Trane Technologies (NYSE:TT) is in a good position to take advantage of some meaningful trends in the HVAC-R market over the next few years. In the short term, Trane should benefit from a rebound in residential construction and a recovery in transportation refrigeration. Over more of a medium-term timeline, Trane is well-placed to benefit from green building retrofits in the U.S. and Europe. Longer term, Trane’s healthy balance sheet and global position give it M&A optionality to be a consolidator and to reinvest in newer technologies in HVAC-R and building controls.
While these shares have lagged HVAC-R peers on a year-to-date basis, that doesn’t mean the shares are particularly cheap. Mid-to-high single-digit revenue growth over the next five years and long-term revenue growth around 4% isn’t enough to drive a particularly attractive free cash flow-based fair value, and the shares likewise don’t look particularly cheap on an EV/EBITDA basis. Trane does offer a good story, though, and HVAC is a popular space, so I’m not betting against further gains, but I do think valuation is a factor investors should consider, even if they decide theme or momentum are more important.
Looking Back At Q2 Results
After a surprisingly weak first quarter, with the company posting very weak decremental margins in the Americas business due to steps taken in response to COVID-19, the business did better on a relative basis in the second quarter. Revenue beat by about 13%, segment income beat by 46%, and the company’s 25% decremental margins in the Americas were on the strong end of the spectrum for the quarter.
Revenue declined almost 13% in organic terms, with Americas down 13%, Europe (or EMEA) down 15%, and Asia down more than 5%. In the Americas, Trane saw mid-single-digit declines in residential and commercial, with the commercial services business holding up pretty well, but transport was down about 40%. In Europe, commercial sales declined by a high single-digit percentage, and likewise, in Asia, while transport declined more than 20% in Europe and was actually up low-teens in Asia.
Gross margin held up well, declining 70bp. Operating income declined 19% on an adjusted basis, with margin down a point, and segment profits declined a similar amount, with margin down 70bp. Americas margins have held up well, falling a point (to 17.1%), while margins in Asia improved three points to 17.6%.
A Murky Outlook Is The Norm These Days
The 7% order decline Trane saw this quarter isn’t so bad relative to other industrials/multi-industrials, with the company reporting mid-single-digit declines in both the residential and commercial businesses, but significant improvements through the second quarter.
I expect a pretty healthy rebound in residential demand later this year and into 2021, and North American residential demand accounts for about 20% of Trane’s overall business. Trane is relatively stronger on the premium side, but Daikin (OTCPK:DKILF) (Goodman) has been making more of a push here in recent years.
The outlook for non-residential is a fair bit more complicated. In the short term, I’m not bullish on commercial new-builds in the U.S. (nor in the EU), and I believe there will be a roughly two to three-year down-cycle as companies hold off on new investment projects. The “but” is that service accounts for about half of the commercial business, and new-build is only about 30% of the equipment business. And even within that, there’s a meaningful contribution from institutional customers that may well hold up better.
While the near-term new-build outlook isn’t so strong, I’m bullish on the sector for its leverage to green building retrofits, and I believe Trane may be the best-positioned for this. Biden’s plan calls for an accelerated retrofit program to reduce energy consumption (HVAC-R accounts for about half of U.S. building electricity usage), and even if that plan doesn’t happen, tenants are increasingly demanding green buildings to comply with their own ESG goals, leaving building owners with the choice of either upgrading or accepting lower rents.
I believe Trane is a good way to play this trend, as over 40% of its revenue comes from the U.S. commercial market (though that includes service), versus about 25% and Lennox (LII) and Carrier (CARR) and 15% at Johnson Controls (JCI).
It’s unclear to me if the transport market is going to rebound in 2021 or more in 2022. Class 8 reefer truck orders were up strongly in July, but off a low base, and truck trailers are only about half the business (the rest is in auxiliary power and various industrial and transport markets).
Management has made it clear that they are intending to continue investing in innovation in indoor air quality, commercial HVAC-R systems, and connected buildings (which means more control-oriented product development). I believe that’s the right decision, but I also believe that the company can make these investments without compromising future margin leverage.
One issue that does concern me some on margins is the prospect that we’ll see a return of inflation in the U.S., given the Fed’s commitment to an extended period of low rates. In the past, deflationary environments have been good for Trane’s price/cost mix, and so I don’t think it’s unreasonable to have some concerns that the reverse will be true. On the other hand, the biggest raw material component of Trane’s cost structure is cold-rolled steel, and nobody is all that bullish on the pricing outlook there yet.
I’m expecting mid-to-high single-digit revenue growth over the next five years, with commercial building retrofits providing a meaningful tailwind, with growth slowing more toward 4% over time. I do see M&A potential for this business, but I do not have it in my model.
On the margin side, I believe Trane can get operating margins into the mid-teens over the next five years, helping drive FCF margins into the low double digits. Although Trane’s recent FCF generation history is not exemplary, this is an area where better management execution over the next few years could definitely deliver some upside.
The Bottom Line
While I do expect high single-digit FCF growth from Trane, neither the free cash flow growth, nor the nearer-term margins and returns support a lot of upside today. Trane is more or less valued like a high-quality industrial, which is not unreasonable, but I have concerns that the entire space is overvalued. That said, the Street likes a good story, and Trane has that, and I don’t underrate the possibility that Trane can produce growth above the sector norms and support a higher-than-normal valuation.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.