2023-04-23 07:21:43 ET
Summary
- Revenue growth will slow but tax credits and megatrends can keep growth above GDP.
- Inventory and receivables should normalize, bolstering cash flows.
- The dividend yield is too low for income investors.
- TT stock is fully valued based on a discounted cash flow model and valuation metrics.
Trane Technologies ( TT ) will see a slowdown in revenue growth in 2023. The company hopes to grow revenues above the rate of GDP growth for the foreseeable future. The company's receivables and inventory should normalize in 2023 giving cash flows a boost, assuming demand stay strong. The company offers a low dividend and is fully valued at this time.
A growth reset is inevitable, but order backlog may cushion revenue.
Trane Technologies grew revenues quickly over the past couple of years. It saw a revenue growth rate of over 13% y/y in 2021 and 2022 (Exhibit 1) . The company's quarterly y/y revenue growth has remained strong since June 2021 (Exhibit 2) . But the heady growth days are over for Trane Technologies. Trane has grown revenues at a 7% CAGR since 2017 (Exhibit 3) . Given the megatrends (Exhibit 4) of climate change, urbanization, and sustainability driving the HVAC industry, Trane Technologies expects to continue growing above the GDP growth rate in the U.S. A growth rate above that of GDP is achievable by the company.
Exhibit 1:
Trane Technologies Annual Revenue, Gross, Operating Profit, and Margins (%) (Seeking Alpha, Author Compilation)
Exhibit 2:
Trane Technologies Quarterly Revenue, Gross, Operating Profit, and Margins (%) (Seeking Alpha, Author Compilation)
Exhibit 3:
Trane Technologies Revenue CAGR (Trane Technologies Investor Presentation)
Exhibit 4:
Megatrends Driving Business Growth for the HVAC Industry (Trane Technologies Investor Presentation)
Still, GDP growth in the U.S. is expected to slow dramatically in 2023 and beyond, so Trane Technologies may find it hard to achieve a 7% growth rate. The company benefits from Federal subsidies and tax credits for emissions reduction and sustainability provided by the Inflation Reduction Act. The company also sees tailwinds from demand from the semiconductor industry due to the CHIPS Act . The company touted that its order backlog gives it good revenue visibility. It reported a worldwide order backlog of $6.8 billion at the end of 2022, of which $5.3 billion was from its Americas region, $941 million from Asia, and the rest from Europe.
Tailwinds from tax credits and Federal subsidies.
The company achieved gross margins above 31% compared to its average of 30.7% over the past decade (Exhibit 1) . It achieved operating margins above 14.8% compared to an average of 12.2% over the past decade. The 14.8% operating margin is well above one standard deviation above its mean over the past decade. The company's operating margin may revert closer to its average. The company's quarterly operating margin has averaged 14.4% since June 2020, with a much higher standard deviation of 2.3% (Exhibit 2) . The Federal tax credits and subsidies can continue boosting sales for a few more years. The company may face less pricing power and lower demand once the tax credits and subsidies run out. Long-term investors should consider this fact when valuing the company and purchase it at a reasonable valuation.
Recently California cut its incentives for home solar installations. Investors and environmentalists are watching how the solar industry will fare in the state moving forward. Although the tax credits for HVAC are not comparable to the net metering offered by California utilities, any subsidy reduction affects product demand. From Trane's perspective, these tax credits could pull the demand for heat pumps and air conditioners forward. A pull forward in demand could boost revenues and margins in the short term while hampering growth when credits are no longer available.
Expect inventory to normalize in 2023
The company saw over a 28% y/y increase in inventory in 2021 and 2022, but its inventory has peaked and should support operating cash flows in 2023. The company's cash flows would have been higher if not for the increased inventory costs of $348 million and $466 million in 2021 and 2022, respectively.
The company carried 66 days of inventory at the end of 2022 compared to its average of 57 days, with a standard deviation of 7 (Exhibit 5) . The company's inventory was slightly above one standard deviation of its mean, which is a bit high. The company inventory should return to normal as it sells through its existing inventory. Since most of the company's inventory was acquired during high inflation, it must maintain its pricing power to protect its margins in the face of a fast-weakening economy . The company may have locked-in prices when it booked advanced orders (backlog), giving it much stability in revenue and margins.
Exhibit 5:
Trane Technologies Day's Sales in Inventory (Seeking Alpha, Author Calculations)
Trane's operating cash flow margin was 9.4% in 2022 compared to its average of 10.3% over the past decade (Exhibit 6) . Its free cash flow margin was 7.5% compared to its 8.6% average since 2013. The increase in inventory costs and outstanding receivables were the primary causes behind the company's operating cash flow margin drop. The company's CFO, Christopher Kuehn, mentioned that $150 million in receivables were shifted to the first quarter of 2023. The increased receivables at the end of 2022 did play a part in lowering operating cash flows.
Exhibit 6:
Trane Technologies Annual Operating Cash Flow, Free Cash Flow, and Margins (%) (Seeking Alpha, Author Compilation)
Trane Technologies is fully valued.
The company is fully valued at current prices with a forward GAAP PE ratio of 21.2x compared to the 19.4x PE for the companies in the Vanguard Industrials ETF. Trane's competitor, Carrier Global ( CARR ), trades at a forward GAAP PE of 17.6x, while Johnson Controls ( JCI ) trades at 19x.
A discounted cash flow model estimates the per-share equity value at $175, at about the same price it currently trades (Exhibit 7) . This model assumes a revenue growth rate of 4%, a free cash flow margin of 10.4%, its average margin since June 2020, and a discount rate of 8%. This discount rate assumption might be low. The company's weighted average cost of capital is approximately 10.4% (source: author calculations) ; the 8% may be a low discount rate assumption. The company has a manageable debt level with a debt-to-EBITDA ratio of 1.7x with total debt of $4.8 billion and net debt (after cash) of $3.6 billion. If a 10% discount rate is used, the company's per-share equity value falls to $110.
Exhibit 7:
Trane Technologies Discounted Cash Flow Model (Seeking Alpha, Author Calculations)
The stock has performed exceptionally well, returning 33% over the past nine months and 15.7% over the past year. The Vanguard Industrials ETF ( VIS ) has gone sideways during the past year, returning 3.5%. Given the stock's outperformance over the past year, there may not be much upside momentum.
Low dividend and poor capital return to shareholders via share buybacks.
The stock offers a dividend yield of 1.7% compared to the 1.6% dividend yield for the Vanguard S&P 500 ETF ( VOO ) and the 1.46% dividend yield of the Vanguard Industrials ETF ( VIS ). The company's payout ratio is 36%, a fairly safe payout. The company paid $620 million in dividends compared to $1.5 billion in operating cash flow and $2.6 billion in EBITDA. Even if the company's operating cash flow and EBITDA are reduced due to slow growth or a recession, it has the resources to continue paying dividends.
I am disappointed by the company's share buyback program since it spent $2.4 billion on share buybacks and reduced its share count by 9.9 million at an effective average price of $242 per share since June 2020 (Exhibit 8) . In my JELD-WEN ( JELD ) article , I discussed the destruction of shareholder wealth due to companies paying well above the intrinsic value of their shares to make buybacks. Trane Technologies carries a low debt load, unlike JELD-WEN, and may not have much use for the excess cash it generates other than finding a way to return it to shareholders. But, buying shares above their intrinsic value destroys wealth and is a poor capital return strategy.
Exhibit 8:
Trane Technologies Quarterly Share Repurchases, Shares Issued, and Diluted Outstanding Shares (Seeking Alpha, Author Calculations)
Trane Technologies has a good order backlog giving it good visibility into revenue for 2023. The company's inventory costs and receivables should normalize and boost cash flows. The economic slowdown could impact Trane's revenue growth and margins beginning in the second-half of the year. Trane Technologies may be fully valued based on a discounted cash flow model and a tad overvalued compared to its peers. Currently, Trane Technologies is a hold.
For further details see:
Trane Technologies: Growth Will Slow