Good morning, everyone, and welcome to Oppenheimer's 20th Annual Industrial Growth Conference. We're continuing the day here with Trane Technologies. I'm very pleased to be welcomed by the company's CFO, Chris Kuehn. Chris, thanks so much for being with us today.
Noah, thanks. Congratulations on 20th anniversary as well. That's great.
We're thrilled to have you as we run it back. I think, you know, one of the through lines certainly has been the strength of commercial HVAC for several years now. I want to follow up our question on the earnings call last week by digging in a little bit more around how to think about payback periods for commercial HVAC. You may contextualize for us, what does the average payback period look like for a retrofit project today versus, say, five years ago? How to understand the drivers of the better payback. I mean, there's got to be a number of factors here to consider. Maybe you can speak to both of those.
Yeah, thanks, Noah. Yeah, I mean, paybacks are always a little dangerous because it always starts with what are you removing when you're talking about retrofit projects. Think about these assets that probably 10, 20 years ago, you'd assume they'd be in place for 30 years. The efficiency, though, around these products has only improved significantly in the last five to seven years. Think of it in terms of our portfolio providing 50-70% more efficiency from just the products we sold seven years ago. Paybacks, it's not uncommon to see a payback in the three-year time frame.
That is before you start looking at maybe local incentives, local laws that can ultimately, with our direct sales force, who are local in nature and they know what is happening in that city and state that they are in, leveraging as many of those opportunities for the customer to get rebates or incentives. Even excluding all of that, the paybacks are very, very strong. Three years is not uncommon, four years, five years even. The paybacks are very strong, excluding any type of incentive.
I think underpinning the strength, you called out the pipeline growing sequentially in Q1, even with record bookings. It's helpful for us to understand how Trane defines its pipeline, how it's constructed within the company, and how we should think about average conversion times from pipeline into orders.
Yeah, I mean, I'll start with commercial HVAC. With our direct sales force, they're spending tons of time with the end customer understanding what their specific project could be. In many cases, it's a multi-year journey to look at all of the assets that our customers have or buildings that they have and working with them on a multi-year journey to decarbonize and upgrade equipment and drive that energy efficiency that drives the financial payback. We'd start with an unfactored pipeline, right? All the projects that we know that we're involved in from a bidding perspective, then ultimately to a factored pipeline that would be based on a combination of probability and also timing. That's what we kind of measure throughout the business is the unfactored and the factored pipeline.
As Dave Regnery, our CEO, described last week on our earnings call, we're seeing very strong pipelines remain through the end of April in our largest verticals and many of our broad verticals within commercial HVAC in the Americas. Whether we saw growth across the majority of verticals in the first quarter, we're seeing a number of those pipelines being very, very strong. This is a multi-year effort, especially when you're talking about applied systems, right? It's not very rare you're having a conversation and within 30-60 days, all of a sudden there's an order. These are large projects that get negotiated over time.
Having the direct sales force with the local knowledge, with the tie-ins globally to our direct sales force globally, you're able to call on the end user, the architect, the GC, the construction firm, ultimately all the players in that space to stay connected to that project. It gives us a lot of opportunity to improve that factored pipeline that then is driving into our bookings growth.
Can we understand a little bit more how that regionalized direct sales force works? I mean, how does it map to, does it map to specific areas? Does it map also to specific verticals? I mean, maybe that'll help us understand how you get a strong visibility into the pipeline and get these win rates. Just to understand how you deploy the sales force to all these different opportunities within your purview.
Yeah, I'll start in the Americas. It is not dissimilar, say, for Europe. It really starts from a local city region perspective. Direct sales force, they know what the local rules and local players are in that region, that city. They know buildings by addresses. They know what that decarbonization plan can be for a building over many years. That is really where it starts, okay? They can jump across verticals and they do that all the time. Having a direct sales force and they know where the opportunities are, if Class B and C office space continues to remain fairly weak, which is what we see in office, they are going to pivot to another part of a different vertical that ultimately is going to drive their commissions as well. The majority of our sales force is 100% commissioned in commercial HVAC.
They're going to spend their time really in Class A office space. They're going to spend their time in data centers that are within many metropolitan cities that we may not know, but multiple floors of buildings could be data centers. They'll spend their time there as well. There are some teams that could be a little more bespoke, like a data center team that we've had for years inside the company. They can pivot from office to education to ultimately selling what is a solution. That's the key for us. It isn't necessarily a team that is only unitary or only applied. It's funny, we don't really talk about it always in those terms anymore. It's a solution that we're providing to a customer and what's the best product for them. The same would happen in Europe as well.
Very regionally focused, country focused, and understands what the local needs and regulations are, building codes, for example, and then ultimately working with the customer to deliver.
You mentioned kind of the shift from B and C office. You know, I think the majority of verticals in Americas reported growth in 1Q . Maybe you can talk a little bit about which verticals were a little bit softer and what your sales force is saying about when they might return to growth.
Yeah, I mean, there's aspects of the office vertical that were softer, as I mentioned. I was on a phone call last week with someone from the investor community that's looking at new office space. They're looking at Class A office space and they were talking about how tight the market is. The marketing for each of the buildings they're looking at was very much inclusive of HVAC, comfort around the space, air quality. We think that's a winning proposition when you're investing in Class A office space for your tenants, for the employees that work there to make sure that they're working in a safe and comfortable environment. Life sciences was another vertical that we called out as being a little bit weaker. We've seen that for a couple of quarters.
As Dave said last week, we saw growth across the majority of our verticals. Again, that direct sales force, the ability to pivot to where the opportunities are, is really part of the secret sauce of Trane Technologies.
Yeah, I think you messaged continued growth in data center and higher ed last week. Obviously, there's been a lot of noise from investors in those verticals. Question around hyperscaler activity in data center, question around the impact of federal funding cuts on universities. What do you look for as the real demand signals in these verticals as you look through the balance of the year?
Yeah, I mean, we've for years done scenario planning with all of our business units. We look at what are those early signs, red flags or even green flags of what we're seeing around various key performance indicators in different verticals, right? The order pipeline would certainly be an area that we'd look at. What's happening with conversion from orders from the pipeline unfactored ultimately to a booking, right? A couple of examples there. Data centers, we, through the end of the first quarter, through the end of April, we didn't see any change in terms of the need for growth. A lot of external reports have talked about that being well over 10%, maybe mid-teens growth for the next several years. We don't disagree with that in terms of the growth in that space. We didn't see any slowdown in that space.
Education, you know, some of the questions we've received over the last year or so has been with the end of ESSER funding. Does that change or have a dramatic impact on the pipeline? We've not seen that through the end of April. Yes, the funding mechanism concludes in the first quarter of 2026. You had to have your order in by September of last year to qualify for the ESSER funding. What it gave with that ESSER funding was a lot of visibility to where schools are in terms of their upgrades and their need to upgrade. Not everything was solved and upgraded in schools with the first round of ESSER funding. We see things are traditionally going back to the municipal bond market.
You're seeing it even in my home state here in North Carolina and Charlotte, where recent bond passages and part of that's going to school upgrades. That's where Trane Technologies really, really can win because we work with those administrators. We work with those school districts. Again, a perfect example of a multi-year plan you want to have with your customers to go upgrade facilities. We hadn't seen any change in the demand appetite for those verticals.
Okay. Maybe talk a little bit about competitive dynamics in EMEA and APAC. You know, any change in the outlook for those markets since early April? I think, you know, in response to a question last week, you know, Dave said, yeah, you know, China specifically has been soft, but it is moderately improving sequentially. Maybe talk to the competitive dynamics overall, and then I have a few follow-ups.
Sure. Yeah, let me start with Asia. You know, the Asia segment represents less than 8% of our enterprise revenues. Half of that would be China. Half of that would be rest of Asia. No different for Asia, EMEA, or the Americas. We really have espoused a region- for-r egion model for well over a decade now. Our manufacturing plants in Asia largely supply the Asia market. Same in Europe, same in the Americas. If I stick with Asia, yeah, China, we're in the third quarter now since we put in, our team locally put in more tightened credit controls and credit policies, just making sure that we had down payments for orders. When those come through, making sure that there's proper payments throughout the life cycle of the project. That'll anniversary really in the third quarter.
What I would say is a little bit easier comps coming to the second half of the year. I would tell you that China just market-wise has been down. It's been challenging markets here in China for a while. We're not expecting much growth in China for 2025, but we have a great team locally and they'll find the right opportunities where they exist. Rest of Asia has been very strong for us. When you balance the two of them, we're seeing 2025 as being a flattish year for the Asia segment, but a lot of strength in rest of Asia. That could be anywhere outside of China, including India. Think again about them 50-50 from a mixed perspective. EMEA, a really strong quarter, performed as expected in terms of revenue and margins.
We can talk about great order growth in commercial HVAC up in the double digits. Strong order growth in Thermo King with up high single digits for the quarter. That's all about innovation. The markets there haven't necessarily grown in years, whether it be commercial markets or transport markets. We're expecting the transport market to probably be down, maybe low singles this year. We'll outperform because of the fact of the innovation that we've introduced into that market over the last five plus years. Commercial HVAC markets in Europe, we're creating the demand in those markets with the paybacks on the projects that we have. It's really a retrofit market, of course, in EMEA just given the build-out there. We're able to convert and create demand based on the energy efficiency and products that we have within that portfolio.
We're very pleased with the EMEA performance in the first quarter and a lot of confidence in their growth and plans for the full year.
Okay, can you just touch on what happened with pricing in EMEA in one Q? You know, was what we saw a function of mix and seasonality or how should we think about kind of price in EMEA for the balance of the year?
Yeah, the impact on the negative price in the first quarter was really in our transport business, our Thermo King business. Think of it as mix of customer, customer mix in the first quarter, okay? Some large customers where pricing would be a little bit different than, say, on average. I look at that as a one-quarter impact. That's a region that's been able to get positive price for many years in a row. We also focus on making sure we get cost out of our products to make sure we can be more competitive and maybe not pass on as much of a price increase. No, the dynamic in the first quarter was really entirely transport and customer mix.
That's super helpful, Chris. I want to ask you about Resi HVAC before we get to margins and the tariff discussion. You reiterated normalization to GDP plus growth, mid-single digit growth for 2025. You also called out, I believe it was $75 million-$100 million of elevated channel inventory at the end of the quarter. Do you have a sense of how much of that inventory is kind of R-410A versus R-454B? How do you assess the readiness of the distributor and the contractor to support the 454B transition at this point?
Yeah, I think for us, the transition with 454B and with our dealers, whether it be company-owned or independent wholesale distributors, were roughly 50-50, nowhere in terms of how the sell-in works between those two channels. That's gone relatively smooth. I think the ability for us to get last buy orders for the 410A product in the fourth quarter last year and then have a pretty quick switch over to 454B, we estimated around 80% of the volume in the first quarter was 454B product, really less so on the 410A. I think on the $75 million-$100 million of a little bit elevated channel inventory, it's probably mostly 454B. I mean, the distributors and dealers have until the end of this calendar year to sell 410A as a system. After that, it's components.
I think those dealers are really trying to bleed down the inventory levels of 410A. No one wants to get stuck with the older product by the end of the year. We saw 80% of our volume being 454B sell-in into the IWDs for the start of the year. It has been a fairly smooth process and a lot of confidence on the mid-single digit growth for the year. We started the first quarter was up high teens revenue growth in residential. To get to mid-singles for the rest of the year, the average growth rate is low single digit Q2 to Q4. I think we have de-risked residential in our guidance that we gave out last week, just ultimately thinking that it is a mid-single digit growth for the year. We will see how that kind of plays out though.
Chris, thanks. You know, I want to pivot to talking about some other markets and also about the cost structure. You know, we actually got this question. I think it's a great one. You know, the 25% plus incremental framework for margins, you know, it's a good place to be in as a company. You know, if we think about long-term margin trajectory, you know, where could margins, whether it's operating margin or even gross margin, go to? What would be the drivers for, you know, higher levels, whether you want to think about it from a mixed dynamic perspective, anything that could lift margins outside of kind of productivity and operating leverage?
Three things immediately come to mind. The first is going to be that productivity and making sure that we're taking cost out of our production processes. Think of it as every year going in with productivity targets to offset other inflation. We want to make sure that we've got a positive spread, price versus cost, and then ultimately allowing us to invest back in the business. The first thing is there's always opportunities within our Business Operating System to take cost out. Whether that's in the manufacturing plants or in the back office, we're always making sure that we're optimizing that type of spend. That being said, what gives us even more confidence on 25% or greater incrementals, and we say or greater because the last couple of years acknowledge it's been stronger. Think about our services business.
You know, it's a third of the enterprise revenues. It's predominantly linked to commercial HVAC applied systems. With all the growth that we've seen in applied systems, which Dave called out last week, the four-year revenue figure for applied systems in the Americas is 200% growth. With 3X the level of revenue what we saw just four years ago, that brings with it a very strong service tail. Complex systems need OEM service. Services on average have stronger margins than the average margin in each of our three regions. Services growth has been low double digits the last four years. It's been high singles the last seven years. We have a lot of confidence that that service business can continue to grow. That's a margin tailwind. Third, I'd actually go to digital.
The digital connectedness that we have with our products, a recent acquisition of BrainBox AI, which we had partnered with them for several years as well, gives us a lot of confidence that we can provide digital solutions, more digital solutions to our customers to remain connected. You want to be connected, Noah. The reason being is we know from the birth date, the commissioning date of a unit, within a year, that unit can drift by 30% off of its intended use. Keeping that unit back to its optimal commissioning date structure allows for less waste of energy, less cost being wasted by the customer. Let's bring that back to its intended use. That is where a great service technician group works, but also remote connectivity, digital connectivity to diagnose problems before someone even shows up.
That remote monitoring allows us to do that with subscription-based revenues over time.
You know, Chris, just to in this public forum, make sure that we're understanding your comment, right? That sort of up to 30% degradation. I mean, I've worked in industry myself, so I know that is an industry-wide phenomenon, right? There also has to be some element here of taking the data from the field and using it to refine, you know, product development to ensure that that doesn't happen. You know, can you speak to that as well in terms of the learning cycles you're getting, whether it's from the connectedness or, you know, now BrainBox or any of the other investments you've made?
Yeah, I think you're hitting the nail on the head, Noah. It's by being connected on a remote monitoring, it allows you to avoid that drift. If you're not connected, the chances are it will drift. Some buildings change with its purpose over time, right? What you thought the ground floor, second floor, third floor were going to be, they change. You're not necessarily adjusting in some cases what the equipment needs to do to keep up with that change. If you have restaurants on the base level or if that's going to change in terms of their usage of energy, if you have a different tenant that's in there. That's some of the examples of where it helps contribute to the drift. I think that makes the point exactly why you want to be remote connected.
Customers that have multiple buildings in their portfolio like to see all of their buildings on a single pane of glass. We have that opportunity to do that and have remote monitoring before even rolling a technician out into the field.
You know, on cost planning and tariffs, you know, I think your customers have to appreciate that you're prioritizing, minimizing the tariff impacts via supply chain before turning to price. I think Dave emphasized that several times on the earnings call last week, so we all heard it. Maybe just walk us through the sequencing of that process. You know, how do you go about determining when you've exhausted all possible supply chain measures and are going to pivot to pricing and kind of how to think about how much mitigation versus pricing we should assume for the projects in the pipeline?
Yeah, it's an estimate for sure because as we know, the rules continue to change as we kind of go week to week. That's where we just need to remain nimble. You know, we've been here before in terms of dealing with inflation. Think about 2022, post 2021 with supply chain challenges and really significant inflation. Trane Technologies as an enterprise, we delivered 10 points of price that year. In 2023, we delivered 5 points of price. We have the ability to price and surgically price here. We're leveraging our Business Operating System to do that while at the same time working with our suppliers, Noah, to then defray that initial cost. The $250 million-$275 million is an estimate, right? It's a 2025 estimate based on the tariffs in place as of April 30th when we gave our guidance, right? Things may change.
The goal is to, right, get that cost down and then surgically price with, think of it as up to price increases, up to X% price increases that allows us to adjust that to really not make this a profit center. We just talked a lot about applied systems and long roadmaps with customers. We like having customers for life, and we do not think this is the right time to turn it into a profit center to ultimately stay gross margin percentage neutral. We are going to be gross margin dollar neutral is the plan. You will see that more impact in the second half of the year. There is a little bit of impact in Q2 on tariffs. We will see if we can update the investor community in July with more insight on what that pricing contribution needs to be. It is going to be surgical.
I think our customers appreciate that. They appreciate that where we can offset it, we'll work with our supply base and think of it as changing the source of supply where the location is. Think of that as trade routes and ultimately taking advantage of trade-free zones to reduce the cost of tariffs as you're moving things across different jurisdictions. Of course, I'd say last but not least will be the surgical pricing.
You know, given your COGS is primarily components, and I think, you know, you source most of your raws, as you said last week, from the US, it sounds like more of that kind of movement of supply would be done therefore on the component side. How do you approach sort of the second order cost pressures when raw material commodity prices have risen sharply since January?
Yeah, we think of our tier one commodity spend in that $750 million-$800 million range, Noah. We source 100% of steel and 100% of copper from the US and over 90% of aluminum from the US. We have great relationships with those suppliers. The dollar impact of tariffs is fairly minimal when you think about a tier one. What we have been able to do within our operations teams and leveraging our Business Operating System is to get into our suppliers' cost structure. Our estimate of that dollar amount, the $250 million-$275 million, is inclusive of looking at the tier two and tier three and where they are sourcing their products from. Again, it is an estimate. It is not perfect, but it gives us a lot more visibility then into what the true cost is.
How do we mitigate that through other ways, through source of supply and transport? It gives us a lot of insight on how to surgically price. We are managing this inflation broadly, whether it be tariffs, whether it be inflation in general. We have had this in-region, for-region strategy for a couple of decades now. I mentioned at the beginning, you know, our factories and what we deliver for Asia is really for Asia. In Europe, really, or in EMEA, for EMEA, and the same for the Americas. You know, we have over 20 manufacturing plants in the US with one in Mexico. We love the plant in Mexico. It is a great team. It is a component supplier really for parts of the US. We have been in region, for- region for many years.
I think it does make that tariff impact maybe smaller relatively to other companies. You'd expect that from Trane Technologies.
It does. I wonder if it implies going forward any kind of structural cost advantage versus the industry average. You know, we've always thought of you as a price leader and you play in more premium parts of the market. To what extent could you start to see some share gains, whether it's on commercial or in resi, if competitors have to start raising prices for tariffs and you're somewhat more protected?
I think it would put us in a better position being in region, four region and having our manufacturing plants, you know, based in the regions where they're supporting. I think it is a nice opportunity. We're going to stay close to our customers and make sure that, you know, we're doing the best thing for them long term. That is to really offset this tariff impact on a dollar per dollar basis and do not make it a profit center. We would like that opportunity, Noah. Yeah.
Yeah. Can I just ask to go back to your prior point? You know, a lot of times companies talk about lessons learned from the supply chain crisis and, you know, just getting improved abilities and capabilities. Your comments around more visibility into tier two supply base, did that materially change as a result of, you know, the process you had to go through the last couple of years? Is that like a good example of lessons learned?
We certainly have more visibility to the supply chain with going through the supply chain challenges, right, coming out of COVID and working with our suppliers to really figure out who were partners. In some, you know, rare instances, there were more transactional players there. The partners, you're able to get a lot of insight on where their source of supply is, the pain that they were seeing. Let's work with the engineering groups with both teams to figure out, okay, we've got this challenge. Now let's get to yes. Let's get to, can we make an alternative source of supply? Can we change what we're ultimately requesting today? It doesn't need to be at that level of specificity. That's where we did get a lot more information around our suppliers, suppliers in that space.
Every inflationary cycle, we're getting better information around what that cost structure is. Certainly, we've taken those learnings from three, four years ago and working with our partners today, right? This is not the first time we've had these conversations with our partners. It's, okay, maybe it's a different catalyst for what we're talking about today. The fact remains, we've got to go find a way to offset this cost. Let's work together to do that. I think that's the power of being Trane Technologies and making sure we have partners there in our ecosystem.
I was also going to say it's the power of being a company full of engineers that are built to solve problems. There you have it.
We do like engineers. That's true. That's true.
We did not touch on transport, but obviously we have gotten a fair number of questions around that. You know, you consistently outperformed an end market that is looking at, I think, a third consecutive year now of contraction. Maybe help us understand, you know, the outperformance, the share gain dynamics here and how much you think you can maintain in terms of the share gain as volumes recover over the next, hopefully recover over the next couple of years.
Yeah, I mean, 2026 and 2027 look like very strong years the way that ACT has projected the Americas refrigerated transport markets. Both of those years up 20% is what they're calling for right now. That would be a nice add to our growth profile as we think about 2026 and 2027. Certainly, markets both in Europe and in the Americas in transport are a little bit worse than we thought even three months ago. Americas is looking like the year could be down 20-25%. We've factored in in the Americas a lower volume than even what ACT is projecting for the year. It would put volumes down or the markets, I would say, down around 25%. Your point was around how do we outgrow? How do we do better than markets? It is the consistent investments that we're making around innovation.
It's the flywheel and why we like that 25% or better incrementals. Could we do better? Absolutely. Could we do better for a few years? We absolutely could. I think we would shorten, I know we would shorten that innovation pipeline for our products. The transport markets are a great example to see how you take existing diesel fuel products and make them more efficient where they consume less. That's some of the innovation we've put into this market for many years. Moving to hybrid systems, you're depending on electricity and a fuel source, a fossil fuel source, and also having full electric capability for those customers that want to move to full electric power. In Europe, you have a number of cities that you need to shift to full electric power when you're in city centers.
It is staying close to the customers on what they need and providing them optionality. It really comes down to energy efficiency, lower usage of fuel. We know where those prices have gone. Energy prices in general have gone up over time. The paybacks on those systems start to become much like the commercial HVAC paybacks. You are talking about three-year paybacks on these fuel systems or these trailer refrigeration units from savings of fuel or energy. Those are strong reasons where you can outperform the market. Keep investing while we are in that third year of a two-year cycle. That is the key for us. You have nice resale value for those units when they ultimately, you know, six or seven years of life and they want to be resold. You have better resale. That makes a nice equation for our transport customers.
Very good, Chris. I think I'll ask one last question. It's really around capital allocation. You mentioned the BrainBox AI acquisition earlier. Maybe talk to us about how the pipeline of opportunities has evolved, you know, since then. Comment on private valuations and what opportunities might you be more interested in pursuing in the current environment?
Yeah, I mean, as a big HVAC player, we get to really see everything that comes across the gamut from an M&A perspective. We like being a pure play. We like ultimately providing reductions to energy intensity and increasing energy savings. That is our sweet spot as a company in driving sustainability and green for green. It can be green for the environment, but it is green for the pocketbook as well for the financial and income statement. Let me just say we have liked doing channel deals, getting closer to the customer. We like taking early stage technology and bringing it closer to our direct sales force. BrainBox AI and Trane have had a partnership for several years. We are really encouraged with the opportunities, even just with four months of them being part of the Trane Technologies family, of seeing those opportunities grow.
Our direct sales force is right in a perfect spot to go sell those remote connected solutions that BrainBox AI brings and taking the power of structured data and unstructured data together to come up with a more optimized solution for how your building can reduce energy intensity and usage 10%, 15%, 20%, real cost savings that customers can prove out. We like those early stage technologies and where we can take something early stage or in a market that they're, let's say, like in Europe, we've done a couple of acquisitions a few years ago, very strong in two or three markets in Europe. We're strong in 30 markets in Europe. Let's go ahead and take that product that's got strong revenues today. Let's bring it to the other 27 markets where we have direct sales force.
That is some of the contributions you are also seeing in our EMEA region for their revenue growth is the performance of those acquisitions. We think that has been a hallmark from the company. We are not going to let excess cash sit on the balance sheet and let us deploy it to the best returns for shareholders.
We look forward to seeing that continue. With that, I think we are going to pause here and thank you, Chris, and thank everyone for joining this discussion. We appreciate everyone's time. We hope you have a great day at the conference. This has been a good one. Chris, Trane team, thank you.
Thanks, Noah. Thanks everyone.