Trane Technologies plc (TT) Q3 2021 Earnings Call Transcript

Good morning. Welcome to the Trane Technologies Q3 2021 earnings conference call. My name is Paula and I will be your conference operator for the call. The call will begin in a few moments with the speaker's remarks, and the Q&A session. 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. Please go ahead, sir.

Thanks, Operator. Good morning. And thank you for joining us for Trane Technologies' Third Quarter 2021 Earnings Conference Call. This call is being webcast on our website at tranetechnologies.com where you will find the Company presentation. We're also recording and archiving this call on our website. Please go to Slide 2. Statements made in today's call that are non-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 David Regnery, CEO and Chris Kuehn, Executive Vice President and CFO. With that, I will turn the call over to Dave. Dave.

Thanks, Zac and everyone for joining us on today's call. Let's turn to Slide number 3. As we do each quarter, I'd like to spend a few minutes upfront on our focus sustainability strategy, the engine that enables us to deliver differentiated shareholder returns over time. Long-term sustainability mega trends continue to intensify and our innovation leadership is transforming the climate industry as the world decarbonizes. Our aggressive goals and bold actions can dramatically reduce carbon emissions and accelerate the world's progress. This is more critical every day as the clock is ticking on climate change. That's why we're calling for businesses and governments to take stronger action at COP26, and why we continue to set aggressive science-based emission reduction targets to push our innovation further and faster. That innovation also extends to emerging trends as we see heightened focus on indoor air quality and strong momentum in aging infrastructure in our schools. We continue to make a difference consistently, relentlessly, and over the long term. This unyielding approach drives market outgrowth over the long term, which in turn helps us drive 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 customers, for our team, for our shareholders, and for the planet. Moving to slide number four, our global team delivered solid execution in the third quarter, and we continue to target top-quartile EPS growth for 2021. Bookings were once again exceptional in Q3, building on strong growth in both Q1 and Q2, and bringing our year-to-date organic bookings growth to over 25% for the enterprise. Underlying demand for our innovative products and services has never been stronger, and our Q3 ending backlog reflects the strength. In fact, Q3 ending backlog for the enterprise is up more than 70%, or approximately $2 billion, from year-end 2020 with all three of our business segments at record levels. Americas and EMEA backlog are both up over 90% and 65% respectively from year-end 2020. We're well-positioned to close out 2021 on a strong note, and to enter 2022 with unprecedented levels of backlog as well. As we highlighted on our second quarter earnings call and in subsequent forums, global supply chains, logistics systems, and labor markets remain tight and inflation is persistent. Our global teams are focused on meeting the unique needs of our wide-ranging customer base and helping them solve complex challenges on a daily basis as we navigate a challenging yet positive demand and supply environment. Temporary supply chain delays on key materials impacted portions of our product portfolio shifting the timing of approximately $150 million, or 4% of our revenue, out of the third quarter and into future periods. Working closely with our key suppliers and with our customers, we anticipate that between $50 million and $75 million, roughly 2% of the Q3 impact, will shift into the fourth quarter, leaving our 2021 revenue guidance unchanged. We expect the remaining balance to shift into 2022. We also highlighted on our second quarter earnings call that persistent inflation would require us to execute an incremental $150 million in pricing actions in the second half of the year in order to neutralize the impact. Strong execution of our business operating system has enabled us to keep pace with the inflationary curve. In the third quarter, we realized approximately $150 million, or 4.3%, incremental price, offsetting approximately $150 million of inflation. Leverage was negligible, as you would expect on flat volume. While adjusted operating income was modestly higher in the quarter, primarily reflecting nominal pull-through on M&A and FX, growth was consistent with our expectations and our guidance. We continue to execute the business transformation projects we discussed in detail at our Investor Day in December and are on track to deliver approximately $90 million of incremental savings in 2021. These savings support leading innovation across our end markets through relentless high levels of business reinvestment. They also enable us to stay on track to deliver incremental margins of approximately 30% organic for fiscal 2021 despite persistent inflation, tight logistics systems, and supply chain challenges. We're also on track to deliver powerful free cash flow equal to or greater than 100% of net earnings. This provides us with strong optionality to deploy significant cash to opportunities now and in the future, including M&A and share repurchases. Lastly, we never lose sight of our long-term purpose-driven strategy and the tremendous leadership role we can play in bending the curve on climate change. By changing the industry, we can change the world. Executing our purpose-driven strategy is how we will continue to deliver top-tier financial performance for our shareholders. Please turn to slide number five. While we're still in the midst of our planning process for 2022 and anticipate providing guidance in conjunction with our fourth quarter earnings call, we thought it might be constructive to spend a few minutes discussing our initial thoughts on 2022 and some of the key dynamics we believe will be in play. While this is not a comprehensive list, it will highlight some of the key reasons why we're so excited about what the future holds for Trane Technologies, as well as some of the key challenges we see on the road ahead. First, we expect to have strong fundamentals entering the year. Exiting Q3 backlog in our Americas and EMEA segments are both at unprecedented levels, up over 90% and up over 65% versus December of 2020, respectively. Asia also has record backlog up nearly 20%. If we very conservatively plot out bookings through the balance of 2021, we anticipate entering 2022 with at least 70% more backlog in the Americas and EMEA than we entered 2020. I've been in this business a long time and I've never entered any year with a stronger backlog position, which bodes well for us in 2022. Another fundamental strength entering 2022 is the foundation of our business operating system. Strong execution of our business operating system has enabled us to stay ahead of the persistent inflation through 2021 and position us well to manage additional inflationary pressures and deliver strong price realization again in 2022. And we will continue to drive transformation savings in 2022 that will support high levels of business reinvestment and continued innovation. These savings will also support healthy incremental margins in what we expect to be another year of tight conditions for supply chain, labor markets, and logistics systems. Looking out to 2022, we also expect to see continued acceleration of the strong secular sustainability mega trends that are so tightly aligned with our purpose-driven business strategy. The decarbonization of the built environment is accelerating. U.S. education stimulus dollars are being put to good use, upgrading our aging infrastructure. And momentum around indoor air quality upgrades, retrofits, and new projects continues. Additionally, the global economy is expected to continue to recover in 2022 with solid underlying GDP and other economic indicators driving broader expansion in the non-residential markets. Lastly, we're excited about the future transport refrigeration markets, where ACT and IHS are plotting a steady growth path forward in both 2022 and 2023. All in, we're exceptionally well-positioned for strong performance in 2022 and beyond. Please turn to slide number six. Customer demand for our innovative climate control products and services continues to grow. We delivered another quarter of robust organic bookings growth up 20% with growth across all segments and business units. Customer demand has been high all year with organic bookings up over 25% year-to-date, driving a record backlog in each segment. Organic revenues were also up 4% driven by continued strong price execution. Our Americas Commercial HVAC business delivered robust bookings growth in the quarter, with orders up over 30%. Strength was broad-based, with applied and unitary bookings both up more than 50% and service bookings up high-teens. Demand for system-focused indoor air quality solutions remained strong and contributed to our mid-single-digit revenue growth in Commercial HVAC Americas. The residential HVAC markets continue to be strong, and our residential team delivered low single-digit bookings growth building on nearly 40% growth in the third quarter of 2020. Revenues were flat in the quarter as demand outpaced supply and we enter the fourth quarter with record backlog, up more than 150% year-over-year, and up from prior record backlog at the end of the second quarter. With year-to-date organic bookings up over 80% and year-to-date organic revenue up over 30%, our Americas transport refrigeration business is significantly outperforming the North America transport markets. During the third quarter, with most of 2021 orders already in the backlog, we opened up our 2022 order book solely for the first quarter of 2022, which drove bookings growth of more than 20%. We are methodically managing our 2022 order book in order to mitigate inflationary risks. Organic revenues were also strong, up low to mid-teens. Turning to EMEA, we continue to see strong demand for our innovative products and services that help reduce energy intensity and greenhouse gas emissions for our customers. Our EMEA teams delivered 25% organic bookings growth in the quarter, with strong growth in both Commercial HVAC and transport refrigeration. Revenues were also strong, up 8% led by high-teens organic revenue growth in transport refrigeration. Our Asia Pacific team delivered bookings growth of 11%. Revenue grew 1% in the quarter. Though we saw growth in China during the quarter, the impacts of the COVID-19 pandemic continued to be challenging in the region, with low vaccination rates in some countries. Now I'd like to turn the call over to Chris. Chris.

Thanks, Dave. Please turn to slide number 7. Organic revenue growth in the quarter was driven by continued strong price execution, yielding 4.3% incremental price in the quarter. Price over material inflation was positive in the quarter, and combined with mix, offset the net impact of productivity over other inflation and increased investment spending to support leading innovation. Organic volume, and therefore pull-through leverage, was largely flat for the enterprise in the quarter. At a high level, positive leverage was primarily the result of mix and a modest flow-through of M&A and FX, consistent with our guidance. Net adjusted EBITDA and operating margins declined by 70 and 60 basis points respectively. Adjusted EPS grew 5% driven primarily by higher adjusted operating income. Please turn to slide number eight. We discussed the key revenue and margin dynamics for the enterprise on the prior page. The dynamics impacting revenue and margins were similar across each of our business segments as we've highlighted here, but strong price realization, productivity, inflation, and higher investments in innovation are consistent drivers. In EMEA, solid price realization was accompanied by strong volume growth, delivering good leverage and margin expansion in the quarter. Both the Americas and Asia Pacific segments delivered higher revenues on modest volume declines impacting leverage. Asia Pacific also experienced price versus cost headwinds in the quarter, further impacting margins. We continue to expect Asia Pacific to deliver solid margin expansion for the full year and are pleased with our overall performance in the region. Now I'd like to turn the call back over to Dave. Dave?

Thanks, Chris. Please turn to Slide number 9. Commercial HVAC Americas has significantly outperformed the broader markets over a number of years through strong focus, agility, and execution combined with relentless innovation for our customers. These defining characteristics, compounded by the strength of the underlying market conditions, power the business forward today, yielding bookings growth of over 30% in the quarter and an exceptional backlog entering Q4. Booking strength was universal across nearly every vertical market and major product category. End-markets continued to improve. Vaccination rates are improving, and end-market indicators are generally strong, with ABI over 50 since February and a healthy GDP. Data centers and warehouse demand remain strong. Education and healthcare end market demand is also growing. We're benefiting from increased demand across our K-through-12 customers, with federal stimulus funds supporting both current and, more importantly, future growth. We see this as a multiyear tailwind for our business, given our strong position in the education market and our direct sales force with deep relationships in this vertical. Our residential end markets remain strong. As I mentioned previously, we delivered low single-digit bookings growth in the quarter, compounding on nearly 40% growth in the prior year. We are entering the fourth quarter with unprecedented backlog. I'm proud of our residential team that has continued to meet customer demand while ramping capacity after our February weather event in our Texas facility. The team delivered historically high revenues in Q3 and is on track for capacity expansion in advance of next year's cooling season. Turning to Americas transport, we're significantly outgrowing strong end markets in 2021. ACT market forecasters are projecting strong growth in 2022 and 2023 as well. I'll talk more about the transport outlook in our topics of interest section. Turning to EMEA, economic conditions are improving across the region. We expect continued improvement for the remainder of the year, with increased vaccination rates supporting the opening of an increased number and variety of venues. Transport markets have been strengthening throughout the year, and we're on track to outperform end markets in 2021, as evidenced by our year-to-date performance. Turning to Asia, we expect growth in China in 2021, supported by increased vaccination rates and strengthened data centers, electronics, pharmaceutical, and healthcare. Outside of China, the picture is mixed, with vaccination and economic recovery rates still low in some countries. Now I'd like to turn the call back over to Chris. Chris.

Thanks, Dave. Please turn to slide number 10. Given all the puts and takes we've discussed today, our guidance for 2021 is unchanged. Importantly, we continue to see our 2021 adjusted EPS growth guidance of more than 30% as top quartile among peers and the broader industrials. We've discussed the shift in revenues from Q3 to Q4 and into 2022 throughout the call. Our fourth quarter revenues are supported by record backlog, and that backlog is firm. Supply chain, labor, and logistics systems will continue to be challenging, and are the limiting factor to potential upside, not demand or backlog. We also continue to expect free cash flow to remain strong at equal to or greater than 100% of adjusted net income. Please go to slide number 11. As we outlined during our investor event in December, we are on track to deliver $300 million of run-rate savings by 2023, including $90 million in 2021. Importantly, we continue to invest these cost savings to further fuel innovation and other investments across the portfolio. This consistent investment strengthens our high-performance flywheel, which has a reinforcing and compounding effect over time. Please go to slide number 12. 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. First, we continue to strengthen our core business through relentless business reinvestment. Second, we're committed to maintaining a strong balance sheet that provides us with continued optionality as our markets evolve. Third, we expect to consistently deploy 100% of excess cash over time using a balanced approach that includes strategic M&A that further improves long-term shareholder returns and share repurchases as the stock trades below our calculated intrinsic value. Please turn to Slide 13, and I'll provide an update on how we're deploying excess cash in 2021. Year-to-date, we have deployed $1.8 billion in cash with approximately $1 billion to M&A and share repurchases, including $250 million for the Farrar Scientific life sciences acquisition we closed in October. We have paid $422 million in dividends and $425 million to pay down debt. Our strong free cash flow, liquidity, and balance sheet continue to give us excellent capital allocation optionality, and dry powder moving forward. We are on track to deploy at least $2.5 billion in excess cash in 2021. Now, I would like to turn the call back over to Dave. Dave.

Thanks, Chris. Please go to slide number 15. I wanted to spend a couple of minutes providing an update on the transport refrigeration markets for 2021, as we've seen the forecast shift with a fair amount since our second quarter earnings call. I think the primary takeaway this quarter is that ACT is projecting an extended and more gradual upturn in the North America transport refrigeration markets than initially projected. North America trailers is probably the clearest example and one of the most watched by investors and analysts as a proxy for overall transport refrigeration health. ACT started out the year projecting an almost immediate snap-back in North America trailer production in 2021, up 39% off the lows of the pandemic in 2020. As trailer OEMs have had a challenging year producing enough trailers to meet the forecast, ACT has gradually pulled the forecast down and is now projecting a strong but more gradual improvement in 2021, up 18%, and continued improvement in production rates in both 2022 and 2023, up another 18% and 14% respectively. If you look at the all-in weighted average market forecast for North America transport refrigeration, 2021 is now expected to be up about 14% versus 24% projected in July. Year-to-date, our Thermo King Americas transport refrigeration business is up more than 30%, clearly outperforming the markets, and we expect to outperform the markets for the full year as well. Looking at IHS and other key indicators for EMEA markets, the outlook has improved about 3 points with the weighted average market growth now expected to be about 12% for 2021. Year-to-date, our Thermo King EMEA business is up more than 20%, clearly outperforming the markets, and we expect outperformance for the full-year 2021 as well. Please go to slide number 16. We added a second transport refrigeration slide to the deck this quarter to add more color around the North America trailer market, from both backward and forward-looking perspectives. One of the things we've talked about over the past several quarters is the North America trailer market has not been particularly volatile over the past several years, and it's not projected to be particularly volatile over the ACT forecast horizon either. On the left side of the page, you can see the visual depiction of what we've been describing. We chart ACT's reported actual trailer units built going back to 2015, and ACT's forecast for trailer builds through their forecast horizon of 2023. The 9-year average is in the mid-40,000 unit range, with the pandemic in 2020 being the only significant outlier. We also see that good growth is projected in both 2022 and 2023. It's important to note that our global transport refrigeration business is highly diversified. Trailer is an important part of the global mix, at about 25% of the total. However, we're focused on strong execution across the transport refrigeration portfolio, which we believe will further help reduce variability of this business over time. Please go to Slide number 17. 2021 is shaping up to be a strong year for us overall, despite a number of macro challenges that we expect to continue over the near term. We're seeing unprecedented levels of demand for our products and services across the board and our backlog has never been stronger. We're executing our business operating system well and staying ahead of persistent inflation with strong price realization, and we expect to deliver top-quartile EPS growth for the full year. Energy efficiency and sustainability mega trends are only growing stronger. We are uniquely positioned to deliver leading innovation that addresses these trends and accelerates the world's progress supported by a business transformation and our engaging uplifting culture. We are proud to have been recognized by Forbes as one of the best employers for diversity and best employers for women, and by Fortune as one of the best workplaces in manufacturing. It's our people that power our innovation and bring our purpose to life every day. We have many reasons to be excited about our prospects for strong performance as we look to 2022 and beyond. When combined with our exceptional ability to generate free cash flow and our balanced capital deployment, we are well-positioned to continue to drive differentiated shareholder returns over the long term. And now, we'd be happy to take your questions. Operator?

At this time I would like to remind everyone in order to ask a question, press the appropriate key on your telephone. Your first question comes from the line of Joe Ritchie of Goldman Sachs.

Thanks. Good morning, everyone. So maybe just the first question on the supply chain. It's helpful to have kind of that visibility on the revenues that pushed out from this quarter. I guess, just any other color that you can provide, is this predominantly occurring in your North America trailer business? And then just confidence that you're going to be able to shift these revenues and not see sustained supply-chain issues in the next few quarters.

Yeah. Sure, Joe, great question. Tight supply chain really globally, we talked about it during our second quarter earnings call. It caused us to push about $150 million of revenue out of the quarter, as we said. We think we'll get about $50 to $75 million of that back in the fourth quarter. Our team is doing a great job of managing the supply chain constraints. We chose not to include a slide in our deck telling you the 50 things that we're doing to manage our suppliers or help our suppliers, but I can assure you that supply chain resiliency has been part of our business operating system for a long time. And I can assure you that Trane Technologies employees around the globe are working hand in hand with our suppliers, ensuring that we could take literally pages out of our operating system and help them implement it. We think it's going to be choppy for a while on the supply chain, at least for the foreseeable future. It's a little bit, I think I mentioned it in the second quarter call, it's a little bit like when you were a kid and you play that game Whack-A-Mole, where we fix one problem and another problem pops up. But if you're looking for overarching kind of where are we seeing constraints? I don't think we're any different than what you probably already heard from the rest of the industrials that have reported. Electronics, resin, semiconductors, wire harnesses—these are all areas that certainly at an overarching level, we're seeing supply chain constraints. That said, just a couple of points I want to make. One is, we're working very closely with our customers. It's very important that in some cases our customers are having supply chain constraints on the job sites, which is causing them to push out jobs. So we're working with them to make sure that we could deliver product when they need it. If you look at our Thermo King business, we're really aligning with our customers there around build slots that they're getting from the trailer OEMs and tractor suppliers. So this hand-in-hand relationship with the customer is pretty dynamic right now. And then the last point I'd like to make, Joe, is that I know we've talked a lot about supply chain constraints. We also have to be fair to our suppliers. I know many of them are probably listening to the call or will read the transcript. We are putting tremendous pressure on our suppliers with the amount of demand that we're seeing in the marketplace right now. If you look at our Commercial HVAC business in the Americas, our unitary and applied both are up over 50% incoming order rates in the third quarter. So with that kind of demand, you can imagine we're pushing that right on to our suppliers and putting orders on them. So they're seeing some pretty big spikes that they're having to manage through. Your question on, is there a particular business? It's pretty widespread. There's more acute pressure maybe in our Thermo King business. We had a couple of suppliers there that we've worked through some of the issues with. So we're pretty confident that we'll be able to rebound there in the fourth quarter. We're also seeing constraints across the globe in our Commercial HVAC business. Certainly there the resin impact and kind of a knock-on effect that we've been seeing now for several quarters.

Thanks, David. That was helpful. Maybe my one quick follow-up. One of your suppliers, they just did their conference call about an hour ago, and they talked about the price-cost formula being roughly a $100 million positive for them in 2022. You did a good job with pricing this quarter. I'm just curious as you think about 2022, should we be thinking about a positive price-cost environment given what you're seeing in your cost and price today?

Hey Joe, it's Chris. I'll take the question. So we are in the middle of our 2022 planning. Going into 2022, though, we would expect some carryover price from the three price increases most of our businesses announced this year; we will start lapping price increases starting in the first quarter of next year. But I will tell you as part of our business operating system, we enter every year coming up with a plan of how we're going to get about 20 to 30 basis points positive spread of price over costs. More to come in a couple of months as we release guidance for next year, but we're going to go in with the mentality that we're going to cover price-cost, but it's also a very inflationary environment which is why we're really trying to size that for pricing increases if we need to going forward.

Yeah, the only thing I would add to that, Joe, is that price is never easy to get despite what people may think. But when you have an innovative portfolio of products, it becomes that much easier. As you're selling additional value to your customer, being able to get pricing becomes a little bit easier.

Great, thank you both.

Your next question comes from Scott Davis.

Good morning, guys. I want to talk about indoor air quality if that's okay and the 1-2 point tailwind that you noted in the slide is pretty material. One, I want to just get some color on the sustainability of that. How many years of project backlog do you ultimately have? Where is that 1-2% tailwind tracked—does it stay at 1-2%, does it become 3% next year, and any kind of view around that? And then what does a systems-focused solution really mean for practical purposes for us at least? Does that mean a service contract with monitoring? Maybe just a little color around that too. Thanks.

Sure. Good question. As far as the demand goes, we had said early on that we thought it would be a 1% to 2% tailwind. We're seeing 2% this year. The pipeline is strong. What started out to be strong in really just healthcare and education, we're now seeing in office and other verticals. So that's the good news. On the other thing, I would tell you that if you remember, we had an approach where we were doing indoor air quality audits where we would do a day-one activity, where we do the audits and make the environment as safe as possible today with existing assets, and then we give a roadmap as to how you would do day-two activity. Those day-two activities are really starting to come through for us, especially in education with some stimulus funds flowing there. So that's a good-news story. We see indoor air quality as a mega trend that's not going to go away. It's top of mind. Trane Technologies has always had a robust focus on indoor air quality. It was always big in the healthcare vertical. It's now top of mind in all verticals, and we don't see this stopping. We're seeing people constantly asking about indoor air quality. I would tell you that we're building it into our systems, which is kind of your second question—this is now integrated into a system, and we're seeing nice traction in all verticals.

What I'll add, Scott, is because it is embedded in systems now, it is becoming harder and harder to spike out the impact of indoor air quality separate from a systems order. I think the fact is, it's really becoming just a long-term tailwind for the Company.

We're really seeing a lot of traction, especially with our dry hydrogen peroxide solutions. This is predominantly in the education vertical as we're building this into the systems. The dry hydrogen peroxide solution's unique innovation is that these molecules last longer. So if you think about a school room where you have students that are moving around the different classrooms and desks, these molecules actually settle on the desk, so they clean the air as well as the surface. We're getting a lot of traction around that.

That's very interesting. I'll pass it on to my peers, but thank you and good luck.

Your next question comes from Jeff Sprague of Vertical Research.

Hey. Thank you. Good morning, everyone. I just wanted to follow up on backlog as it relates to price and, Dave, you mentioned opening the order book and how you open up the order book to not get caught here. To what extent do you have the ability or are you in fact going back and repricing some of the backlog? Or given the environment that we're in, perhaps you're changing commercial terms just to protect yourself better. If you take an order today and you deliver it 12 months from now, who knows what we're dealing with on the inflation front. So just any color there on how you're managing that, protecting yourself and possibly changing commercial terms.

Hey, Jeff. This is Chris, I'll start and then Dave can jump in. If I go business by business, when we started the residential, we have the ability to look at our backlog and reprice our backlog as we see higher inflation impacting orders that will shift now a couple of months out where the backlog and residential used to be a couple of weeks, now we see it continue to be a couple of months out. We actually have repriced the backlog already in 2021, and we've got that ability to reprice going forward should we see significantly more inflation. On the Commercial HVAC side, when I think about long lead-time equipment, those contracts generally have price escalation clauses in them that allow us to reset pricing based on an index. So we have some protection there as well. And then on Thermo King, today's remarks earlier—we've been really selective with opening up the order books for 2022. We wanted to get as much insight as we could on the inflationary environment through the third quarter of 2021. We've only had the first quarter of 2022 order book booking. We've now recently opened up the '22 order book for the balance of the year, and we did that intentionally to make sure we had the right ability to reflect that in the backlog. So I think we're in a good position in terms of price and inflation.

What I would add to that is also we have pricing built in and we have mechanisms in place and also our backlog is very firm. We're not seeing cancellations on our backlog and don't anticipate cancellations for backlog in the future.

And then separately just on residential, I don't think you've mentioned residential as something you're positive on in terms of your 2022 outlook. Obviously, we've got this question that everyone is asking about how comps play out and that sort of thing. Dave, what is your high-level view on how the residential market behaves next year? You might have a different view on how you behave inside that, but any perspective would be appreciated. And I'll leave it there. Thank you.

Okay. Thanks, Jeff. We look at our residential business at a very high level as a GDP-plus business. So if you could tell us what GDP is and what consumer confidence is, we could dial in how the residential business is going to perform. We do have detailed models that we go through and they're really just to validate our high-level approach. So GDP is projected to be positive next year, and we do not see the residential business falling off a cliff in 2022. We see it as a GDP-plus business.

Great. Thank you.

Your next question comes from Julian Mitchell of Barclays.

Hi, good morning. Just starting with price-cost to understand the sort of jumping off point into next year. I saw you said that you have $150 million of price in Q3, similar sort of cost step up. Maybe just help us understand on those two numbers what should we expect for Q4, and then what's the total year 2021 for price and cost, please.

Hey Julian, it's Chris. Thanks for the question. We were really pleased with the price realization in the third quarter—4.3% of price realization—which really equals the revenue growth we had in the third quarter as we were very flat on volumes. For the quarter Q3, we saw slightly positive price-cost. When I think back a few years ago when we had our last inflationary environment, we were really trying to catch up on the price-cost equation for about six quarters where the Company was negative. Now, we're able to keep up with that at least through Q3 of this year. That goes back to the business operating system we continue to enhance in the Company. So very positive price-cost in Q3. For Q4, I'm expecting price realization to get a little bit stronger, but I also can see inflation getting stronger in the fourth quarter as well. So we're right now kind of expecting price-cost to be flattish in the fourth quarter. And then we'll see how this plays out for 2022, where we're always targeting 20 to 30 basis points of price over cost for a given year, but I'm expecting that to be flattish in the fourth quarter.

The only thing I would add to that is that the operating system—don't underestimate the amount of work we've put into building our operating system to stay ahead of these inflationary curves. As Chris said, I think the last time we had this type of inflation, it took us several quarters to overcome it. Now we're in a position to offset it. We're very proud that we've been able to do that.

That's helpful. Thank you. And then maybe just following up in terms of firm-wide operating leverage, it looks like in the fourth quarter you are looking for maybe around 20% operating leverage year-on-year. I just wanted to check that's roughly the right ballpark. And do you think that's a good sort of entry point starting out next year given you've still got price-cost margin headwinds, at least in the first quarter or two?

Yeah, Julian. I think you're in the ballpark for Q4. We left the full-year guide intentionally intact given that we can see the push-out of some revenues into the fourth quarter. The figure was $75 million. From our perspective, the backlog and demand are very firm. It really comes down to supply chain, and that's why we have some uncertainty on the full year from an adjusted EPS perspective. Could it be a little better? Could it be a little worse? I think we're right around that $6.05 based on how we see the supply chains today. But it really is going to depend on that. You're in the ballpark for fourth quarter. We'll see how leverage plays out for next year. I think we're certainly expecting an inflationary environment next year with pricing actions. We'll need to continue to manage that. We'll have more insight as we get into January.

Great. Thank you.

Your next question comes from John Walsh with Credit Suisse.

Hi, good morning. Maybe piggybacking off of Jeff's question earlier. I think in your answer it was mostly around the equipment. I wanted to hear a little bit about your ability to pass through inflation on your service contracts because obviously labor availability and wage inflation is something we're all expecting in the next year. Do you have the same ability to pass through those inflationary pressures there?

Good question. Yes, we do have long-term contracts with price escalation provisions. So our estimates are taking those into consideration.

Got you. And then maybe coming at the backlog and orders question a little differently here—20% order growth, it's not like you're comping a down 20, you're comping up plus 7. So how do we think about just the order rate? And if you think you can actually build backlog next year, potentially? Obviously, I understand you're not in the business of guiding orders, but it's definitely a question we're getting from investors here. Appreciate any color. Thank you.

If you look at it, it's really phenomenal what's happening right now. We had 30% order growth in the first quarter, 30% in the second quarter, and here in the third quarter talking about 20%. In some of our businesses, our Commercial HVAC equipment is up 50%. I don't anticipate that bookings will continue at the 30% growth rate, but we're seeing a lot of demand right now for our innovations in the marketplace. Whether it be in the Thermo King business or in the Commercial HVAC business, that's really driving a lot of this demand. We also have tailwinds around sustainability and the decarbonization of the built environment that are gaining momentum. We like what we see going into 2022. We're going to have record backlogs and we'll see what 2022 looks like from an incoming order rate, but right now we really like our position going in.

Great, thank you. I'll pass it along.

Your next question comes from Andy Kaplowitz with Citigroup.

Hey, good morning, guys. EMEA continues to be a significant out-performer versus the other regions. Maybe you can give us a little more color into what's going on there. How big has your heat pump business already become? Are products such as heat pumps and the advanced electrified products accretive to margin and helping? And how sustainable is that 30% incremental you put up this quarter?

Innovation—you kind of hit on it, Andy. That's what's really driving us in EMEA and it's such a great place to be. The advanced product in our Thermo King business is exceeding our expectations. If you look at what we've been able to do with the electrification of heating in the HVAC business, it's in tremendous demand. I don't want to get into specifics as to how big we are or the market size, but it is propelling our growth and we're excited about what the pipeline looks like in the future. Rest assured, the innovations are continuing as we look to expand the operating maps of how our HVAC product works. We're targeting higher temperatures on the heating side and lower temperatures on the cooling side, which will expand our market further. I'll add, Andy, we've set up each of the segments to really have over the long term 25% plus incremental margins, so we think Europe is well situated to deliver that over the long run.

Very helpful, guys. And then maybe you can give us a little more color into what you're seeing in Asia. You mentioned record backlog in the region, I did notice that your transport revenue turned down a bit and the pandemic does remain a challenge in the area. Are you seeing China hold up well, and how are you thinking about that region into 2022?

Asia Pacific is about 10% of Trane Technologies and it's an important region. Let's split it into China and the rest. China GDP has slowed a bit in the third quarter versus some expectations. That said, areas like electronics, pharmaceuticals, data centers, and healthcare are strong and we are strong in those verticals. We're seeing nice growth in China and expect that to continue. Outside of China, it's country-specific and mixed, with some countries still experiencing lockdowns based on the pandemic. So it'll be mixed into the fourth quarter.

I appreciate it, guys.

Your next question comes from Steve Tusa of JPMorgan.

Hi, guys. Good morning. Where are you ending on price and cost for the year now, with this neutral back half—what was the price-cost dynamic in the first half?

First half was positive, but much smaller numbers given how price has ramped up from Q1 to Q3. We've realized a lot more price in Q3. We're expecting Q4 to be flattish price-cost. For the full year, I think we're probably around flattish, maybe slightly positive. Our goal is to keep driving innovation and pricing to reflect what we think inflation will be. We're happy with our year-to-date price realization. We're trying to stay ahead of inflation. So I'm thinking flattish to slightly positive on the full year.

Steve, we've already had three price increases in many of our businesses. If we still see inflation being persistent, another price increase will be part of our business operating system where we would execute on that.

I guess I'm just looking for the 150 and the 150—what was that in the first half?

I don't know if we've explicitly given that number, but the price in the first half was less than the $150 million realized in Q3.

Okay, thanks. And then on commercial equipment, you said orders up 50%. Can you split those out between applied and the light commercial unitary business?

To be fair, Steve, it was more than 50%, and both our unitary and applied are both over 50%. The unitaries and applied categories were very strong. We've seen unbelievable growth in our Commercial HVAC equipment business. To be fair to our suppliers, we're putting that demand right on them, which is causing them to have to ramp and manage spikes.

That's very positive. And then on sell-through for residential, what do you think movement was for your residential business—stuff that you sell through to the customer given order patterns?

On the IWG side, which is about 50% of our business, sell-through was mid-single-digits and sell-in was flat. Inventories adjusted as you'd expect in a shoulder season. Inventory levels are about what we'd expect, maybe a bit lower than we'd like this time of year, but nothing to call out.

Great color, thanks a lot.

Steve, just to follow up on that, for the enterprise price through Q1 to Q3 is around 2.2%, so less than the $150 million we realized in Q3. That price has really ramped up and we're expecting it to grow a bit in the fourth quarter. At the same time, we're seeing inflation grow into the fourth quarter, so we're trying to stay ahead of it.

And cost? End cost the $150 million cost?

In the first half it was positive but less than the $150 million; slightly positive in Q3, and we're expecting pressure in Q4 as well.

Your next question comes from Nigel Coe of Wolfe Research.

Sorry, comes on me and I had a pretty funny joke which I won't repeat. I want to go back to that first half price-cost question, but let's not. I do want to go back to the backlog because obviously super hot, plus 70% in Americas. I'm just wondering, how does the aging of that backlog look? Do you expect the majority of that to convert in 2022 outside of supply chain pressures? And I guess my real question is, we really haven't grown higher than 8-9% in climates over time organically—could 2022 be above that bar if that backlog converts?

As we said earlier, you're going to need to look at the backlog by business. For Commercial HVAC with applied orders, that backlog can have a six- to nine-month burn rate before actual shipment. In Thermo King, it's been a little different this year—many customers placed orders in the first quarter and lay them in through the rest of the year. The burn rate in Thermo King normally would be two to three months, but that's been extended because of constraints associated with the actual building of a trailer. In the residential space, our backlog turns on a regular basis. Overall, we have a very large backlog and order demand is among the best I've seen in my career. Our backlog is not stale; it continues to churn and we're shipping out while getting order rates we haven't seen in a long time that continue to build backlog.

Okay. On price-cost, you called out APAC as challenging near-term—any concerns as we go into 2022 around that region?

Yes, price-cost in APAC is a little challenging in the near term. We're on track for strong full-year margin expansion in the region. If you go back two years, we're up over 400 basis points in margin expansion in the region, and if you go back to when we invested in our direct sales force we're up over 500 basis points. The region has had great growth, and we've been selective around orders. We're evaluating pricing and will make price increases where necessary. I'd expect the region to be price-cost positive going into 2022, but near-term there are some challenges. Q3 margin contraction in Asia related to these dynamics was on relatively small revenue numbers.

Okay, thanks. That's great color.

Your next question comes from Josh Pokrzywinski of Morgan Stanley.

David, on this commercial equipment growth—historically it's a replacement business with a massive installed base. Is there sufficient labor, whether in your own house or in the independent world, to install this stuff in a reasonable timeframe, or is that going to be a gating factor on converting backlog as well?

In our own operations, we saw some labor constraints early in Q3 but that subsided a bit through the quarter. It's a matter of training and hiring. On job sites, we've seen some jobs push out because of job-site labor constraints. It's not super alarming but it is present and not just in North America—it's global.

And the supply chain—on the revenue you're starting to make up in the fourth quarter, have you seen actual improvement over the last 30 days or is it just stability?

Yes. We had some acute supplier problems in our Thermo King business and we've been able to overcome those. We have line of sight to what we're guiding to right now. That said, supply chain remains volatile—whack-a-mole. We fix one problem and another pops up. It comes down to staying on top of it, working with customers and suppliers, and communication. Our operating system allows us to work hand-in-hand with suppliers to meet the strong demand we're seeing.

Thanks. Good luck working those moles.

Your next question comes from Andrew Obin of Bank of America.

Good morning. A longer-term question—about education stimulus funds: my understanding is there's a timeline on spending that money, I think over three years. Can you tell us what you have seen so far and how you expect spending to play out over this period of time in education specifically?

Yes. We're seeing funds flow, which is good. The current spending timeline goes to 2024 for some programs. That may get extended, but generally you do the work in off-peak seasons when students aren't there, so there's seasonality to execution. Funds are flowing from states down to local levels—elementary and secondary school emergency relief (ESSER) funds—and we're seeing good traction. We've done phase-one indoor air quality audits, provided roadmaps, and customers are executing upgrades in their facilities.

Got you. And a longer-term question on residential—after a strong 2021, how should we think about 2022 and beyond? Any pull forward or is it just positive in '22, '23 and continuing until consumer gets tired? Just the broader shape of the residential cycles as you think about it.

Hopefully the consumer doesn't get tired. Historically, cycles have played out differently at times, but we use GDP-plus models with replacement cycle data to forecast. At the end of the day, consumer confidence drives the market. We're happy with our 2021 performance and GDP is expected to be positive in 2022.

Great answer. Thanks a lot.

Your next question comes from Deane Dray of RBC Capital Markets.

Thank you. Good morning, everyone. A question about your CapEx plans: we're hearing from some companies that projects are being delayed due to supply chain and labor constraints. As a customer, are you seeing any of that, and how is that factored into CapEx planning for 2021 and 2022?

We have several upgrades underway as we continue to upgrade our lines. We've seen some push-out but nothing we can't manage.

I'd add that we're still tracking roughly 1% to 2% capital spend as a percent of revenue, probably closer to 2% this year. With enough advance notice and ordering within lead times, we've been able to mitigate some supply chain pressure on CapEx projects.

Got it. And a quick follow-up on the whack-a-mole phenomenon—are you doing much in the way of partial assemblies at your manufacturing plants while waiting for components? That would imply work-in-progress inventory and then when the component arrives you complete and ship, which could affect margins when recognized. Are you doing partial assemblies and how does that factor into your planning?

Yes, partial assemblies are used in operations when appropriate. In some cases you can do partial assemblies, in others you cannot.

If we have a partial assembly, we cannot recognize revenue until it's complete. We're capturing all the costs associated with it; it stays in inventory until we ultimately recognize the revenue. The following quarter, we add the components needed to make it complete and that's when the full cost gets expensed.

Okay, that's really helpful. Thank you.

Your final question comes from Stephen Volkmann of Jefferies.

Hi. Thanks for squeezing me in. Most of my questions have been answered, but maybe a big-picture question for you, Dave. The old model in this industry kept inventories as lean as possible and worked well in a slower-growth environment. Now with potentially stronger growth, do you need more capacity or does it make sense to layer in more inventory structurally to deal with stronger growth?

Excellent question. We pride ourselves on being lean, which is part of why we saw the supply chain choppiness early. We do have capacity, but inventory investment is something we're evaluating. Inventory shouldn't be thought of only as finished goods—especially in Commercial—it is often raw material that can be converted more easily into work-in-progress and finished goods. We're looking at those trade-offs.

Great. And anything else you've thought about over the last few months since taking on the CEO role that might differentiate you a bit from your predecessor?

It's been about 150 days and it feels like forever in a good way. This is such a great company and industry. I'm proud to be CEO of Trane Technologies. I'm speaking next week at COP26 about how we can accelerate decarbonization—many decent technologies already exist today. We also just completed our employee engagement survey and achieved top-decile performance for engagement. Our culture is a differentiator; it's our people who drive innovation and bring our purpose to life. Trane Technologies is in a great place today and we're headed for an even better future. Thanks for the question.

Great. I appreciate it. All the best.

This ends the question-and-answer session for today's call. I will now turn the call back over to Zac Nagle for any additional or closing remarks.

Thanks, Paula. I'd like to thank everyone for joining today's call. As always, we'll be available in the coming days and weeks to answer any questions that you may have. Hopefully we will see you in person on the road in the not-too-distant future. Have a great day. Thanks.

Ladies and gentlemen, thank you for your participation in today's call. This does conclude today's event. You may now disconnect.