Trane Technologies plc (TT) Q1 2021 Earnings Call Transcript

Good morning. Welcome to the Trane Technologies Q1 2021 earnings conference call. My name is Mariama and I will be your operator for the call. The call will begin in a few moments with the speaker remarks and the Q&A session. Operator Instructions. At this time, all participants are in a listen-only mode. I will now turn the call over to Zac Nagle, Vice President of Investor Relations.

Thanks operator. Good morning and thank you for joining us for Trane Technologies first quarter 2021 earnings conference call. This call is being webcast on our website at tranetechnologies.com where you will find the accompanying presentation. We are also recording and archiving this call on our website. Please go to slide two. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our SEC filings for a description of some of the factors that may cause our actual results to differ materially from anticipated results. This presentation also includes non-GAAP measures, which are explained in the financial tables attached to our news release. Joining me on today's call are Mike Lamach, Chairman and CEO, Dave Regnery, President and COO and Chris Kuehn, Senior Vice President and CFO. With that, please go to slide three and I will turn the call over to Mike. Mike?

Thanks Zac and everyone for joining us on today's call. Please turn to slide three. While the pandemic continues to present significant challenges around the world, our strategy as a global climate innovator remains steadfast. We are innovating rapidly to address complex and pressing sustainability challenges for our customers and for our planet. This is even more critical as the clock is ticking on climate change and the battle intensifies. Our aggressive goals and bold actions can dramatically reduce carbon emissions and accelerate the world's progress. We are committed to making a difference, consistently, relentlessly and over the long term. Our unwavering focus on innovation has been fundamental to our ability to drive market outgrowth and share gains in recent years and it continues to be a path forward for long term value creation. At Trane Technologies, we have never built strategies around episodic investments, which may increase for a year or two to drive growth and then slow in favor of margin or cash or any changing new priority. Our approach is markedly different. We remain confident in our ability to lead, precisely because our investments are continuous and ongoing. They are focused on a clear purpose driven strategy, a consistent operating system and goals and expectations focused always on top quartile results for our stakeholders. This relentless approach drives market outgrowth, which in turn helps us deliver strong margins and powerful free cash flow to deploy through our balanced capital allocation strategy. The end result is more value across the board for our team, for our customers, for our shareholders and for the planet. Moving to slide four. Our global teams drove exceptional performance in the first quarter, which positions us well as we look towards the balance of the year. We delivered broad-based market outgrowth and share gains in each of our segments and business units with total enterprise organic revenues up 11%, while at the same time delivering more than 400 basis points of margin expansion in every segment and for the enterprise as a whole. We delivered double digit bookings growth in all segments growing our backlog over 30% sequentially versus December 2020 and up more than 30% versus our already strong backlog at the end of 2019 heading into 2020. Adjusted earnings growth was also exceptional, up 135%. Although it's still early in the year and overall visibility remains limited, our strong quarter one performance, growing backlog, improving markets and optimism for improved vaccination rates gives us confidence to raise our full year 2021 guidance for both revenue and adjusted EPS above the high end of the prior ranges. We also continued to make excellent progress towards our transformation savings goal of $300 million by 2023 and expect to realize approximately $190 million in total savings in 2021. That's up from $100 million in 2020. These transformation savings help fund superior innovation, market outgrowth and share gains with sustainable, strong leverage. We expect our strong growth and leverage in 2021 to once again deliver powerful free cash flow which further strengthens our balance sheet and fuels our balanced capital allocation strategy. We have raised our capital deployment expectations for 2021 by $500 million from approximately $2 billion to $2.5 billion as we continue our commitment to deploying 100% of excess cash over time. Lastly, our core strategy remains focused on secular, sustainability megatrends of energy efficiency and sustainability which are becoming more pressing every day. A few weeks ago, we were one of just a handful of companies to achieve validation for our second set of science-based targets on our path to net zero carbon emissions. For those of you who know us well, you know sustainability has been at our core for a very long time. Our first set of science-based targets were approved in 2014 and we achieved those in 2018. We also have revised our annual incentive compensation plan for approximately 2,300 leaders beginning this year to link directly to ESG metrics, including both carbon emission reduction and advancing diversity and inclusion. In addition, all salaried employees must now include at least one sustainability-related goal in their annual performance plans. Our commitment couldn't be stronger. With our purpose to challenge what's possible for a sustainable world, we are uniquely positioned to solve pressing challenges for our customers. This passion powers us forward to deliver top tier financial performance and differentiated returns for shareholders. Now I would like to turn the call over to Dave to discuss our bookings and revenue performance in the quarter. Dave?

Thanks Mike. Please turn to slide number five. We delivered robust organic bookings growth of 31% in the first quarter with growth across all segments and business units. We also delivered strong revenue growth in each segment. Our Americas segment delivered growth in both bookings and revenue, up 36% and 9% respectively. Our Americas commercial HVAC business has remained resilient since the start of the pandemic, delivering strong Q1 bookings growth of low single digits in the quarter. We are especially pleased with this performance relative to the mid teens growth comp in the first quarter of 2020, making the two-year growth stack for Americas commercial HVAC high teens. Revenues were flat in the quarter, which also represents strong performance relative to the growth in the first quarter of 2020, making the two-year stack up mid-single digits. Services were up low single digits. The residential HVAC markets remain robust and our residential HVAC team delivered strong revenue growth, well in excess of 30% in the quarter as they once again grew market share. We entered the quarter with a strong backlog and exited the quarter with an even stronger backlog, putting us in a strong position entering Q2. Our Americas transport refrigeration business outperformed the North America truck and trailer markets in the quarter, delivering strong revenue growth, up mid teens and exceptional bookings growth in the quarter. Turning to EMEA. Our teams delivered 18% bookings growth in the quarter with strong growth in both commercial HVAC and transport refrigeration. Revenues were also strong, up 12%. EMEA commercial HVAC bookings were up high single digits and revenues were up mid teens, once again outperforming the market. We continue to see strong demand for our products and services that help reduce the energy intensity and greenhouse gas emissions of buildings. EMEA transport bookings were up over 20% in the quarter and revenues were up high single digits, outperforming the broader transport markets. Our Asia-Pacific team delivered bookings growth of 14% and revenue growth of 34% in the quarter, lapping a soft Q1 2020 that was heavily impacted by the COVID-19 pandemic. China continues to outperform the rest of Asia where a number of economies are still struggling with the impacts of the pandemic and low vaccination rates. Now I would like to turn the call over to Chris to discuss our operating performance and margins. Chris?

Thanks Dave. Please turn to slide number six. Dave provided a good overview of our revenues on the prior slide, so I will focus my comments on margins. Adjusted EBITDA margins were strong, up 460 basis points driving adjusted EPS growth of 135%. We delivered strong operating leverage in all regions supported by superior innovation for our customers, strong productivity and cost containment actions. Price-cost tailwinds were particularly strong in the first quarter, driven by realization of premium pricing on leading innovation and pricing actions taken to remediate increasing material cost inflation in 2021. In addition, we maintained high levels of business reinvestment in innovation, technology and productivity. Please turn to slide number seven. In the Americas region, market outgrowth, cost containment, productivity and price drove solid EBITDA margin expansion of 400 basis points. Likewise, the EMEA and Asia-Pacific regions delivered strong market outgrowth, productivity and cost containment to improve EBITDA margins by 540 basis points and 1,160 basis points respectively versus 2020. Our market outgrowth in each region is supported by relentless investments in superior innovation to help our customers solve their most challenging and complex problems, fueling new product and service offerings. We delivered strong productivity from both our robust pipeline of projects and the structural transformation initiatives that we outlined at our December 2020 investor event. Now I would like to turn the call back over to Dave to provide our market outlook. Dave?

Thanks Chris. Please turn to slide number eight. Commercial HVAC Americas has significantly outperformed the broader markets since the beginning of the pandemic through strong focus, agility and execution, combined with relentless innovation across products and services to our customers. Demand remains high for comprehensive indoor air quality solutions and we continue to see indoor air quality as a long term tailwind for our business. End markets are mixed with continued strong data center and warehouse demand. The pipeline for our education end market is also strong. To-date, we have engaged with many of our K-12 customers to perform indoor air quality assessments in anticipation of the time when federal stimulus funds will be made available. At this point the full impact and timing of the stimulus remains to be determined but it's clearly a multiyear tailwind for our business, given our strong presence in the education markets and our direct sales force with deep relationships in this vertical. End market indicators are improving with ABI over 50 in both February and March, both positives for the road ahead. In summary, though our visibility into some end market verticals remain somewhat limited due to continued uncertainty related to the pandemic, we continue to see solid prospects for continued underlying market improvements in the second half of 2021, given positive progress and trends related to increased vaccination rates. Turning to residential. We saw a record first quarter bookings and revenue which puts us in a strong backlog position entering the second quarter. Overall, we expect a strong first half and a challenging second half with tough comps in the back half of the year, given record bookings and revenue in the second half of 2020. Turning to Americas transport. We are expecting continued strong growth for the balance of 2021 as markets continue to improve. Orders were very strong in the quarter with many customers placing orders for the year. All in, we expect 26% weighted average market growth for the year, reiterating our prior outlook. Turning to EMEA. The recovery continues to be country dependent with some countries in additional rounds of lockdowns. It's early to call the recovery broadly in Europe, but we expect continued improvement in 2021 with increased vaccination rates in the region. Transport markets in particular are expecting approximately 8% market growth, given the current rate of economic improvement, reiterating our prior outlook. Turning to Asia. We expect continued growth in China in 2021. However, the rest of Asia has been slow to curb the virus and vaccination rates remain low. Overall, we see a mixed picture for Asia in 2021. Now I would like to turn the call back over to Chris to update you on our guidance for 2021. Chris?

Thanks Dave. Please turn to slide number nine. Based on our strong first quarter performance our growing backlog and the expectation for an improving pace of global vaccinations, we have raised our full year guidance for both revenues and adjusted EPS for 2021. As Mike indicated earlier, we expect to deliver strong organic financial performance with organic revenue growth of approximately 9%, up from our previous guidance of between 5% and 7%. We expect to deliver strong organic leverage over 35% for the full year with organic leverage of approximately 30% for the balance of the year. We continue to see about 1.5 points of revenue growth from the channel acquisitions we announced last quarter, which will carry about five points of operating margin and deliver EPS accretion of about $0.05. All in, total revenue growth is expected to be approximately 10.5% and adjusted EPS is expected to be approximately $6 which translates to approximately 35% earnings growth versus 2020. Our updated guidance reflects both our strong performance in Q1 and an improved outlook for the remainder of the year. We also raised our free cash flow guidance with our increased EPS growth. We expect free cash flow to remain strong at equal to or greater than 100% of adjusted net income. If we project current FX rates out to the end of the year, FX would likely be a tailwind, albeit too early to call, given market volatility. Our FX exposure is largely translational and each point of revenue will translate at approximately translational OI rates. Net, each point from FX would translate into about $0.05 of EPS. Please go to slide number 10. As we outlined during our investor event in December, by transforming Trane Technologies, we initially identified $100 million of fixed cost reductions by 2021. We have exceeded our initial cost reduction expectations, delivering $100 million of savings in 2020, a full year early and we expect to deliver $90 million of incremental savings for a total of $190 million in savings in 2021. We are now targeting and are on track to deliver $300 million of run rate savings by 2023. As we outlined in December, we will continue to invest these cost savings to further strengthen our high-performance flywheel which has a reinforcing and compounding effect over time. First, we invest a significant portion of the savings into unrelenting business reinvestments in innovation and leading technology. This fuels the second element, sustained growth above our end markets. Third, we invest another significant portion of the savings into an improved cost structure which drives the fourth element, improved and sustainable incremental margins at or above 25% over the mid to long term. When combined, this creates a compounding effect of high-quality earnings growth and free cash flow year after year. Please go to slide number 11. We remain committed to our balanced capital allocation strategy that is focused on consistently deploying excess cash to opportunities with the highest returns for shareholders. We continue to strengthen our core business with high levels of business reinvestment in high ROI technology, innovation and operational excellence projects which are vital to our continued growth, product leadership and margin expansion. We remain committed to maintaining a strong balance sheet that provides us with continued optionality as our markets evolve. We have a long-standing commitment to a reliable, strong and growing dividend that increases at or above the rate of earnings growth over time. We continue to pursue strategic M&A that further improves long term shareholder returns and we continue to see value in share repurchases as the stock trades below our calculated intrinsic value. All in, we expect to consistently deploy 100% of excess cash over time. Please turn to slide 12 and I will discuss how we plan to deploy excess cash in 2021. Looking at full year 2021, after fully reinvesting in the business, we plan to continue executing our balanced capital allocation strategy and have increased our capital deployment target to approximately $2.5 billion, a $500 million increase to our prior guidance. We anticipate deploying the additional $500 million between value accretive M&A and share repurchases, taking the total target for M&A and share repurchases to approximately $1.5 billion for the year. In the first quarter, we raised our dividend by 11%, deployed $174 million to M&A and share repurchases and paid down $300 million of debt. We plan to retire an additional $125 million in debt as it reaches maturity in the third quarter of 2021, taking the total debt retirement to $425 million for the year. This guidance increase reflects our strong balance sheet and liquidity position, our commitment to deploying 100% of excess cash over time and our continued confidence in our ability to deliver powerful free cash flow to execute our balanced capital allocation strategy. Now I would like to turn the call back over to Dave and Mike to cover key investor topics of interest and to close with a summary of key points. Dave?

Thanks Chris. Please go to slide number 14. We have covered the main points of our guidance earlier in the presentation, so I won't spend a lot of additional time on it now. The objective of this slide is to lay out how to think about organic growth and leverage and the impact of the acquisitions. It also provides some helpful modeling guidance elements outlined on the bottom of the slide. The key takeaways are that we are expecting strong organic growth, leverage and EPS and that M&A adds additional revenues and modest EPS accretion in 2021. Please go to slide number 15. We want to provide an update on transport markets, as we know this is a topic of interest for investors and analysts. The net takeaway is that our outlook for 2021 is largely unchanged from our prior outlook where we highlighted that we expect to see approximately 26% weighted average market growth for transport Americas and approximately 8% weighted average market growth for transport EMEA. While ACT has raised our outlook slightly for our North America trailers about 1%, from 39% growth to 40% growth, they modestly lowered their outlook for truck, which nets out to be a wash on total growth. EMEA is in a similar boat with IHS lowering their 2021 forecast slightly but not enough to shift our view. In total, we have seen very strong demand through the first quarter in both transport markets and we think that ACT and IHS have called the markets about right for 2021, which means transport globally should have a very strong year for us. This is consistent with our prior 2021 view. But I would say, we have greater confidence after our first quarter performance and our growing backlog. The other element I wanted to highlight for transport North America is that ACT has increased their trailer forecast for fiscal year 2022 to 51.1 thousand units, which represents an increase of about 13% over their 2021 forecast. While on the subject, we are occasionally asked about the historical cyclicality in the North America trailer market. Data would suggest the patterns have changed. The North America trailer market took a step-up in 2015 and has been above 40,000 units ever since with only one exception, 2020. 2020 saw market declines intensified by the pandemic. So I am not sure how informative it is about the future. The driver lodge, driver shortage and added economic activity appears that fundamentally shifted the markets to new levels above 40,000 units, excluding economic disruption. ACT's forecast for 2023 is also at the mid 40,000 unit level. If they are correct in their forecast for 2021 through 2023, it will be eight of nine years where the North America trailer market has been in the mid 40,000 unit range, plus or minus 10%. Net, 2022 and 2023 are shaping up to be strong years as well. I would now like to turn the call back to Mike for closing remarks. Mike?

Thanks Dave. Please turn to slide 16. Energy efficiency and sustainability megatrends are only growing stronger and we are uniquely positioned to deliver leading innovation that intersects with these trends and accelerate the world's progress. And we are not only focused on investments in innovation and growth, but also on investments in our business transformation. We are on track to deliver $300 million in savings that will continue to improve the cost structure of the company and enable additional reinvestment to expand margins and further strengthen our ability to outgrow our end markets. When combined with the long term sustainability megatrends underpinning our end markets, our exceptional ability to generate free cash flow and balanced capital deployment of 100% of excess cash over time, we are well positioned to continue to drive differentiated shareholder returns. I have said that Trane Technologies has the essence of a startup with the credibility of a market leader. That unique profile fosters a culture of inclusion, ingenuity and performance that delivers results as we demonstrated in the first quarter. It's this type of passion and purpose that sets Trane Technologies apart and it's how it will change the industry and ultimately change the world. And now, Chris, Dave and I would be happy to take your questions. Operator?

Operator Instructions. Your first question comes from the line of Jeff Sprague with Vertical Research Partners. Your line is open.

Thank you. Good morning everyone. I just wondered if you could just dig into kind of the price-cost dynamics a little bit. I am not surprised to hear you are nicely ahead of the curve in Q1. Just a little more color on the year. It sounds like you expect to stay positive all year long. But is there any particular point and I am thinking perhaps Q2, where actually you end up on the negative side of this as price is catching up? You are ready to price to catch up, is that?

Hi Jeff. This is Chris. I will get started. Thanks for the question. So yes, Q1 we did see particularly strong price-cost in the quarter. When thinking about our first round of price increases, they went into effect in November and January, really just trying to get ahead of what we saw to be the rising material inflation coming into 2021. With that, that helped drive some really strong price-cost in the first quarter. But for the balance of the year, we are really seeing from Q2 to Q4 that price-cost about really being flattish. We have announced and put into effect the second round of price increases here in April. But continued material cost inflation has us continue to climb up as well. So we are really seeing the balance of the year that being roughly flat which we continue to manage and monitor where we can. On material inflation, we got our playbook. We're executing well at this time. For example, about 70% of our copper is locked in at any point in time. The steel pricing has roughly a six month lag. We are still executing the playbook. But I would say, for the balance of the year, we are seeing that really moderating and becoming flattish.

Great. Thanks.

The other thing I would add to that, Jeff, is that our innovation really helps us with price realization as well. So as we have a really robust pipeline and we keep on executing on our new product launches, it's always nice to go to a customer and tell them about the value that you have created and how this solution could add to their bottom line.

And just secondly, Mike, on the strategic angle, you are not interested in raising our capital deployment and obviously the cash flow is there and looks solid. Is your confidence level on finding interesting M&A rising here? I understand if it doesn't materialize you toggle to share repurchase. But just interested in your kind of visibility and confidence level on the M&A front?

Yes. Jeff, it starts with really confidence in earnings and the ability to turn it into cash. And so it's really the commitment we have had for a long time about deploying cash to shareholders over time. And so the confidence there on $2.5 billion is really that. Further, there is a strong pipeline. We are very, very disciplined about how we look at acquisitions. We still feel the intrinsic value of our own share price offers opportunity. So I am confident that one way or the other, we will split it. But we will be able to spend it. As I said on the last call, the pipeline is robust and I am sure that we will find some value before the end of the year there.

Great. Thank you.

Your next question comes from the line of Julian Mitchell with Barclays. Your line is open.

Hi and good morning. Maybe I just wanted to clarify on organic sales growth. So you took out the guide for the year, about three points, I think. Maybe just help us understand, it sounds like transport refrigeration there will change, sort of weighting of that commercial versus residential HVAC. And within Americas commercial HVAC, flat sales in Q1. How do you see that playing out from here?

Yes Julian, I will start and Mike and Chris could add in. If we just really go around the global, overall we expect continued market improvements with the increased global vaccination rates in 2021, but at a global level. If you look at Americas commercial HVAC, we see nice demand in data centers and warehouses and we have seen that for a while now. The education verticals are also showing strength. Hospitality is still weak. Healthcare is showing some strength. So it's kind of mixed right now, but you have got some leading indicators. ABI is strong, which is a good read for us in the future. One point I would point out in the Americas, if you look at incoming order rates, we run it with the Americas, so it's North America and Latin America. If you look at just North America, incoming order rates were up mid single digits where Latin America was actually down mid teens. So we are seeing some strength in our commercial business in the Americas. You go to residential, continued strong bookings, continued strong backlog going into Q2. That's going to be a story of first half versus second half. First half will be very strong. Second half, we have some very tough comps that we are going to be facing there. But overall, we are still positive on our residential business. If you look at the full year, the prevailing consensus is that that would be up in the mid single digits. And we have no reason to disagree with that. Transport, I talked about. It's going to be a strong year. And the nice thing about that is, if you look out into 2022 and 2023 forecast, that strength continues, which is a good sign. EMEA, it's really dependent. We still are seeing some lockdowns occurring. But we are seeing nice results there with our innovation and really around our heat pump, especially in the commercial business with our heat pump solutions that are really making a benefit to our customers. EMEA is another one you have got to break that down. If you look at Europe, our incoming order rates in Europe were up mid teens and actually our incoming order rates in the Middle East were down mid single digits. Asia-Pacific showing strength in China for sure. Data centers, electronics, pharma, healthcare, nice strength there. Rest of Asia has been slow, and we are hopeful that vaccine distribution can start to pick up and that it could bounce back. But if you look at the first quarter incoming order rates for the rest of Asia they were actually down in the mid single digit range. So a lot of strength there in China. Hopefully that helps you with seeing what we are seeing for the outlook.

Yes. That's perfect. Thank you Dave. And then maybe a broader question around that commercial HVAC business, sort of equipment versus service. I understand there is a push to do a lot more contractual type service to keep the attachment rates high, trying to deliver to customers who sell for that sort of IAQ versus energy efficiency conundrum. Maybe help us understand where Trane is on that service push within commercial HVAC and what the uptake is from customers for any kind of newer service offerings?

We continue to see strength in our service business. It was up low single digits. Attachment rates are very high on the applied systems side. Indoor air quality continues to be a tailwind. The neat thing about indoor air quality is not only are we seeing indoor air quality audits being conducted in the education vertical, we are also seeing an uptick in offices. Vaccines are being distributed and people are thinking about getting back to the office. We are seeing a nice uptick in our office inquiries and actually the activity. As far as your question about indoor air quality and energy efficiency in buildings, we do a very comprehensive audit. We have the day one which is let's make sure the building is as safe as possible today. Day two, let's do long term infrastructure improvements that you could make to not only make your building healthier, but also to reduce the energy intensity of your building. We are seeing a lot of traction with those audits and we are starting to see the day two activity come through, especially when combined with some of the stimulus funding that's starting to flow in the education vertical.

Julian, I would add a little bit by saying, we had a view that we thought IAQ would be a tailwind of about 1% to 2% going forward. That's turning out to be right in the last quarter and this quarter and it's nearer the top of that range. It's been pushing towards the 2% end of that range versus the 1% end. Over time, it's going to be difficult to necessarily parse that out as you get more design and more standards being written in a way that that's written in as opposed to a retrofit. But for now, we are seeing that pan out to be 1% to 2%, kind of trending closer to the 2%, which helps explain why North America commercial is a little bit better as we are seeing strong uptick on the offerings that we have.

Great. Thank you.

Your next question comes from the line of Steve Tusa with JPMorgan. Your line is open.

Hi guys. Good morning. Just to follow up on that. I mean, you guys had highlighted, I think, last year that you did have an Americas weakness in services and parts impacted due to lockdowns. I would have thought the comp was a bit easier and you were going pretty nicely in the second half of last year. So up low single digits on that side of the house. Carrier, I think, put up double-digit growth or something in services. Anything going on there with regards to timing? Or is this just kind of — can this business be lumpy? I had thought of it as being a little bit more consistent?

Steve, I think quarter one last year you didn't really have service lockdowns and the complete absence of being able to service buildings physically. That really occurred in quarter two and on. As I recall, quarter one last year was pretty strong. Around the world, as buildings were closed you were delivering more digital services than physical services, so that changed. You are seeing a constant drumbeat towards more of the openings with the exception of important economies like India and Brazil, parts of Europe, and some parts of the Middle East. But it's a healthy recovery. It was a good sign for us to see growth in the first quarter and service again continuing along that pattern. It doesn't appear that we are really going to see any fallout from a contractual basis at this point relative to our service base, which is the other thing you worry about when you see the economy ramping back and we seem to be renewing those relationships in those contractual agreements in an effective way.

Got it. And then just to clarify the follow-up. I didn't quite get the answer to Julian's question on what precisely you are raising the guidance around? What revenue source? Just simply, you are raising the guidance around? And then just one nitpick, will price-cost be positive in that 20 to 30 basis points range this year all-in on price-cost? Or will it end up being kind of a normal year on price-cost spread?

Steve, I will take it. So for the full year revenue increase, call it, three points, we had a strong first quarter. So we are passing that on to the full year. We have got price increases to cover material inflation. That's being baked into the guide. And we are still an HVAC-predominant company. The first quarter is kind of our lightest quarter of the year. So we have got some visibility into the second and some optimism around the second half of the year. So that's ultimately driving the three point increase we are seeing on revenues right now, the Q1 beat, pricing actions to control material inflation and then a little bit more optimism we are seeing in the second half. Your other question was on price-cost. Yes, I think we expect that spread is going to narrow and we expect it will be flattish. Could it be net positive, 20 to 30 basis points in the full year? It could be. But this is a volatile area, as we know. We are monitoring and tracking material inflation. And I wouldn't rule out another set of price increases depending on where that goes. But it could be net positive, in that very low 20 to 30 basis point range or flattish on the full year.

Got it. Thanks for the details.

Your next question comes from the line of Andy Kaplowitz with Citigroup. Your line is open.

Hi. Good morning guys. Mike, so I know we aren't even halfway through the year and likely still early in the transport up-cycle. But as you know, many investors get concerned regarding the cyclicality of the business. And you just talked about the strength that could last into 2022 and 2023. Maybe you could talk about the durability of the strength you are seeing now? How much of the underlying trends that we are seeing — last mile, cold storage, maybe more significant China-related growth — are helping you? As you go out into the out years, there still could be good demand in that business?

Thanks Andy. I will let Dave start and I can add a little color. Dave?

For sure, the trailer demand in North America, as I said earlier, I think there's a new tipping point there. It's 40,000 units, eight over the last nine years. So this is no longer a business that's going to dip down into the 20,000s range, at least in North America. Thermo King is a very diverse business right now. We are very happy with the growth rates we are seeing in trailer not only in the Americas but also in Europe. Because of our diversification, we are seeing growth in other areas as well, especially on the electric side with home delivery. We are very excited about some of the new products we have been able to develop there that are in the market today and more to come. We are also supporting refrigerated container solutions for vaccine distribution and storage capability. As vaccine supply starts to outpace demand in some areas, these vaccines, especially the mRNA ones, need proper storage. We have solutions for that on a global basis, and we are helping in areas like India working with the World Health Organization to ensure they have the products required to get as many people vaccinated as possible.

Andy, the volatility often shows up in bookings, not so much in revenue. From an operations perspective and units, it stays fairly constant. Larger trailer customers are looking out over a year and getting their orders in earlier in the year which may change booking patterns. I think we have some customers lining up for firm orders earlier in the year, which gives more visibility.

Mike, that's helpful. And then recently, you suggested that your opportunity for the electrification of heat could be $2 billion versus we initially thought a $1 billion opportunity in Europe and China, maybe even U.S. But maybe you can give more color: how much for instance of your EMEA revenue at this point is heat pumps? How fast is it growing? What are you thinking in terms of growth this year? And what kind of opportunity could be in China or the U.S. over time?

When you say electrification of heat and heat pump, Canada became the poster child for that because it's an easy concept for people to understand. These are complex systems that really combine boiler plant and chiller plant into a single unit which is capable of doing air-to-air or air-to-water, using heat sources that would move from sewage to seawater to lake water to you name it. We are seeing this applied both at a building level and at a city level. We are seeing great wins there.

It is, by far, the fastest growing part of our business. It is a meaningful part of business today and will continue to be. I think it's at least a couple billion dollar opportunity globally. It's centered primarily in Western Europe. We are seeing some implementation in parts of China and we think there is further commercial opportunity moving into colder North American climates. Over time it creeps further north as the technology gets better to work with lower ambient temperatures. Very positive on that.

To add, today 95% of buildings operate with two silos — cooling via chiller plant and heating via boiler plant. By combining them with our heat pump technology and sophisticated controls we are able to have a big impact on efficiency. A conventional system has a total energy ratio of around two, meaning every unit of energy in yields two units of service. When you combine these systems with our technology, you can get total energy ratios around four times conventional systems. The value prop to customers is very strong, and the environmental benefit is very green. This is a big market in Europe and it's expanding quickly.

Very interesting, guys. I appreciate the color.

Your next question comes from the line of John Walsh with Credit Suisse. Your line is open.

Hi. Good morning everyone. I was just wondering, obviously you gave us the help on the incrementals. We have really unusual comps coming here in Q2. How would you think about the business? Should we think about kind of sequential growth rates? You talked earlier about the two-year growth stack. Next quarter's even easier for you. How would you help us think about what kind of lift we should see here in the second quarter?

Hi John. It's Chris. I think about the second quarter where organic revenues are probably around that mid teens range. When you add in acquisitions, they are driving about 1.5 points of growth for us for the year and that's continuing. We saw that in Q1 and we will see that again in Q2. When we stack organic and acquisitions together, we are probably in the mid to high teens range of revenue growth. And then we are expecting continued strong organic leverage. We would expect about 30% leverage for the balance of the year with organic leverage of approximately 30% for the balance. For the second quarter specifically, we would expect about 30% organic leverage; when you factor in acquisitions it's probably high 20s on a reported basis for leverage. That's how we are thinking about the second quarter right now. Still a little early to call the third and fourth quarter.

Thank you for that. And then, I think there's obviously a lot of funding and excitement around not just K-12 as you highlighted but it's broadening. Is there anything else you look forward to because of supply chain or labor that would kind of govern the growth? Or anything that would slow down the pace of being able to do these energy efficiency and IAQ retrofits?

John, on the supply chain, we have a pretty robust process managing our supply chain. We developed detailed roadmaps early in the pandemic and we continue to execute to those. It's not easy, but our team is doing a great job managing through constraints to make sure we have proper components to manufacture our products and meet customer demand. On labor, it's tight but we are managing through and we have processes in place that allow us to do that.

John, from an internal labor perspective we are fine. If there is a major U.S. infrastructure plan passed, historically there are fewer skilled tradespeople after downturns which can extend institutional project cycles to complete. That would extend new construction or retrofit timelines somewhat, but in our world it's manageable — it just extends the timeframe for completion.

Great. Thanks for taking the questions. Passing along.

Your next question comes from the line of Josh Pokrzywinski with Morgan Stanley. Your line is open.

Hi. Good morning guys. Just a question on some of this IAQ assessment and day one versus day two. How much are you guys able to do upfront in a timely manner as these customers want to reopen versus stuff that might wade into 2022 or even later just as the function of natural bottlenecks in the process? Is this something that lasts two to three years with more on the backend? Or is more of the activity front-end loaded? I am thinking about folks who want to get into offices right now who might need to do something more comprehensive, clearly there will be some band-aid approach in the short term.

Josh, when you think about the roughly 400 billion square feet of space around the world and our portfolio of hundreds of thousands of customers, it is difficult to average this. We think about archetypes. Institutional customers critical to the economy like healthcare and education will move quicker if they are healthy financially and can pass bonds or access stimulus. Large retail complexes, movie theaters and other types of facilities will vary. We have strong pipeline management tools and analytics that build pipelines from individual salespeople in the field, so we have a strong sense of what's in the pipeline and win and close rates and timelines. That gives us some visibility. But it's not an average; it comes down to archetypes and local conditions.

Got it. And then as you think about the mix of business today and maybe Q1 because the hot season was not the best example, is this still sort of post-crisis management where folks are catching up on late activity or wanting to tackle indoor air quality? Or are we kind of back to the normal business of replacing things that are at end of life, doing energy retrofits, the core HVAC business we have known over time?

You are perhaps on the front-end of a return to normalcy in some parts of the world and economy, but largely we are still focused on indoor air quality measures to get people to open safely and figure out where customers should invest. It's early innings around reopening in my view.

I agree. We are now starting to see a lot of office activity where six to nine months ago we weren't seeing many IAQ audits there. As people realize they may get back to the office, they need to think about reopening, which is driving demand.

Six to nine months ago we were educating the market about options. Now we're moving to execution — helping customers audit and implement those reopening plans.

Great. Thanks for the color. Good luck guys.

Your next question comes from the line of Scott Davis with Melius Research. Your line is open.

Hi. Good morning and I will echo congrats on the great start to the year. I guess when you see this kind of growth, it begs the question of, at what point do you have to take CapEx up to another level? And perhaps a better question to ask is what kind of growth can you handle without spending money, meaning after all these years of implementing Lean and being such a productive company overall, can productivity, which probably suffered a bit during COVID, step up and help deliver the kind of unit volume that perhaps prevents you from having to spend a ton of capital on the backside of this?

Scott, what I love about Lean is it never stops. The old adage 'you don't have to be bad to get better' really applies. For example, at our Tyler operations in residential, after a roof collapse in part of the production system, the team worked shifts and returned with a 20% capacity increase in a smaller footprint. We have capacity playbooks for many facilities and options like third shifts or weekend shifts. So I do not see a need to add capacity purely to handle near-term demand. We are thinking about resiliency differently — where we need resilience in the supply chain or manufacturing operations — and we may invest for resiliency rather than pure capacity.

That makes a lot of sense and it's encouraging. The follow-up is around emissions targets and how you get to zero emissions. High-level, how do you get there? Does it require spending money? Is it iterative and takes time or are there step changes?

Scott, that's a longer conversation but please go to our website and read our recently published ESG report. It's about 100 pages long and lays out the roadmap you are asking about, with a lot of transparency on metrics, where we are today and where we are going. That report should answer many of your questions in detail.

I will read it. Thanks.

Your next question comes from the line of Nigel Coe with Wolfe Research. Your line is open.

Yes. On residential, we haven't spent a lot of time talking about that. It's obviously very strong. Several channel partners and competitors have said stimulus dollars are getting some equipment replaced rather than repaired. Do you think the strength we are seeing today because of stimulus is taking some demand out of 2022 and maybe 2023 into this year? Any thoughts on the repair versus replace cycle?

We had a very strong quarter for residential and April was another strong month. I don't believe it's pulling demand forward from the future. People working from home realize comfort matters and we are seeing an uptick in SEER ratings sold — people are choosing higher-efficiency products. We don't see this materially pulling demand from 2022 or 2023.

There is economic optimism with unemployment rates falling, rising home values, and the future of work meaning people are spending more time at home. This is an upgrade cycle phenomenon. I don't think it's pulling replacement demand forward; people are replacing with higher efficiency systems now. Over the long run, regulations will continue to drive toward full system replacements with more efficient systems, and it should be a GDP-plus business.

To clarify, you have to look at years. First half last year was low, second half last year was strong. In totality, residential has been in the low to mid single digit growth range, with quarterly swings driven by the pandemic.

Right. And then a follow-up on M&A: we saw large deals like Melrose selling an HVAC business at a high multiple. How should we think about where you are looking for M&A? Are you looking at future trends like electrification, software, digitalization? How should we think about where you may land on your M&A strategy?

First, the Melrose transaction had parts that would have fit and parts that wouldn't. We remain disciplined. The pipeline is robust. Most of what we look at is strategic — things discussed in our strategies before they show up on an M&A screen. There's always a portion of ideas from other sources. Valuations are relatively high, so we will be selective. We may look at channel, technologies that need scale, or businesses where we can improve operations. Through the pandemic, the top-four HVAC companies gained concentration, which affects potential consolidation opportunities. We'll be selective but will lean into attractive strategic deals when they fit.

Okay. Thanks Mike. Thanks Dave.

Your next question comes from the line of Joe Ritchie with Goldman Sachs. Your line is open.

Hi. Good morning everybody. Mike, maybe following Nigel's question, you know the pipeline is robust. You also had JCI announce the acquisition of Silent-Aire to grow in data center. When you think about your portfolio, are there any pieces or end markets where you feel like you need to get bigger to get after the opportunity, whether it's data centers or warehousing? I know you've been enthusiastic around heat pumps.

Joe, thanks. The answer is no — there are no strategic gaps that we feel we need to fill. We're discerning. We don't want to do M&A for the sake of M&A. We look at novel technologies that need scale or channel partners where our capabilities add value. During the pandemic the largest players increased concentration and that changes dynamics for consolidation, making some M&A opportunities more restrictive. We remain cautious and selective.

Got it. That's super helpful. Maybe one follow-up: there's been a lot of discussion around price-cost. It seems like you are managing it well this year. What do you think is different for you this time around versus the 2017-2018 period in your ability to manage through this?

One thing is the operating system hasn't changed; we've been successful with it for a long time. The difference in 2017-2018 was more speculative commodity moves in areas like copper, making it harder to predict. This time the changes in commodity prices have been more visible and it's been easier to recognize and manage the rate of change. We've also used substitution between copper and aluminum as appropriate. Systems are the same; it's a bit more predictable now versus the volatility of that prior period.

Got it. That's helpful. Thanks guys.

Your next question comes from the line of Dan Flick with Cowen and Company. Your line is open.

Hi guys. This is Dan Flick, on for Gautam. Thanks for taking my question. I was hoping you could explain some of the moving pieces on the operating leverage target for the remainder of the year coming down to 30%, which was so strong in Q1? Is that related to absolute R&D dollars coming up? Or is it all COGS? Any color would be helpful.

Hi Dan. This is Chris. We had strong leverage in Q1, but as we think about the balance of the year, we are still targeting 30% organic operating leverage for the balance of the year, consistent with our prior guide. When I think about the performance flywheel, the first step is reinvesting. We fully expect stronger investments Q2 to Q4; we had strong investments in Q1 and they will ramp up. We have an innovation pipeline and new product development which materialize in stepped-up investments. Second, the price-cost spread is going to narrow — price increases don't bring as much leverage if cost continues to climb, so price and cost will roughly approximate Q2 to Q4. Third, we are still managing through the return of some temporary cost takeouts from last year; that's part of our guide. All in, 30% for the balance of the year and full year organic leverage now targeted around 35% given Q1 performance.

Cool. That's helpful. Thank you.

Your next question comes from the line of Andrew Krill on behalf of Deane Dray with RBC Capital Markets. Your line is open.

Hi. Thanks. Good morning. I wanted to go back to residential HVAC. Can you give a sense of sell-through you saw in the first quarter with distribution? Was that close to the plus 30% you cited for your sales? And then, can you give us a sense on how you see inventories heading into the peak selling season?

This is Dave. Our residential business is about 50/50 direct and independent wholesale distributor channel. On the independent wholesale distributor side, sell-through was strong, in the 20s. Sell-in was stronger as distributors filled inventory. We are not seeing a significant excess build in their inventory levels from the visibility we have. It was a solid quarter for our residential business and our teams executed to customer demand.

Got it. And then just a quick follow-up. Cash flow in the first quarter looks very strong. Anything you would highlight there and any other big moving parts to be aware of as the year progresses?

This is Chris. We were happy with first quarter performance — around 96% free cash flow conversion to earnings, high-quality earnings. We continued to make structural improvements in working capital; I think working capital was around 1.5% at the end of Q1. We may modestly invest in inventory through the year, but days sales and days payable have improved from two years ago and inventory turns have improved. We continue to make operational excellence improvements in working capital. Full year we are guiding to greater than or equal to 100% of adjusted net income in free cash flow and we have the structural ability to hit or slightly exceed those numbers.

Thank you.

There are no further questions at this time. I will now turn the call back to Zac Nagle for closing comments.

I would like to thank everyone for joining on today's call. As always, Shane and I will be available today and for the coming days to answer any questions that you have and we certainly look forward to connecting. Be safe and we will talk soon. Thank you.

This concludes today's conference call. Thank you for participating. You may now disconnect.