Trane: Strong lag supporting growth for both FY24 and FY25

Since I presented my “Strong Buy” thesis on Trane Technologies (NYSE:TT) in March 2024, the stock price rose more than 14%, significantly outperforming the S&P 500 (SPX). I highlighted Trane’s strong ad HVAC growth driven by energy efficiency. The company launched its Q2 result on July 31 with a 19% increase in orders and a 13% increase in revenue. As I believe the economy is more likely to enter a lower interest rate cycle in FY25, I argue that Trane Technologies’ new residential business will benefit from a lower interest rate environment. I reiterate a “Strong Buy” rating with a one-year price target of $380 per share.

Strong lag supporting near-term growth

Trane Technologies reached a record $7.5 billion, growing 19% organically during the quarter, as shown in the chart below. The biggest takeaway I’ve had this quarter is their strong will in waiting supports growth through both FY24 and FY25.

The strong increase in arrears was driven by the following factors:

• Over the past three years, Trane Technologies has invested in their commercial HVAC business, focusing on some high-growth verticals such as data centers and semiconductor fabs. During the earnings call, management expressed strong confidence in the growth momentum from these verticals. The company pursued 14 different verticals in the commercial HVAC market, and Trane Technologies saw growth in all of them.
• Trane Technologies promoted its applied technology to commercial customers. They reveal that the applied HVAC business has grown 90% over a three-year period, and management estimates that applied HVAC can generate 8-10 times more lifetime equipment and service revenue. As such, rapid growth in applied HVAC can increase both equipment and aftermarket revenues.
• Trane Technologies has been actively launching new products to shorten the HVAC replacement cycle. For example, on March 26, 2024, the company announced a completely new residential portfolio of HVAC and heat pumps, offering better energy efficiency. These new products are expected to drive replacement demand and have a higher gross margin.

Residential business

As I mentioned in my previous article, Trane Technologies’ new residential business in the US market has faced growth challenges due to high interest rates and weak housing starts.

Despite these difficulties, Trane Technologies delivered a stronger-than-expected result in the US residential market and expects revenue to grow in the mid-single digits for the full year. While management remains cautiously optimistic about the new U.S. residential market, Trane Technologies benefited from moderating duct inventories and a strong start to the cooling seasons, as noted during the earnings call.

I think it is more likely that the Fed will cut interest rates in September, bringing the economy into a rate-cutting cycle in 2025. The housing market could gradually recover when interest rates fall, which will boost demand for Residential HVAC and Heat. pump market. In this context, I see Trane Technologies as a potential beneficiary of the interest rate cut.

Outlook and assessment

Due to strong revenue growth and backlog, the company raised both top line and EPS guidance for FY24 as detailed in the slide below.

My considerations for their short-term growth can be summarized as follows:

• Trane Technologies has 2.8 billion in backlog booked for 2025 and I estimate that new bookings will represent more than 13% of total revenue in FY25. It is worth noting that the backlog contains only equipment and does not include any services. Historically, Trane Technologies has maintained a high rate of service attachment, particularly among commercial customers.
• Trane Technologies posted a 2% price increase during the quarter, which is in line with historical averages. Trane Technologies has significant pricing power for both residential and commercial customers due to their leading technology, better energy efficiency, brand strength, as well as extensive service networks. We anticipate that the company will continue to achieve 2%-3% price growth in the near future.
• Grand View Research predicts that the US HVAC market will grow at a CAGR of 7.4% from 2024 to 2030. I am confident that Trane Technologies can outperform the global market growth driven by applied technology, pricing power and strong capabilities of services.
• I assume Trane Technologies will allocate 4% of total revenue to acquisitions, contributing 2% to overall growth.

Taking all these considerations into account, I estimate Trane Technologies’ revenue to grow 12% annually. I model an annual margin expansion of 40 bps, driven by:

• 20bps gross margin improvement due to price increases, service business growth and applied HVAC penetration growth.
• Operating leverage of 10 bp from general and administrative costs.
• 10 bp from cost optimization initiatives, including back-office consolidation and supply chain optimizations.

DCF can be summarized as follows:

I calculate free cash flow from equity (FCFE) as follows:

The cost of equity capital is estimated at 12% assuming: risk-free rate 3.7%; beta 1.19; equity risk premium 7%. Discounting all FCFE at 12%, the one-year price target is calculated to be $380 per share, according to my DCF model.

Key risks

Trane Technologies has some HVAC business in China with exposure to the local real estate market. They revealed that China accounts for about 5% of total revenue, and the growth rate has been quite bumpy in the past. Management expressed a very cautious outlook on China’s real estate market, noting that they do not believe the bottom line has yet been reached. As such, they do not anticipate any market recovery in the second half of the year.

In addition, Trane Technologies’ transportation revenue was down by high-teens during the quarter due to a difficult comparable last year. Transportation business has been very volatile in the past because it is driven by capital spending cycles. Investors should be prepared to earn volatility in this segment going forward.

Closing thoughts

Trane Technologies’ strong backlog growth provides a solid foundation for their revenue growth in FY24 and FY25, and they agree with the company’s pricing power, applied technology, and strong service/aftermarket business. I reiterate a “Strong Buy” rating with a one-year price target of $380 per share.