First off, thank you to everyone joining. I'm Chris Snyder, multi-industry analyst, here at UBS. Very excited to be joined by Dave Regnery, Chairman and CEO at Trane, and Chris Kuehn, CFO. I think Dave's gonna start with a couple prepared remarks.
Sure. Thanks, everyone, for coming today. Thanks, Chris, for the conference and the invite. This is certainly a great event so far, so glad to be here in New York. I do not know if I like all the smog that is here or the fire, but could not figure out why my plane was delayed last night, but now I realize. Look, at Trane Technologies, our purpose is to challenge what is possible and innovate for a sustainable world. The mega trends around decarbonization and sustainability continue to intensify. The unfortunate event that is occurring right now is global warming continues to increase. There is an article out in the paper today about, you know, the Arctic Ocean will no longer have ice in it by 2030. That is pretty—that is right around the corner.
We need to take action, and we need to take action now if we're gonna curb the global warming that's occurring. At Trane Technologies, we have technology that exists today, and I'm sure we'll get an opportunity to talk about it here in a few minutes, but technology that exists today that can dramatically reduce the carbon footprint for the built environment, dramatically reduce it. We had a very strong first quarter. Our revenue organically was up 9%. Our book to bill was 117%. Our EPS growth was 26%. We ended the first quarter with a backlog of $7.3 billion, which is more than two and a half, three times what we would consider to be normal. We're very well positioned to ensure our guide will be hit in 2023, and we're gonna be very well positioned as we enter 2024.
With that, I'll turn it over to you, Chris, and we'll go from there.
Thank you. So, you know, I think if we kind of step back, a year or two from now, I do not think most in the market expected not only this level of demand, but also just the way the demand has been sustained. So, you know, obviously, a lot of mega trends that are out there. But I guess my first question to you is, have you been surprised by the magnitude and sustaining that demand?
Yeah. I guess the short answer is no. Okay? I mean, the mega trends that are happening around decarbonization are real. I mean, I have the opportunity to sit with many of, other CEOs around the world, and I would tell you that the message is clear. We need to take action. You know, it used to be thought of years ago that lighting was the low-hanging fruit, right? That was—that was the easy thing. Let's just change the lighting. We'll have a dramatic impact on the demand side. A lot of lighting projects are complete—not all, but a lot are complete. HVAC and the technology that we've been able to deploy is the next opportunity in front of us. 40% of all the energy in a building is for heating and cooling. 15% of all greenhouse gas comes from heating and cooling buildings.
We have the capability of significantly reducing that. You take the mega trends around decarbonization and what is happening. You take the innovation that we have been able to create around that. Then you have a tailwind of policy or policy stacking that is occurring really on a global basis, whether it be ESSER funding here in the United States, IRA that is in front of us, CHIPS and Science Act that is in front of us, and other, other policies or, or, you know, the carrot or the stick as policy goes in Europe. Those are all additional tailwinds to our business. Am I surprised? The short answer is no. Really, the biggest opportunity is still in front of us.
Yeah. I appreciate that. You know, you kinda called out the book to bill. You called out organic revenue growth. You know, there's a lot that are impacting these numbers. You know, obviously, supply chain's kinda been all over the place. I guess kinda my question is, when you talk to customers, and when the salespeople talk to customers, does it seem like demand is beginning to soften or deteriorate?
They do not let me talk to a lot of customers. That is really what I like doing, so I do talk to customers, actually. The answer is no. I mean, you know, what we have to do, there is a lot of demand out there, and it is, you know, I will speak specifically about our commercial HVAC business here in the Americas. Okay? We follow 14 different verticals. We are diversified in all of those verticals. Yeah, there are some verticals that are weaker than others, you know, office for sure, but then you have other verticals where we are seeing tremendous demand right now. Think about what is happening in the industrial, the high-tech industrial with EV battery plants coming online, or what is happening with data centers, what is happening in the education vertical.
Those are all, you know, verticals that are very, very strong right now. One of the advantages that we have as Trane Technologies is really our direct sales force. Because we have a direct sales force, we're able to pivot to where the opportunities exist. Yeah, office might be down, and I think office is—to say office is down, you gotta be careful with that because there's—if you subsect office, you'll find out that Class A buildings is actually in demand right now. There's a lot of activity there. B and C are in retrofit capabilities right now, or, or they're trying to be. There is some demand still there. The other thing I would add is that we have a service business that represents 30% of our entire enterprise revenue, 30%. It is extremely, extremely resilient.
That is also a catalyst to our business right now.
No. Yeah, absolutely. You know, you kinda started off, you know, your premarks talking about climate change and global warming. So, you know, obviously, the advantage of, you know, more energy-efficient HVAC is it helps the environment, you know, helps companies, you know, achieve their ESG goals that almost all of them have now. But what about the financial profile, and the returns? Anything you could talk to that, you know, that the companies are benefiting from as they upgrade their systems?
Yeah. We develop—I'll talk about Europe. We develop what we call a thermal management system in Europe. Let me just explain to you a little bit about what that is. The conventional way in heating and cooling a building is you have a heating plant. We'll call that a boiler. You'd have a cooling plant. We'll call that a chiller. These two plants operated independently. What we did, because we like to think of things at a system level, we said, "Let's combine that into one system." When we did that, we deployed four different technologies as part of that system. The first is heat pump, right?
I think we all know what a heat pump is, but just to make sure, when you're heating a space, you're really removing heat from it, and you usually take that heat and you put it out into the atmosphere. If you need heat, you go out to outside to the ambient air and bring the heat in. We took that technology. There's another technology called simultaneous heating and cooling. In a building, oftentimes, you have the need for both cooling and heating at the same time. If you ever went into a mechanical room, which I've done a lot of, you'll find that the boiler is running the same time that the chiller is running. It's ludicrous, right? 'Cause you're just rejecting the heat. Let's reuse that heat. We call that simultaneous heating and cooling.
You take that with a cascading system, and I would need more time to explain to you what a cascading system is. It basically allows you to operate in any climate on a global basis. Regardless of how cold it is outside, you could still extract enough heat to make this system work, right? You take that and you wrap it around with sophisticated controls, and that's kinda where the secret sauce is, is in the controls. You create a thermal management system. Thermal management systems are three to five times more efficient than this conventional heating and cooling plant. Three to five times.
If you look at it on the financial returns, if you come at it from the cooling side, like, say, I need to replace my chiller plant, you could get a payback that's probably in the less than three years, probably in the two and a half year range. Think about the financial returns. Two and a half year, these systems are so efficient that, you know, I was at a conference a couple weeks ago, and the consensus was, you know, people won't pay for green. I'm like, "Well, they pay for our green because, by the way, there is a financial return associated. It's green for green," right? You think about that concept. That's why we're able to take this technology and really scale it throughout Europe. We're having a lot of success. You see that in our first quarter results.
I mean, our equipment business in Europe was up, you know, 40% in the first quarter, right? This technology is being adopted. It's just not being adopted fast enough for what we have to do to really curb the global warming that's occurring.
Green for green sounds like a great headline for a note. I wish I thought of that.
I think someone wrote a book just recently about it.
Okay. All right. Fair enough. You know, you kinda talked about the, you know, the opportunity within buildings. I think you said 40% of the emissions, you know, coming from the HVAC.
Energy.
Oh, energy. Sorry. Energy. You know, when we think about, you know, the ability for that to be sustained, I think everyone, you know, kind of understands, okay, you know, you're outgrowing, you know, whatever kind of construction index we'd look at. Is there a way to think about the duration of that opportunity? You know, kinda how long can that, you know, kinda secular, outgrow the macro?
Yeah. You know, it's a great question. The way I look at it is, I think there's—and this number may be a little bit dated—but I believe there's like 400 billion sq ft of commercial space on a global basis. 400 billion. If you add residential into that, you get to a number that's really hard to get your head around. It's in the trillions. There's a lot of built environment that's in front of us. I think for the first time in maybe at least I've been with this company a long time, we're now getting the tailwinds of policy behind us. Not only do we have great financial return—great solutions, great financial returns for those solutions—we have policy that's actually becoming more and more of a tailwind. This is gonna take a while, unfortunately, to build out and to scale.
A lot of it has to do with knowledge of what's available today. You know, we always wanna talk about, like, what's coming, like carbon capture, and can we put carbon capture in buildings? Yeah, we move a lot of air. I, you know, at this conference I was at last week, we talked a lot about that. At the end of the day, putting in a thermal management system, it's really low-hanging fruit, right? It has a return today, and it could have a dramatic impact. Let's scale that so that we could at least have that impact today. You know, people say, "Why isn't it scaling faster?" It really has to do with knowledge about what people don't know what's possible.
If you're running a building, right, and your boiler breaks, do you call Trane Technologies and say, "Hey, my boiler broke"? Probably not. If you knew what was possible with a thermal management system, hopefully, all of you will now call me. If you did not know that, you're gonna call, and you're gonna go with this conventional way of heating and cooling a building. It's crazy. We all need to be, you know, knowledgeable of what's happening so we could have an impact. I'll tell you. This is a funny story, but I'm building a house right now in North Carolina, right? In North Carolina, I'm building a house. I told my builder, right? This is a custom builder, so he works for me, or at least I think he does.
And I tell him, I say, you know, "Ken, I'm gonna put in all—I don't want any fossil fuel in my home," or, "I wanna minimize it," right? 'Cause I'm gonna put it in for the generator. I said, "But I wanna put in 20 SEER heat pumps." And he looked at me, and he goes, "You're gonna be disappointed." I was like, "Why am I gonna be disappointed?" Now, I live in North Carolina. He goes, "Those heat pumps, if it gets below, you know, 30 degrees outside, you're gonna be cold inside." I'm like, "Where'd you get that data from? How old is that data?" He knows what I do, right? I'm like, "How, but how, how do you—how does that happen?" Right? And so now he's, now he's, you know, now he's—he's, you know, I've convinced him, right?
We put the system in. He's like, "I can't believe how well this system works." Now he's out selling it to others. We gotta find a better way to explain to people what's possible. We're all gonna be disappointed as to what's gonna happen to the next generations that live here.
Yeah. No. I appreciate that. You know, you kinda talked about some of the policy. Obviously, a lot coming through IRA, you know, CHIPS Act, you know, just broader, you know, reshoring trends and, and policies supporting that, rising minimum efficiency, refrigerant, a lot. You know, can you just talk about, you know, what that means for the company, you know, being that, you know, historically, you've kind of been viewed as the leader on, on innovation? And, and are those benefits already starting to accrue to the business, or do you see them still mostly heading up?
I see both. I think some of them certainly are there. The whole, you know, you mentioned a bunch there, right? Policy, we talked a little bit about reshoring or rebalancing is happening before our eyes. That started to happen. There is a long tailwind there. I mean, people forget that we have been integrating into Asia, China specifically, for over 50 years. That just does not switch, like, you know, at the snap of a finger here. There is going to be a long tail there. I do not think anyone is going to be pulling out of those areas. They are just going to be rebalancing and manufacturing in other areas of the world as well. That is a tailwind that is going to happen. Decarbonization is going to continue to be a tailwind. It is kind of a mixed bag. Some of them, if I go to policy, right?
That's a great example, right? If you look at ESSER funding, right, which is for the education vertical, we're probably in the mid-innings of that. I look at IRA, and I'm saying we're in the first inning, right? Because there hasn't even been the rebate side of that decided by state. You're getting a little bit of a tailwind right now from the tax credit you'll get as you file your 2023 tax. It's a little bit. If I look at CHIPS and Science Act, I mean, that's in front of us, right? I mean, to put a, from design to when a microprocessor plant starts to produce, it's, you know, close to four years. A lot of that is still in front of us. There is a tremendous opportunity in front of us.
Yeah. No. I appreciate that. You know, when we, you know, kinda think about demand, and, and try to, you know, think about orders alongside that, you know, the order run rate's been a bit over $4 billion or, or so a quarter. You know, do you think that is reflective of demand in the market, or do you think it's still, you know, maybe, running ahead just because, you know, while lead times have compressed, you know, not all the way back yet?
For sure, lead times are extended for the industry and for us. They will eventually normalize over time. Supply chain is dramatically better than it was 18 months ago, but it still has a way to go to improve. Yeah. I mean, at the end of the day, there is a little bit of inflation just because of the extended lead times, but it will normalize over time. I keep telling people, "You need to really look at what's the order rates, what's the backlog, and what's the revenue," right? Look at all three of those. Don't just look at one 'cause you're gonna get the wrong answer. It will normalize over time. The opportunities that lay in front of us, okay, is just tremendous as to what has to happen.
Yeah. I appreciate that. On the, you know, on the big U.S. mega projects, you know, as a former shipping analyst, you know, reshoring is always something I've been focused on. The numbers are pretty crazy. U.S. manufacturing and construction up 100%. Numbers we've just never seen before. You know, can you talk about the Trane's opportunity within industrial? And then also, at what point does the company start to benefit from that? You know, these are huge projects. When do people start ordering or looking for the HVAC?
Yeah. I think, if you look at microprocessing, right, so think about the CHIPS Act. Think about it from planning to startup. These are averages, which are always dangerous, okay? I'm not an expert in this field, but it's about four years. Think about HVAC equipment being on site 12 months before startup. First production, 12 months, back it up 12 months. That's when the equipment would be installed. Then you could back up the ordering process from there. These are very sophisticated systems for a microprocessor plant. This is really kind of our sweet spot. These are highly engineered. You want them to be, right? 'Cause you want them to optimize vis-à-vis how they're gonna be using their manufacturing space. These are projects that we do a lot of.
I mean, I know that everyone's waiting for a CHIPS and Science Act. We've been strong in this vertical for a number of years. Microprocessor plants on a global basis, there, we're always working on those, so it's not like this is like, "Oh, there was nothing, and now it's gonna start." There was always a pretty high base there. It's now gonna accelerate as you have what's happening here and some of this reshoring or rebalancing that's happening. Another one is EV battery plants. Again, a lot of cooling capacity required, a lot of moving of air, very sophisticated systems. Look at what's happening right now. You have every auto company you could think of with an EV platform right now.
A lot of them are partnering with people like LG Chem and their building facilities here. They are building them local. They are building them where they are manufacturing. There is a sophistication there that is part of those systems that we have been able to really dial in. The other one is data centers. I mean, data centers are, you know, that curve is going up, and I do not see it slowing down. Very sophisticated systems. We love working with data center customers. I was telling a group earlier today, I can never mention any of them by name, or I think I go to jail. I am not sure. I love working with them because they are very sophisticated buyers, and they really push technology with us.
They like working with us 'cause we have a lot of expertise. We have a whole separate, you know, business around data centers, and we have it really dialed in from a technology standpoint. We're able to work with some of these big companies, and we come up with solutions that we did not even think were possible. Then we could absolutely scale those to others. Anyways, it is a tremendous opportunity with these quote mega projects, as they are being called. Do not think that those just dry up in 18 months or 4 years, right? This is a continuous process. Question, I think. Two or three extra data centers? We see a lot of demand in data centers, okay? This data center world is very secretive. That is why I am not allowed to say the names.
do not like anyone else to know where their data centers are going. We obviously have the privilege of getting some of their longer, and they want to plan out, right? They want to make sure that we are ready. This is a critical element to make sure the data center is going to operate efficiently or operate at all. We do get a little bit of foresight as to what is happening out there. I think it is going to continue to grow. I mean, AI is going to consume even more data than what we are seeing today. It is not going to stop. Anyway, I think the projections will go up. Four weeks. I will not have enough intelligence to say in four weeks, but I would tell you that it has been the chatter. I would not call it chatter.
I would just say there's been a lot of demand there for a long time, and the projections going forward is it's gonna continue to grow.
You know, if we kinda compare Trane to competitors or the industry, you know, there's a track record of outgrowth. You know, it seems, you know, from my vantage point, a lot of it's driven by innovation and spend, and investment there. You know, would you argue that the advantage of innovation is more important than ever, just, you know, whether it's more focus on efficiency, better returns via efficiency? How do you think about that?
Yeah. I mean, I think there's a system of things that makes Trane Technologies a great company. And innovation is part of that. It's a big part of it, right? Being able to relentlessly invest in the business, good times or bad times, and not taking a year off or taking a quarter off, but relentlessly investing. Chris could talk to you about how we're projecting our long-term leverage and how we're always gonna make sure we have enough to reinvest in the business 'cause that's, you know, I was told early in my career, if you stop inventing, you stand still. If you stand still, you get caught, right? We're not gonna stand still 'cause we're never gonna get caught, right? We are gonna continue to pump dollars into innovation. It's part of who we are.
I would also tell you it's a system of things, right? It's an operating system that we've been honing for the last 10 years that allows us to take best practices and scale them on a global basis. We manufacture things, right? I tell our teams, "I want you to be the best manufacturer in the world," right? Think about lean. Think about how you operate, right? We make things, right? We make things at the end of the day. So we wanna be the best at that. We have an operating system that allows us to do that.
We have an operating system around our service business that allows our service business to be, you know, I do not talk a lot about it 'cause I do not want to create roadmaps, but our service business has grown compound annual growth rate over the last six years, high single digits. That includes the pandemic year. We did not have access to many buildings, right? High single digits over the last six years. It is our direct sales force, right? Think about having the advantage of having a direct sales force where you are constantly in contact with your customers. You are constantly understanding what their needs are. You are constantly looking for feedback as to how you can help them, right? If you go through distribution, that is really hard. Trust me, I have run distribution businesses in my career. That is hard.
It's hard to understand what the customer really wants versus what the distributor thinks they want. It is a difficult equation. That is part of our advantage. If I had to say one thing that differentiates us, and I am very passionate about this, it is the culture that we have as our company. The fact that all 40,000 of our employees think every day that we can make this world a better place because of our purpose, that is what attracts talent to Trane Technologies. You know, next week, I actually, it is one of the best weeks that I have of the year because I get to talk to all of our interns. I did this last year, and it turned out to be a bigger deal than I realized. We had, what, 600 and some interns, 700 interns.
Yeah.
I get to do that next week. I love just talking and getting the feedback of the interns as now they would've been on board now for three or four weeks, but what do they think of Trane Technologies and what's their impression of our culture? It's just a, it's just a, it's very enlightening for me to have those conversations. I'll give everyone an update after I have my conversation. Last year, the year before, I had all the interns, and this is a pretty funny story, but I didn't realize we had 700. I had all these IT people running around my office, and I was like, "What the heck's going on? This is just a Zoom call." They're like, "Yeah, there's 700 people on it," or whatever. They had to orchestrate it.
I was getting all these questions, and I started it out saying that, "Look, I want you to think of this as a long interview, right? I want you to have fun, but this isn't college," right? Sort of like me talking to my kids, right? At the very end, and this, it was like sometimes you have calls and you do not get any questions. There was, too many hands were up for me to answer, right? I said, "Look, I gotta go to another meeting, but I'll take one more question." The last question comes in, it's, I forget who it was, but it says, "Oh, Mr.
is, "Oh, you can call me Dave." He says, "Okay." He goes, "Well, I just have one question for you." He goes, "I want you to know that you said this is a long interview for us. I want you to know that this is a long interview for Trane Technologies. And we want, I wanna make sure that everything you've just been talking about is really who you are." And I was like, "I'm pretty confident you're gonna be applying for a job." It was just a great, so I'll let you know how it goes this year.
Pretty bold out of that intern.
But that's okay. That's a culture that we want, though. We want this, that's why I say I'm so proud of our culture because it's built around, you know, we want diversity of thought. We want diversity of how we solve problems, right? It's not just saying we're gonna, you know, hire to have diversity. It's how you inclusively include diversity into everything you do. That just doesn't happen by accident, right? There has to be some, we have a process around that as 'cause we love processes and we love our operating system. We've built out a whole, think of it as a chapter around how you make that successful. To me, that's what differentiates Trane Technologies.
I appreciate that. I wanna ask on service, you know, you kinda brought it up a couple times. You know, it feels like, obviously, a good opportunity for a lot of the big players. You know, one thing that I kinda find interesting is that, you know, I think the value, the prop makes a ton of sense. Yet, you know, everyone seems to have relatively low share of the market. You know, I guess why has it been, you know, kind of so hard to kind of like build material market share there? Why does it feel like it's starting to flip now?
Yeah. I don't, I don't talk externally a lot about our service business 'cause I'm so proud of what we've been able to do. A business that's grown over the last six years, high single digits, including a pandemic year. The reason why I'm gonna talk is I don't wanna create roadmaps 'cause I, and I could tell you about the roadmaps I created around heat pumps and thermal management systems, which, okay, we're, we are where we are, but I'm not gonna do the same thing over for service business. Look, we have an operating system around our service business. It's growing nicely. I think our service business is transitioning to a, the equipment is not operating properly to the equipment or the building is using too much energy.
That is happening as you're becoming, from a digital standpoint, as you're becoming more connected, whether it be to the asset or to the building or to the campus. Think about how you're taking the data as an asset and aggregating it and learning from it through AI tools. That is where the service business is really transforming. The other thing I would say is, the product that's being sold today versus a product that was sold, you know, five years ago, they're dramatically different, and the sophistication of the equipment has totally changed. If you had equipment that had one or two microprocessors in it, it now has 50. Everything's connected. The sophistication that's required to work on that, it's similar to your car. I mean, when I was a kid, I used to work on my car. I opened the hood.
Now I don't even know, I don't, I don't even know what anything is in it, right? It is very similar. You have to have a very sophisticated, you know, technician work on these pieces of equipment.
Yeah, I appreciate that. Maybe one for Chris. You know, the company, I believe last quarter backlog in the $7 billion ballpark, if my memory serves.
You're right.
You guys are saying, you know, $6 billion kinda plus, which is, you know, obviously there's a, could be a range associated with that. When we see that anticipated backlog burn or that guided backlog burn over the rest of the year, does that include some level of demand deterioration, or is it really just a function of, you know, supply chains compressing, and orders kind of, you know, falling with that?
Yeah. We ended the first quarter with a backlog at $7.3 billion. We grew at $400 million in the first quarter. And that's the two and a half to three times normal level, Chris, than we would've had, you know, pre-pandemic, pre the megatrends that Dave was speaking to. We put out a scenario, which was, $6 billion of backlog at the end of 2023. And what would you need to believe for us to land at $6 billion, which would've really, the math is, order rates down 6% on a full year basis based on our guide for revenue. First quarter, we were relatively flat on orders, right? We had minus 1% at the enterprise level. Book to bill was 117% in the first quarter. And we grew backlog, as I mentioned before. So we believe we're gonna enter 2024 with a much stronger backlog than $6 billion.
It was meant to be a scenario. Over time, the backlog should normalize a bit as lead times come in. We're not there today. Going out the next 12 months, we would tell you we're gonna be in an elevated backlog position for some time. Think of that backlog, though. That's over 90% non-residential, right? Think of our commercial HVAC business and our Thermo King businesses represent more than 90% of that backlog, okay?
Yeah. I appreciate that. You know, the company has done a really good job through all of this on price cost. You know, what are kind of the expectations there going forward? You know, what, how does the company think about, you know, incremental price, and then what are you seeing on the cost side?
Yeah. I mean, Dave mentioned before the business operating system, one of the things that differentiates the company, and this is a clear example of throughout 2021 and 2022, us staying ahead on significant inflation and remaining price cost positive. That was not the case back in 2017, 2018 when you saw tariffs, you know, instigate inflation. We were behind for four or five quarters in price cost on a dollar basis. So, self-healing, improvement in that period of time, and then we hit the next inflationary area. Now we had the first quarter price cost positive on a dollar basis and on a margin basis. Look, our target for the year on price is in that 2-300 basis point range.
I'm hoping we don't need to be in a position to raise prices, you know, three to four times a year like we've had to do the last two years. But that's the power of the business operating system. It's taking the inputs, evaluating, pricing for value with our customers and making sure we're gonna stay ahead. Target for the year is 20-30 basis points of price over cost. Should we start seeing commodities pull back, I think that presents an opportunity. I'd say commodities keep to be, they're kinda bouncing around in a range here the last 6-12 months. We have a lot of confidence we're gonna be able to deliver on that price cost spread.
Yeah. And when we see, you know, I think the guide, I feel like roughly 25% or so kinda incrementals, which is, I would normalize levels. You know, it does feel like price cost is a tailwind. I'd have to think that just productivity and efficiency is going to improve. So those are obviously tailwinds, the incrementals. What are some of the offsets that are pushing it back, you know, just into that kind of normalized range?
We said 25% plus, right? It could be better, to be fair. What Dave was talking about before with innovation, just let me, if I could, just let me spend a little bit of time on the long-term financials. Think of incrementals in the 30% plus range, and then we like reserving 5 points of those incrementals back to investment and back to innovation, okay? We are gonna do that this year, and we are still gonna be, we are targeting 25% or better in terms of incrementals. I think productivity is a future opportunity. We may start seeing that a little bit this year. A much higher cost to serve customers the last two years, and it is not only buying chips on the spot market, it is expediting freight, you know, overnight to make it to your factory in time.
It's units not becoming fully completed, and their first run-through in the factory, you have to put them to the side and you bring them back again. That's a lot of cost, and it's the right thing for us to do to get product out. That's a significant opportunity for us, Chris, as we go forward to unleash and recover some of that productivity going forward. In terms of what are some of the headwinds, look, labor inflation from a tier two perspective, energy inflation, tier two, those are areas we're watching very closely that have been inflationary here, really balancing out some deflation against the inflation.
I appreciate that. You know, I think, I do not think there is much kind of concern on the secular opportunity. I think everyone, you know, kind of agrees that Trane will continue to execute. You know, some of the concerns that we have heard in the market, you know, around inventory in the channel, you know, maybe a rocky start to kind of the spring selling season. Like, how do you guys kind of feel about, you know, some of those potential headwinds, you know, which could, you know, in some way maybe dampen all the great secular positives?
Yeah. I think you're referring to our residential business.
Yeah.
Which just makes sure everyone's grounded. It's about 20% of the total portfolio, and we're about 50% independent wholesale distributors and 50% we act as the independent wholesale distributor. So we're talking about 10% of the company. Yeah, as I said on the first quarter call, inventories are a bit elevated and they'll normalize. I would tell you that that inventory has been normalizing now for probably the last three quarters, and it will continue into Q2. You know, let's not judge our residential business on the first quarter of any year, okay? It happens to be the lightest quarter, and the cooling season hasn't even started yet. We'll see where the year plays out. Our residential business is a great business. It really is. I know I tend to get more questions.
At least recently, I haven't gotten a lot of questions on it. It is a great business, and we're pumping innovation into that business as well. A lot of times people don't understand some of the innovation that's happening there. Think about IRA and what the opportunity's gonna be in front of us there. That will be a tailwind to that business. We've developed some really cool, no pun intended there, but real cool, hybrid systems for the heat pump application where, you know, you'd get away from having to rewire your home. If someone is interested, I could explain it to you in a little more detail. There're gonna be some great opportunities.
The other thing that's happening in residential business is as products are getting more sophisticated, meaning they're at higher SEERs, you have more intelligence that's being built into the product. In the past, residential really was electromechanical. It's now going to microprocessors. As you have microprocessors, there's just a tremendous opportunity. We know how to do this 'cause of our commercial business as to how you can extract value out of that. You're now gonna have data, and you're gonna be able to have this system operate at a totally different level than an electromechanical system. It's pretty exciting as to what's happening there. Again, it's 20% of our business.
The part that we were referring to, Chris was referring to with inventory, is 10% of our business, and it will normalize over time, as I said, in the first quarter, and that will continue through at least the second quarter for sure.
Yeah. No, I appreciate that. Maybe next on commercial new construction, which I know similarly is a much smaller percent of the business than the headline commercial exposure given, you know, the aftermarket service upgrades. You know, has demand been impacted at all by the tightening lending standards, which have now been in place for, I guess, almost eight-plus months?
How time flies, right?
Yeah.
I'll start. Through the first quarter, Chris, we did not see that. Short answer is no. I think part of it is the power of the paybacks on these systems, the green for green, right? If you've got a component that's even just seven years old and now, come back seven years later and the efficiency in those units are 50% or stronger, more efficient today than they were then, and you can drive paybacks that on the higher end seem to be around three years, if not maybe two and a half years, those are still very strong projects that not only meets the needs of someone trying to decarbonize, but if you're looking at the uncertainty of what fossil fuel costs will be in the future, let's make that investment today.
Through the first quarter, we did not see any kind of hastening of demand or, due to tightening of lending standards.
I appreciate that. And when we get kind of similar questions when I talk about, you know, the paybacks are good, that's obviously supporting demand. You know, the pushback from investors is, well, that wasn't the way it was historically. Usually in a downturn, there's just a CapEx pullback and great, you know, I'm not worried about, I worry about paybacks when I feel more comfortable. I guess has that been the case in prior downturns? They all predate me. And is that logic?
Are you saying they don't predate me? I'm not.
I think, let me start. I mean, there's a couple other factors happening here too. There's obviously regulation, and we're in New York City, and there's local law 97 that, you know, maybe there's a little bit of the stick approach here that if you're not gonna decarbonize and reduce your energy efficiency, there's gonna be fines or penalties. Companies that are thinking about, you know, maybe getting ahead of that and not paying that type of money, I think they're gonna wanna make sure they preserve some CapEx for that. At the same time, a lot of companies have made commitments around 2030, 2040, 2050 goals. I'll steal a line from what Dave has shared. You know, it's kinda easy to make that commitment. It's really hard to now put the plans in place to get there.
If you've got physical property in your portfolio, and we know 40% of heating or emissions are really coming from buildings, right? You gotta deal with that in your portfolio. I think those are tailwinds for us today that would not have been there maybe in the last cycle. The decarbonization focus and then the regulation part of it, whether it's a tailwind for the carrot or the stick, I think those are things that are playing into the factors today. I appreciate that. You know, on commercial, it sounds like from a high level, you know, demand kind of steady firm. You know, you called out office as one that is getting worse. I'm just kinda interested, which ones are actually getting better?
High-tech industrial for sure. Data centers, if you wanna call that a vertical. I know it's not part of office, believe it or not, but it'll be separate soon. Industrial in general is very strong. This reshoring or rebalancing, whatever words you wanna use, is real. It's happening. Those are certainly very strong right now. We're also seeing strength in education. Don't forget about education, right? The ESSER funding there, we're mid-inning, mid-innings. We have another couple years in front of us on that. That's been very strong for us. Healthcare has been strong. We're still seeing a lot of tailwinds, even though no one wants to talk about it anymore. Maybe they wanna talk about it after yesterday here in New York, but indoor air quality, right?
I mean, we still see a lot of, this is all built into our applied systems right now. That is a conversation that happens on a regular basis. There is a lot of strength. You know, Europe has performed extremely well. We have strength across our portfolio there. Even in Asia, we have not talked about Asia, but, you know, very strong first quarter, very strong 2022. We have a great team there, and they are continuing to innovate as well. They are now, it is funny, we had a call yesterday on, we have these innovation reviews because I love innovation. Every SBU, Strategic Business Unit, will report on their innovation. We had a great call with the team in Asia and what they are working on.
It's just such an exciting time, and it's such a, you know, I, I've never been a CEO of another company, but I'm glad I'm the CEO of Trane Technologies 'cause we have so many opportunities in front of us. It's just such an exciting time to be a part of this change that's happening around the world. I'm glad that Trane Technologies is helping to lead this change. We had this crazy vision. I know we only have 10 seconds here. We had this crazy vision a few years ago that one company could change an industry, and that industry could impact the world. We're seeing it happen. I'm proud to be the leader of that company that's helping that change happen. Thanks, everyone, for coming today, and really appreciate you learning more about Trane Technologies.
Thank you, guys.
Thanks, Chris.
Thank you.