2023-06-27 01:49:15 ET
Summary
- Trane Technologies is well-positioned to benefit from megatrends such as decarbonization, electrification, and indoor environmental quality, driving increased demand for their HVAC products and services.
- The company has strong pricing power and robust growth in its commercial HVAC sector, which is expected to offset weaknesses in the residential market.
- TT stock has a favorable outlook and valuation, with a "Strong Buy" rating due to its strong capital allocation strategy, double-digit free cash flow growth, dividend payouts, and high stock repurchase plans.
After the separation from Ingersoll Rand, Trane Technologies ( TT ) has transformed into a dedicated provider of climate solutions, focusing on heating, ventilation, and air conditioning, as well as transport refrigeration and custom refrigeration solutions. The company's strategic direction aligns with key megatrends such as decarbonization, electrification, and indoor environmental quality, which are driving an increased demand for Trane's products.
Trane boasts a robust pricing power, enabling them to attain an additional 20-30 basis points of pricing over cost inflation throughout economic cycles. While part of their residential business, which accounts for around 10% of group sales, has been impacted by a weak housing market and wholesaler destocking, the strong growth of their commercial HVAC sector is expected to more than compensate for this weakness over the course of the full year.
Growth Drivers
Supportive government policy of energy efficiency, decarbonization and sustainability : Trane is poised to benefit from supportive government policies and regulatory changes that align with their strengths as a leading climate innovator. This creates a favorable tailwind for Trane's future prospects, presenting multi-year opportunities.
The mega trends of energy efficiency, decarbonization, and sustainability are expected to continue intensifying, driving an increased demand for Trane's products and services. Many large corporations have made commitments to reduce their carbon emissions by 2030, 2040, or 2050. As a significant portion of these emissions ((40%)) comes from buildings, enterprises are compelled to address heating and high-efficiency HVAC systems.
Strong pricing power : Trane demonstrates strong pricing power, as evidenced by their performance in Q1 '23. They achieved approximately 6.5% price growth and about 2.5% volume growth, which was in line with expectations. Prior to the impact of the COVID-19 pandemic, Trane's pricing contribution was less than 1%, with the majority of their growth driven by volume. Currently, Trane benefits from both pricing and volume growth. In the commercial HVAC industry, Trane's market leadership allows them to exert pricing power and set market rates. Their target of achieving 20-30 basis points of pricing over cost inflation throughout economic cycles is commendable.
Strong commercial HVAC demands : Commercial HVAC represents a significant portion, accounting for almost half, of Trane's group sales. The megatrends surrounding decarbonization are expected to continue intensifying, creating favorable conditions for Trane's business. It is worth noting that Trane's success extends beyond North America, as they are experiencing strong growth in Europe and APAC regions as well.
In EMEA, Trane's commercial HVAC business demonstrated impressive performance in 2022, with a 20% increase, and continued the positive trend with a 25% increase in Q1 '23. Moreover, the orders in EMEA experienced a substantial surge of nearly 40%. When looking at a two-year comparison, the first quarter showed a remarkable 35% increase in orders for their commercial HVAC business. These figures indicate significant demand and substantial growth opportunities in the region.
Key Risks
Tight supply chain : Similar to other industrial players, Trane faced challenges with a tight supply chain during the COVID-19 period. However, they have observed gradual improvements in the effects of these constraints. The shortages of chips and electric components are expected to improve as China lifted its zero-covid policy. Trane's backlog reached a record high of $6.9 billion at the end of 2022, increasing to $7.3 billion by the end of the first quarter of 2023. The backlog typically represents 20% of forward revenue, providing resilience and improved visibility into 2023 and 2024.
Weak residential business : Trane anticipates a normalization of their residential business throughout Q2 2023, with guidance indicating flat to low-single-digit declines for the year. The residential segment accounts for approximately 20% of group sales, with 50% being independent and 50% wholesalers. The wholesaler segment, which constitutes around 10% of group sales, is facing headwinds due to elevated inventories. Trane has already initiated normalization efforts over the past three quarters.
While the weak residential markets may present a modest headwind in the second quarter, the strength of Trane's commercial HVAC business is expected to more than offset the weakness for the full year.
Why not invest in other HVAC players?
It is evident to me that commercial HVAC is a favorable business in nature. There are other players in the HVAC space listed in US as well, including Lennox (LII), Carrier Global (CARR), and Johnson Controls (JCI).
Lennox : Their primary focus is on the residential sector, with residential HVAC accounting for 68% of group sales and 81% of group profits. The commercial business represents only 19% of group sales and 9% of profits. In my view, the residential business has fewer structural tailwinds for future growth compared to commercial HVAC.
Carrier Global : They hold the top position in the North American residential HVAC market. Carrier is targeting an organic sales growth rate of 6-8%, annual margin expansion of 50 basis points, and double-digit EPS growth. HVAC contributes around 67% of their group sales with a decent operating margin. Nearly half of their HVAC business is in the residential market. Overall, Carrier is a decent company that has begun focusing on capital allocation and core investments after the spin-off. In comparison to Trane, I believe Trane has slightly higher direct exposure to high-growth areas.
Johnson Controls : They are a more diversified company, offering fire and security, commercial HVAC, residential HVAC, and other businesses. Personally, I am not fond of the fire and security business due to its inherent low growth. Fire and Security constitute the largest business segment for Johnson Controls. Their overall EBIT margin is only around 11%, which is relatively low compared to Trane.
Outlook and Valuation
Trane has raised their full-year organic revenue growth guidance to between 7% and 8%, up from the prior guidance of 6% to 8%. This adjustment reflects strong results in the first quarter and improved visibility for the entire year. They have also increased their adjusted EPS guidance range to $8.30 to $8.50, up from $8.20 to $8.50. Additionally, they expect to deliver free cash flow equal to or greater than net earnings.
Year-to-date through May 2023, Trane has allocated $170 million to dividends, $300 million to share buybacks, and $250 million to M&A activities. They currently have significant available funds, with $2.9 billion remaining under the current share repurchase authorization. It's important to note that the remaining share buybacks represent approximately 7% of the current market capitalization. Given their strong free cash flow, liquidity, and balance sheet, Trane continues to have excellent options for capital allocation moving forward.
In my DCF model, the assumptions for '23 are pretty much in line with the company's guidance. I assume a normalized 7% of organic sales growth, and 0.7% of growth from M&A. I expect Trane can expand their operating margin to 17% in FY32. In the model, the free cash flow conversion is estimated to reach 14.1% in FY32.
The model uses 10% of WACC, 4% of terminal growth rate, and 20% of tax rate. The present values of free cash flow from firm over the next 10 years and terminal value are $16 billion and $35 billion, respectively. Adjusting the gross debt and cash, the fair value of the stock price is $215 in my DCF model.
Trane's DCF Model-Author's Calculation
To My Dear Readers:
When assessing the potential total return from an investment, it is crucial to consider collective factors such as normalized free cash flow growth rate, dividends, and share buybacks. Relying solely on one component can lead to biased conclusions. For instance, some deep value stocks may have high dividend yields, but investing in them carries the risk of losing a significant portion of capital due to underlying structural risks or headwinds. To make informed investment decisions in stocks, conducting thorough fundamental research is crucial.
Trane is one of my key holdings in the industrial sector. I believe that the ongoing mega trends of energy efficiency, decarbonization, and sustainability will continue to benefit Trane's HVAC business. Moreover, their market-leading position allows for growth in both volume and pricing. Most importantly, Trane's strong capital allocation strategy convinces me to hold onto their stock for the long term. I expect their double-digit free cash flow growth, dividend payouts, and high stock repurchase plans to contribute significantly to overall returns. Therefore, I give Trane a "Strong Buy" rating.
For further details see:
Trane Technologies: Riding Energy Efficiency And Decarbonization