most recent forecast for 2023 through 2028 for your reference. Please go to Slide #16. We expect to provide 2024 guidance on our fourth-quarter earnings call. However, given increasing visibility, we believe it may be constructive to discuss key dynamics at play that give us confidence we'll see healthy growth in 2024. Our commercial HVAC businesses, which make up roughly 65% of our total revenues, are executing well in healthy markets, and the agility of our sales teams to quickly pivot focus to growing vertical markets is driving record bookings and backlog. Our applied backlog is a standout and provides a long higher-margin service tail that makes our business stronger and more resilient. Secular mega trends continue to support growth, and policy and regulatory stacking is amplifying these tailwinds with the majority of these programs still ahead of us. We expect to enter 2024 with our residential business largely through the normalization process and on path to our long-term target of GDP-plus growth. We continue to lead with innovation, which yields healthy pricing opportunities, and our business operating system is primed to stay ahead of inflationary pressures. The supply chain has vastly improved and pockets of remaining challenges continue to abate. Our culture is lean-based, and we're excited about the productivity we can unlock as we move into 2024. We've also been heavily investing in productivity-enhancing projects such as factory automation, which we expect to unlock further value. ACT is forecasting a dip in North American trailer production in 2024, a snapback in 2025, and growth thereafter. While we're in the process of further assessing their forecast, our North America transport refrigeration business is approximately 10% of our total revenues. We expect to execute well, manage the business tightly, outperform the end markets, and if necessary, manage deleverage within gross margin rates. Lastly, while we don't talk about our service business a lot, we're quietly putting up double-digit growth in 2023 on top of a 6-year compound annual growth rate of high single-digit growth. Our service business is strong, resilient, and poised for growth, and we continue to build out our energy services and digital capabilities and offerings, which represents a big current and even larger future opportunity. Please go to Slide #17. In summary, we are well positioned to drive significant value over time. We are proud to have been named one of Fortune's Best Workplaces for Women and one of the World's Best Companies by Time Magazine. Our culture and people fuel our innovation and help us to fulfill our purpose every day. This steadfast focus on purpose, our leading innovation, and our proven business operating system enables us to execute our strategy and stay nimble across our resilient portfolio. This, in turn, enables us to consistently deliver a leading revenue and earnings growth profile and powerful free cash flow. With our strong performance, elevated backlog, and continued high levels of customer demand, we are confident in once again raising our full-year revenue and EPS guidance and reaffirming our free cash flow conversion target. We have the team, the strategy, and the track record 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?

I'm kind of getting sick of congratulating you on good quarters, but this is one of the better ones.

Please keep it up.

You're making Lehigh proud, Dave. All good. When considering the backlog you have and the demand environment in commercial, is this a situation where you can be selective about projects and choose those with the desired margin and pricing structure? Or is that not quite how it works, and are you bidding on a broader range of projects but at higher prices? I'm just trying to understand the relationship between project selectivity and the current supply-demand imbalance.

Yes, Scott, it's a good question. We have a strong core business right now. And we spend a lot on innovation, and we price our innovation to ensure that we get proper returns. So I would say it's leading more with innovation, and we're constantly looking for how we can improve our portfolio, how we can improve the efficiency of our products, how our products can use next-generation low-GWP refrigerants. That's all inclusive in our business operating system when it comes to innovation. And that's what's really leading our markets right now. And I would also tell you that having this, and I know I've told you this before, but this direct sales force and being able to educate them on new innovations real-time and having them take those messages to the influencers on jobs is very, very important when you go to close especially some of these large applied jobs.

Yes, that's helpful color. I have to ask this question. You have a competitor who had a ransomware issue in the quarter. Did that help you guys as it related to bidding on things and such or was that a non-event?

It was not a significant event, so I hope everything is okay there, but it was not significant.

I think, Dave, you emphasized a couple of times the strength in applied bookings and the difference versus light commercial because of the service element. So maybe just a follow-up on that point would be around sort of what's the rough split today of, say, the revenues in your commercial HVAC business between applied and light commercial? And just wondered when you're looking at the revenue outlook next 12 months, do you anticipate much of a difference in revenue trends of applied versus light commercial maybe because of stimulus impacts or the scale of the respective backlogs? Any sort of perspective around that, please.

Yes. Julian, we don't look at just light. We look at units in total so it would be light and large. And historically, it's been about 50-50 in our equipment business. But obviously, in the third quarter, we had very, very strong demand in our applied business. So think of data centers, high tech, education, we're very strong. We had solid performance in other verticals too, like health care, life science, government, industrial. And then there were some weaker verticals as well. Think of traditional office, warehousing, and retail and those weaker verticals where you tend to see more unitary than applied systems.

That's very helpful. And then just my follow-up. It's more of a sort of silly short-term one, but only 1 quarter left in the year. Your sales guide, I think your Q4 sort of construct on guidance is the same as it was back in July, and you just kind of flowed through the Q3 beat to your full year guide. But if I wanted to look at the Q4 for what that's worth, the revenue guide implies nearly, I think, sort of 8%, 9% sequential sales decline from Q3, which seems a bit heavier than normal. Is that just kind of noise around backing out from the year? Or is there anything specific maybe in transport or something like that, that's weighing on Q4?

Julian, it's Chris. I'll start off. The Q4 implied guide is kind of around mid-single digits organic revenue growth, and it is a little bit of a stepdown versus Q3. But if we put a few reasons behind it, one is when I think about the toughest comp of the year. Our commercial HVAC businesses, this is really the toughest comp across the board going into the fourth quarter on a year-over-year basis. Second would be the contribution from price. We would expect to be a bit lower in the fourth quarter than the third quarter. We commented price delivered around 4 points of growth in Q3. You probably dialed that into about 2-ish points of growth in Q4, so there's about 2 points right there sequentially. And then maybe just to round out another response here, really be around residential as it continues to normalize. We did a little better in the third quarter on revenues. Our constructive view around residential for the full year hasn't changed with revenues down around mid-single digits. So we're very focused on making sure inventory in the channel is positioned well for the start of 2024. So we would expect that normalization to continue really into the fourth quarter. So I hope that gives you a little bit of some view here on how we think about Q3 to Q4. But let's not forget maybe the first point, the commercial HVAC on tough comps, we had 40% growth in EMEA last year, 30% growth in Asia last year, really toughest comp of the quarter.

Impressive quarter. Dave, with the understanding that orders can be lumpy, it appears that you actually had a positive inflection in orders in Americas commercial HVAC in the quarter despite concerns of higher U.S. rates. So did you see larger mega projects start to hit a little more frequently in the quarter? I know you mentioned strength in data centers. Did you see like some of your bigger verticals actually heat up a bit as the quarter went on? And would you say that, that gives you more of a probability of ending backlog at the end of this year closer to $7 billion than $6 billion as I know you're guiding?

Yes. I mean, we're still tracking a lot of 'mega projects', and we're defining a mega project, again, as a project where the total revenue size is over $1 billion. We're still tracking a lot of those in our pipeline. So yes, we had a little bit of activity in the third quarter but we just had some really nice growth. And as I said earlier, data centers, education continues to be very strong. And then we had what I would call solid performance over a lot of different verticals, health care, life science, government, industrial. Those are all performing very solidly in the quarter. So I think a lot of the mega projects are yet to come, which is still good news. And I think I've told you on our second-quarter call, our ability to track these projects and triage them on a global basis, because some of these big mega projects, you have decision-makers that are in different parts of the world. And you could have the owner in Korea, the engineer in Seattle, Washington, and the project is in Texas. And we're able to triage that and work with the customer and show the value that we can provide. So we're super excited about a lot of the mega projects that are still in the pipeline.

And then Chris, could you give more color into the organic leverage you've been delivering? Organic leverage in the mid-30% range is obviously a good result for Trane. We know you're guiding to 30% for Q4 and 25%-plus long term. But maybe you could talk about whether you have an extended period of productivity projects along with good price versus costs that could help your margin performance well into '24, given I think it was more difficult to engage these projects during the pandemic?

Yes, Andy, that’s a good question. We approach each year aiming for incremental growth of 25% or higher. We will refine that as we near 2024. We continue to see growth from normalized pricing and improved productivity as the year progresses. The supply chain has consistently improved, contributing to continuous volume growth, which was about 5 points in the third quarter. The inefficiencies that made productivity challenging in recent years are decreasing, allowing for further growth. We are beginning to see some benefits from this in 2023, and we expect this to be an ongoing opportunity into 2024 and beyond. We are returning to the core strengths of the company, enhancing our lean culture, focusing on cost reductions, and investing in automation in our factories. This year, we are shifting our workforce to prioritize these efforts instead of grappling with supply chain issues from the past few years.

Yes, Andy, I had the opportunity to visit several of our locations during the quarter. It was just such a great feeling to feel the flow that's happening in the operations today versus where we were a year ago, where we were looking at the yard full of product that had to go back on the line to be reworked. So that's all helping with the productivity. So we're really starting to hit our stride here in our operations, which is a great job by the team because they've had some tough times they're working through the supply chain. But I'm glad to say that they're operating extremely well right now.

Great quarter. Just wanted to get your sense on, you mentioned the transport refrigeration, you opened the order books in October. Any early read on how demand looks and how far out you're booking into 2024 right now?

Yes. I mean, like I said, we did open the order book in October. As expected, Gautam, I mean, the Thermo King business has performed very well for us over a number of years. And with our current guide, we're forecasting that we're going to outperform the markets again in 2023. So it's a great business. We have a lot of innovation that we're pumping through that business right now as we electrify our portfolio of products. Great team, and I'm pretty excited about where we are with Thermo King. I know that ACT is forecasting a bit of a dip in 2024. We're validating that. There are some things that don't align with our internal forecast, but we'll validate that in the short term and update everyone as we report out our fourth-quarter earnings.

Okay. Can you comment on how far out you guys are actually booking into '24 at this point or...

It's always within a 12-month period. So these orders don't get booked way out. But in fact, in the prior years, we would only open up the book for 6-month increments. So just because we wanted to make sure we were pricing right when we were in a higher inflation market.

Yes. I think for Americas, it transitions through the middle of '24, Gautam. And I think for Europe, it may be open for a bit longer than that. But to Dave's point, the order book would really only be for 2024 at this point.

And just 1 quick follow-up on resi. Any evidence of people deferring replacement and instead repairing units? Are you seeing any uptick in those products?

Yes. I was with the residential team recently. We're not seeing that, no. So I think the short answer is no, we haven't seen that yet.

I wanted to ask on commercial HVAC. Orders this quarter clearly bifurcated from the broader industry. And the company has always prided itself on driving innovation. So I guess my question is the world moving to emissions targets and just higher electricity prices globally, are you seeing customers more so appreciate the innovation and efficiency that you are providing to them? And do you think that could result in a higher rate of share gains moving forward?

Chris, hope all is well with you. Great question. Look, we always lead with innovation. I think our customers always appreciate higher efficient products and greener products using low-GWP refrigerants, so we pride ourselves on that. Look, we do a lot of innovation around verticals, and I don't talk a lot about that for obvious reasons. But if you think of data centers, we had a very strong quarter in data centers. A lot of that has to do with the innovation that we're providing while working with the customer. So these are unique solutions for them, and then they scale it through all the data centers that they're building. So we'll continue to do that in the future. We'll continue to sell our energy efficiency to our customers. And we'll continue to make sure that we have connected solutions so that our service business can continue to expand in the future.

I appreciate that. And then maybe following up, Dave, you mentioned in the prepared remarks that orders need to go down at some point due to the law of large numbers. So the other question is, wouldn't you need a step change negative in the macro to see that? Because it feels like the lead time compression headwinds are kind of largely in the rearview at this point. Commercial is healthy. Resi seems to be turning. And you mentioned before, the mega projects really haven't ordered yet. It's mostly still in the pipeline. So I mean, what do you need to see on a macro standpoint to have material order declines off these levels?

Yes, Chris. It's Chris. I'll start. This is why we want to make sure it's important that investors look at growth rates as well as backlog position and just absolute bookings levels, right? I think the trends around decarbonization, and as you mentioned just before, customers putting out emissions targets, we see these as long-term tailwinds. Growth around data centers appears to be a multiyear tailwind as we think about the need for data and for saving data and to process data. So we see this as some longer-term tailwinds. When we think about the beginning of the year, we guided ending backlog down to around $6 billion, and that would have implied bookings down around 5%, 6%. But even on a down 5% or 6%, that would have still been very elevated levels in terms of absolute bookings, and we continue to see that strength here through the third quarter. So I would say the trends, we don't necessarily see as abating. Could we find some quarters where the backlog will start to normalize or bookings growth will be negative? I guess we could. But I would just encourage people to look at absolute bookings levels because when you look at 2-year stacks, 3-year stacks around bookings growth, they're significant. You think about commercial HVAC in the Americas, a 3-year booking stack of over 65%. So the fact is if we went down 5 points in a given period, you still have to subtract that from 65% points of growth. So maybe a bit of a long answer to your question, but where we're confident we've got a long-term tailwind here.

Nice quarter. So yesterday, Eaton resized the mega project funnel up 25%, now tracking almost close to like $900 billion. And they suggested that about 20% of the projects have kind of broken ground and a lower percentage, they've actually bid. I'm curious, like I know that you guys have your own funnel and you guys are also tracking projects over $1 billion. But does that all kind of jive with what you're seeing in your pipeline broadly? Or any other color around that would be helpful.

Yes, I haven't reviewed Eaton's reports, so I can't provide specific comments. However, I can say that we have numerous projects in the pipeline that we're monitoring. It's important to exercise caution when comparing one company to another, as the timing of order acquisitions can differ. Eaton might be slightly ahead of us. The positive takeaway is that we still see a significant number of opportunities out there, and it appears Eaton does as well. We are very confident in many of the solutions we're discussing with our customers, and we believe we are in a unique position regarding these projects.

Yes. Maybe following up on that, Dave. Have you had any concerns? I know you're not seeing it really in the order book today, but are there any concerns out there on project financing or things putting to the right, just given the rate environment that we're in?

Joe, it's Chris. No, we're not. I think while certainly interest rates have gone in the negative direction on paybacks, I would tell you that the change in paybacks is minor when we think about the energy-efficient systems that we're able to quote customers. A payback may have gone from 2, 2.5 years to around 3 years now with interest rates. So the fact is there's still very strong paybacks when you're implementing some of these solutions. So we're not seeing that right now.

Got it. That makes sense. And I have one last quick question for you, Chris. I understand we're not ready to provide any numbers for 2024 at this time. However, as you consider pricing and mix for next year, do you have any initial thoughts on how that might play out across the Americas business?

Yes. We'll dial it in a little bit further, Joe, as we get a couple of months from now. But we do target, from a price inflation measure, let's say, a spread of 20 to 30 basis points in a normal year. We'll dial that in as we get closer to next year. To Dave's earlier point, we're making sure we're pricing for innovation and also long-term customer relationships. So I'm confident that we'll have a good set of numbers there. We're going to target positive on a dollar basis and a margin basis on price versus inflation. And we've been able to demonstrate that for the last 3 years, so I have a lot of confidence our teams will be able to do that going forward.

I'll echo that those orders have been quite strong. How robust has your light commercial business, both large and light, been?

Our revenue was up, in the Americas, was up over 20%. Equipment was up over 30%. Applied was stronger than unitary.

Applied was stronger than unitary?

Yes, yes, yes. Both were strong, but applied was stronger than unitary. I mean, you could look at the verticals that really had the strength in it, Steve. You have data centers, high tech, education. Those tend to be more applied systems. And even the verticals that were solid like health care and life science, again, those tend to be the more intricate projects where you need a really design system, which is our applied systems. So we're pretty happy with the performance that we saw in the third quarter. And again, not to iterate, but these implied, I know you know this, but this is where you get the long service tail. And so this is going to continue to fuel our service business in the future.

Can you provide us with some details on the four verticals you have mentioned in your presentations over the years? Since commercial HVAC accounts for 65% of your revenue, could you share how much these four verticals contribute to your overall portfolio? Is it around 50%? Just a rough estimate would be helpful regarding the significance of these growth verticals.

They're strong, Steve, is what I would answer. We track about 14 verticals in the Americas. And certainly, office and warehousing would be areas, retail, that'd be a little bit weaker today. I know the office vertical has a number of things kind of buried in it today. We've been lobbying to try to break that out, just given demand on warehouse and data centers. But I won't dial it in specifically, but we like our positioning here. And what I think is, again, most important with the direct sales force is their ability that if a vertical is slower like office, the ability to pivot into another vertical is really...

That's exactly where I was going to go, Chris. I mean, these verticals, we track 14. You could even get 18 if you do a little subdividing there. But there's oftentimes when one vertical is stronger than another vertical for an extended period of time, I'll use warehousing as an example. Two years ago, three years ago, warehousing was extremely strong. We pivot our sales force to focus on warehousing. We develop programs for them, and they go capture share in those particular verticals. Right now, the strength in data centers, I don't see that going away in the near term. High tech, we have all the mega projects that are really in front of us. And education, education has been strong. Obviously, ESSER funding is helping that. I think ESSER funding is probably in the fifth or sixth inning, but we've been extremely strong in education for an extended period of time.

One last one for you. Your peers have talked about this refrigerant change in resi driving some pretty nice price mix, 10% to 15% or something like that over the next couple of years, perhaps a bit more back-end loaded into '25, given the change comes then. Can you just give us your latest and greatest lens on price and mix from that transition and what potentially you could see in '24 and '25 on that front for resi?

Yes. The short answer is we're dialing it in. But I mean, if you think about the whole refrigerant change, right? We've been leading with refrigerant change really the industry, I think we've been at it since about 2013 with next-generation refrigerants. So we're more than ready for this transition away from R-410A to, in our case, R-454B. Our designs are complete, our manufacturing is ready to go. We'll start up production here in early Q2. So all systems go there. There are some definitions, Steve, that we're still working with the EPA to make sure our interpretation is correct. And then really our focus is going to shift to the channel. I'm sure we have a clean phase in, phase out of inventory. We will be manufacturing both R-410A product and R-454B product in 2024 and probably even into 2025, at least our interpretation right now, what we're seeing with the EPA. As far as price, we're still dialing that in. The R-454B product is going to be more expensive. Obviously, it's a slightly flammable refrigerant so you're going to have to put different sensing equipment around the unit. So we'll get more data on that in the coming weeks here, and we'll update everyone on our fourth-quarter call.

Not as good as you guys but doing well. I wonder if we could just dig a little bit more into just customer behavior and backlogs. As big as the backlogs are versus history, right, if I think about 90% of $6 billion, maybe it's $6 billion-plus, right, but that would be, call it, my math, roughly half of your 2024 commercial revenues are in backlog. I mean, that's a good healthy number. But given the size and scope of some of these projects, maybe goes back a little bit to one of the earlier questions. I'm not sure why backlog would really go down much from here. Do you actually see customers just kind of changing their order patterns or there's kind of something else that would suggest that backlogs really do need to kind of go back down towards where they were historically?

Jeff, I'll start. I mean, I think the lead times are still a bit extended in applied systems, getting better certainly from where we were at the beginning of the year. Same in unitary, getting better. So I think as the lead times come in a bit, you may see where the backlog contracts a bit over time. It is elevated today. You're right, 90% of the backlog would relate to our global commercial HVAC business. And when you think about our commercial businesses, including Thermo King, it's over 95%. So it gives us a lot of visibility into what we think 2024 would be with some healthy growth. But let's see how the policy stacking effects that continue to positively affect us and order rates. Mega projects, as Dave said, are ahead of us here in terms of bookings. And applied, these are long-cycle projects. Let's see how this plays out. We think it can be elevated for longer, but it will start to normalize at some point.

Yes. I think the only thing I would add to that, Jeff, is I'll go back to data centers again, and our strategy was to work with the data center engineers and develop solutions that are optimal for them. Once we do that, they do tend to lock in for an extended period with you. So they'll provide orders beyond your lead times just to ensure that they have slots available and we don't disappoint missing a shipment.

Jeff, from an IRA perspective, that’s all ahead of us and not really in the backlog right now. However, we've had ESSER funding for several years, which has allowed us to prepare projects and ensure that we can service and upgrade equipment during the summer months when schools are open. That’s been a backlog for some time. Data centers continue to grow, and we see it as a long-term trend. Regarding the CHIPS and Science Act, we don’t have specific details at this moment, but it's an area that could influence demand. Currently, the need for data centers is primarily driven by general demand.

So going back to the commercial HVAC growth in Q3, which was obviously spectacular, but especially in the Americas, the pickup Q-over-Q was quite something. So you called out obviously the strength in the verticals. Was there any kind of supply chain sort of loosening or kind of flush there that maybe drove that? Understand demand is very strong. And then within that, education, I think there's some concerns out there with the stimulus funding kind of reaching a peak, perhaps that maybe education falls off in '24. So any visibility on education would be helpful.

Yes, I'll start with the latter. We haven't seen a slowdown in education yet. Our pipeline remains strong, and there is still significant funding available. I would compare it to being in the sixth inning of a baseball game, meaning there's more funding expected. We've maintained strong performance in this area for a considerable time. The other question was...

Yes. Just obviously, supply chain constraints have been a factor in the applied business, yes.

The supply chain is not completely normal, but it's close to normal. There are always some issues present, but our teams have managed the situation well. I wouldn't attribute our third-quarter performance to a sudden improvement in the supply chain, as it has been gradually getting better.

Okay. And then on the comment...

We're executing very well on the front end of our business. We're executing very well on the operations side of our business, and you really see it in our results.

Maybe to revisit the situation in China, you had solid bookings. I was impressed that despite having lower revenues, the margins were significantly stronger. So how did things turn out for you in China?

I'm very pleased with our performance in Asia Pacific overall, so thank you for the question. To start with orders, they were up in the low teens, specifically up 12% for the region. China experienced high single-digit growth, while the rest of Asia saw mid-teens growth, indicating a very strong performance in order rates. Although our revenue remained relatively flat and decreased slightly, it's important to remember that we had 30% growth in Asia Pacific last year, so this is mainly a comparison issue. The team in that region is performing exceptionally well, and I'm very satisfied with the incoming order rates. Additionally, the pipeline remains strong.

Great. As a follow-up to the September customer experience event in New York, could you provide insights on the applied business, specifically regarding the backlog and the funnel? How many customers are choosing this thermal management feature? Using your baseball analogy, are we still in the early stages of adoption? What is the current status?

Yes, we continue to see adoption in thermal storage. We've been selling thermal storage systems for quite some time. One aspect of the IRA that could accelerate adoption is the rebate, which we are still working to define and determine how it will be implemented. This could be significant and drive further uptake. For everyone to know, our thermal storage systems not only enhance energy efficiency but also help balance the grid. They provide an effective solution for managing peak power demands by utilizing ice instead of running compressors on chillers. We are excited about this technology, which we've had for a while, and the IRA could act as a catalyst for even faster growth.

A question on gross margins, I guess. Look at my model, I think gross margins are hitting all-time highs. And I know you guys don't look at other companies but we do. And I'm just wondering how much price cost, the spread between price cost is a benefit. And I guess the bigger question is, have we rebased gross margins? Because clearly, you guys have done a lot of work on cost cutting, right? It seems that you have an aggressive stance on maintaining the spread. But also how much of it is timing, right? It's just the peak between the balance between price and cost. So if you could just talk about, are we in the new normal with gross margins or should we expect the gross margins normalize somewhat going forward?

Andrew, I'll start. As I think about the third quarter, we really were able to execute across all parts of the P&L to drive leverage and gross margin expansion. So the price execution versus inflation, as I said earlier, it was positive on a margin and dollar basis. There are areas, though, of inflation, especially in tier 2 around wage and energy inflation that are impacting the business. So it was a positive. The incrementals on volume and 5 points of volume in the quarter so we like those incrementals. And we've continued to invest in the business as well, right? We're still targeting for the full year around 70 basis points of incremental investment above a 40 basis point normal. So all parts of the P&L are really working. But I would tell you the productivity opportunity for us as price comes back to a bit more of a normalized level, that is really the opportunity for us going forward to really continue to drive 25% or better incrementals.

And we really like our mix and service.

Great. And just a follow-up question on Nuvolo, right? I think JCI also bought a workplace management software company. Fortive has a presence. Can you just talk about what excites you about this vertical and maybe also remind us how big is software as a business for you at this point?

Yes. Nuvolo is a cloud-based connected workplace and enterprise asset management company, and it's leveraging the ServiceNow platform. Look, we look at this as a way to augment our current digital capabilities. Just to remind everyone, we have over 36,000 connected buildings. We have well over 1 million connected assets. So we think this is a great company, great leadership, great technology, and we're excited to get this closed and have it be part of the Trane Technologies portfolio, and it's going to really help us grow our digital business at a nice clip.

And how big is the digital business now?

I won't be specific on that. I would say that this acquisition is less than 1% of the enterprise revenue.

Thanks, operator. I'd like to thank everyone for joining on today's call. As always, we'll be available in the coming days and weeks to answer any questions that you may have, so please don't hesitate to reach out. Stay safe, and we look forward to seeing everyone soon.