Trane Technologies: Hot and Cold - [Business Breakdowns, EP.144]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Matt Russell, and today we venture into the world of HVAC to break down train technologies. Now, it's not often that I come across an industrial company with a $50 billion market cap that I just hadn't heard of. So when our guest today, Brett Larson, an investor at NZS Capital, suggested train, it was as easy of a yes as I will give. Brett and I cover the long corporate history of train. And like many industrials, it has lived a life paired under the umbrella of a conglomerate, along with a life of independence, including this most recent chapter.

1:28And we talk about the dynamics that separate residential HVAC from commercial HVAC, and how train has helped create this unique consolidated industry. You may never look at your thermostat the same after this episode. So please enjoy this breakdown of train technologies. All right, Brett, I'm excited to have you on breakdowns. And I'm excited to go back into the world of industrials broadly. I don't think that train is a household name for consumers and even for investors potentially, but sporting a $50 billion market cap, it is a large name. So maybe we could just start at a high level with an introduction to what exactly Trane does.

2:11Absolutely. And thanks for having me today, Matt. I'm excited to be here. High level, you could think of Trane as participating in commercial HVAC globally, residential HVAC in North America, and then a transport refrigeration. So you might see a Trane AC unit sitting outside of your house or one of their sub -brands, American Standard or Ameristar, Oxbox, or Runtru. So that's about 20 % of the business and it's an 85 % to 90 % replacement business. The bigger chunk of the business is actually commercial HVAC at about 60%. And most have been in a commercial building, I would assume, that's had train equipment for climate control.

2:47So think of large water cooled chillers in the basement or air cooled chillers on the roof or smaller light commercial units. Or maybe you've noticed a van rolling around with the service technician with train on the side. So it's again, 60%, about half of that is aftermarket service. And again, it's about 70 % replacement on the equipment side. And then the last one, Thermo King or Transport Refrigeration, they sell the refrigeration units that keep the trailers cold. Once you learn about the business, you'll be cursed with having to look at the brand every time you drive by a duration trailer.

3:18And that's 20 % of the business as well. Super helpful. And there's a unique backstory here in terms of why it might not be as popular or well -known of a name. And that's because of a recent spin -out or spin -off. So maybe you could talk a little bit about the corporate history and how it came to be Trane. Trane itself traces all the way back to the early 1900s, which is pretty remarkable. But fast forward a century, they were a part of American Standard and were spun out and then reacquired shortly thereafter in 2008 by Ingersoll Rand. And they spent the next decade plus within Ingersoll Rand really getting the current operating system in place, which we can talk about later.

3:56But then in March 2020, Ingersoll Rand and Gardner Denver executed a reverse Morris Trust transaction where the industrial businesses within Ingersoll Rand merged with Gardner Denver and those businesses took the Ingersoll Rand name and that left the climate businesses. So Prane and Thermoking as a standalone business and that was rebranded as Trane Technologies. So that's how we ended up where we are today. It's always interesting to see, especially in industrials, you have independents become conglomerates, then become independents again. And it seems to be the cyclical bundling, unbundling, but just in the form of businesses and companies.

4:31But interesting here, because I think it's something that you're seeing more and more where these specific end markets that have maybe fragmentation or opportunities to capture market share and really focus in on one core thing. In this case, it feels like HVAC. And excuse me if throughout the conversation, I say HVAC. But let's dive into that market a little bit. You talked a little bit about the differences between residential and commercial. And maybe we split it up and start on the commercial side. So talk a little bit about how big of a market or how you would separate that market on commercial HVAC and specifically for how train fits into that.

5:08Maybe setting aside the half of commercial HVAC for train, that's the aftermarket and services. And just looking at the equipment side, it's about 70 % replacement. And the way to think about it is really in two categories. So there's what's referred to as light commercial, which is think of it as that the unit that you might see sitting on top of a Chipotle. It's a package system with all the components in the same unit. And it's actually, I think of it more similar to Resi in terms of the type of unit. And then the other half is large commercial or what's usually referred to as applied HVAC.

5:39And you can think of this as a collection of components that make up a much more heavily engineered system for a larger building. Think of a hospital, data center, an office, or even industrial processes and the like that's applied. And within that, the workhorse of the refrigeration cycle is the chiller. So that's the most energy intensive piece of equipment in any building is the chiller. But also you're going to have the air handling units pumping the air through the different boards or pump cooling tower sensors. So it's a much more complicated system that's very heavily engineered. And within this segment, within commercial, what is the go -to -market sales strategy like this?

6:18Are they doing a lot of it direct? Is there a major process in terms of the build out of these buildings or with replacement where there's a lot of bidding going on? Can you just walk through what that's like in terms of the actual sale itself? It's also very different, again, commercial versus applied or large commercial. And I should say train is 100 % direct on their commercial businesses. So maybe 40 % of light commercial is going to be emergency replacement. So that Chipotle is going to call you and say, our unit's broken and you're competing on obviously performance and price, but almost more importantly, how quickly can you get us this unit installed?

6:51And then there's another 40 % that's going to be more planned replacement. And then 20 % is new construction. And those categories are going to be more bid and performance and price are the key criteria. On the other end of the spectrum, applied or large commercial, it's a lot more complexity. it ends up being a big project. It's a big outlay as well. There's a lot more of a process here that can take up to a year. Generally, what this looks like is the building owner decides that they're going to replace their system. And that could be for a variety of reasons. Maybe they want to reduce their scope to emissions as part of their commitments, or maybe they just decided it was time to because the system was so old, or maybe a train or somebody was in there pitching them on the value proposition and that got them over the ledge.

7:35But for whatever reason, they decide to replace it, they're usually going to loop in a mechanical engineer, an HVAC engineer to consult and really help set the basis of design. So think of that as the specs and performance requirements that they're then going to put into an RFP that gets bid on, they'll select, and then there'll be a project to replace the units. And when you think of what differentiates within that, how do you win that business? There's some sellable differences at the equipment level, maybe wider breadth of refrigerants, for example, but most have the range of equipment. When you think of for a chiller that's going to be operating for 25 years, maybe 10 % of that lifetime cost is going to be the upfront CapEx for the chiller, whereas the rest is going to be the energy intensity.

8:18So you're more competing on system level efficiency, and then really trying throughout the whole process to influence the basis of design that's going to go into the RFP to situate yourself really well to win that business. So this is where trains direct channel is a really important differentiator for them. I should say it's known to be a very highly trained and technical channel. They're usually about 100 % commission -based, each of the salespeople that they have, and they fight really hard to keep them. So they have top decile type of retention rates. And why it's so important is they're managing relationships with each of the constituents in this complex projects.

8:55HVAC engineers, the building owner, the boiler Bob who's fixing the units and has a say, the general contractor. They're frequently being a really technical resource for them and trying to, again, influence the basis of design in their favor. And then another interesting thing is TrainTrace is probably the most commonly used software for load and energy simulation used by these HVAC engineers. And it comes pre -populated with Train's product catalog. And you can go in there and you can manually enter the specs of different OEMs equipment and the like. But that's obviously more cumbersome than just using what comes loaded.

9:32So maybe that has some impact. And then maybe I can just hit market share as well. So when you think of light commercial in North America, it's carrier and trainer about half of the market. And then Linux, Aon, JCI, and then Daikin make up the rest. And then an applied, think of more chillers. So train, JCI, carrier is the big three. And then Daikin also has some participation as well. And then aftermarket services is super fragmented. And that's been a good growth opportunity for the OEMs we can talk about later. That data point on only 10 % of the costs being the equipment upfront is particularly interesting.

10:08It's something I hadn't considered. But when making the buying decision, obviously, that makes sense. Is that other 90 % a split of the actual energy cost itself and the maintenance cost or is it just the energy cost being that other 90 %? My understanding is that the energy is probably going to be 70 % to 80 % of the lifetime cost, but then there's going to be a 10 % maintenance or something around there as well. So 10, 10, 80 is how I generally think about it. It's a really unique dynamic when thinking about how to price when the buyer is making a decision based on this number that is taking into account 100 % of the costs and the seller is basically taking 20 % of the revenue associated with those costs.

10:48It's just something interesting. I hadn't thought too much about before. It's interesting. Whenever you ask them about price, it's a difficult question to answer and apply because it's so much at a system level and then value -based pricing as opposed to this unit costs this much. Now it costs this much. And the trace software that you referenced, that's software that could be used regardless of whether or not they are using a train piece of equipment? Think of it as when they loop in that HVAC engineer to help design the system that they're going to go bid or put out RFP for. That's one of the key pieces of software they'd use to essentially model the energy intensity of the system.

11:27And that's train owned software. There are others, but it's the standard. So you can think if you're designing a system and you're dropping in different types of chillers to see how it impacts energy intensity and ultimately what you settle on that goes to RFP, the specs that were used in that were the specific train equipment. You could see how that could have an impact. Is that software a material driver of revenue or does it show up much as a line item or is it an afterthought? It is a paid for software, but it's a rounding error. It's interesting. It's probably a rounding error from a revenue standpoint, but maybe as more of a hidden benefit as you were referencing there.

12:03Let's transition a bit to the residential side of things, which I assume is a more simple process, as you mentioned, more aligned with light commercial. But talk a little bit about what that sales process is like and whether they're doing that direct, whether they use distributors, however it works. When we think of residential, again, train only participates in North America. And you can think of these as air conditioning units, furnaces, heat pumps, that's the equipment. It's a two -step distribution model in Resi. So the OEM sells to a distributor who sells to the dealer contractor that's in your home and installing it.

12:37And some of the OEMs own a majority of their distribution. Linux, for example, I think is 80 % company -owned. Others are completely outsourced, like Carrier. They have their relationship with Wattsco. And then Train is about 50 -50, company -owned versus independent distribution. It's largely a replacement market. And the sales process, how it works is my AC or furnace isn't working. I call a contractor or hopefully a few, and they'll come and assess it and what it'll cost to fix the unit. And then they'll also provide quotes for new. And hopefully they'll capture in that discussion, the context of say rebates that are available for higher efficiency equipment, future regulations that might make for, if I kick the can replacing this unit today, a new unit's gonna cost 15 % more next year or something like that based on regulation.

13:28Ultimately, then the customer chooses what they'd like to do. And the contractor either has that inventory on hand will go to the distributor and get it and then install it. So it's definitely a more simple process than the applied piece in commercial HVAC. And maybe some other detail here. So it's about half of the volumes are going to be the minimum efficiency level. So you're more competing on portfolio coverage and then operations. On the portfolio coverage side, each of the OEMs runs a multi -brand strategy. So premium and value brands. Train's a good example here. When they acquired by Ingersoll Rand, they used to just participate in the premium side of Resi HVAC.

14:08So think of it as $6 billion of the $12 billion market they participated in. But then they brought to market Ameristar, which was a value brand for the premium channel. So if you were a train dealer sitting at the table with a homeowner and you used to only have the premium train product, but this homeowner just wanted the cheapest piece of equipment in their home, they would lose that 100 % of the time. But now they have the train equipment, but they can also say, and we have this Ameristar brand as well. It hits at a different price point, and it allows them to win some share that way. And then over the last few years, Trains rolled out a few other value brands for the value channel, which are Run True and Oxbox.

14:46That expanded coverage has helped Trains gain some share in Resi over the past decade, not just participating in the premium side anymore. And then the other one, operational challenges. The contractors and distributors are reluctant to change their OEM relationship just because of the friction it causes in their business, unless they're really given a reason. And in the past, there has been someone stumbles through a regulatory transition or someone has operational challenges, and that can lead to share shifts. The most recent one was Linux. Unfortunately, in 2018, had a tornado go through their manufacturing facility, and it forced them to have to prioritize dealers in terms of who gets units and what types of units.

15:29You could see how that could create an opportunity for the other OEMs. And the other OEMs took advantage of that, took some share. Then once it settles again, it's really hard to get that share back. So that's the nature of the resi industry. Sticky once it's in there with certain distributors. What is the rough market share? Is there a way to give rough estimates around that for training residential? The top four are about 85 % to 90%. And you can think of it as Carrier and then Goodman, which is owned by Daikin. So those two are the two biggest, and they're probably somewhere between 20 % and 25 % of the market each.

16:05So collectively, call it 50%. And then Train and Linux are high teens market share. And then in the tail, that leads you with Ream and then York, which is owned by Johnson Controls. So that's become relatively consolidated over the years. everybody acts rationally, which you like to see. And then for anybody listening, if you're like, hey, none of those brands match the brand in my unit at home. Again, they all have multiple brands for the different price points. It's like the car dealerships. You can get the premium, you can get the entry level and work your way up. Makes a lot of sense. Forgive us for going back and forth between the two, but I think it's a good comparison.

16:43When you think about the commercial side and being able to actually offer a differentiated product, What does that look like? I can imagine just thinking about my own buying decision on the residential side. They might be able to tell me there's more bells and whistles, and I might have some idea of it. But I imagine the differences are significantly less, or there's not as much variance as there would be on the commercial side, where it seems just from the size of the building and different things you have to think about, it's substantially different. So what does that look like? And how do you think about their product versus what the competitors, those that have legitimate market share in the industry?

17:16So again, in commercial HVAC, you're competing very much at the entire system level of a building and the energy intensity. And I think there are some differences at the product level, even to the extent that Trane, I think, has the widest breadth of different refrigerants that they offer a customer that have different GWPs, global warming potential of the refrigerants, for example. There are differences like that, but it's really more about at the system level. I would say Train is really known for having a really good direct sales force. It's very highly trained and very sophisticated and technical.

17:51And I think that is probably more of a differentiator in any specific bid than maybe at the equipment level. And thinking about that visibility in terms of what's going on, if I think about it like a dashboard and being able to see how the system is running in various places, is there a software component to what they're selling? Is it pure equipment sales? What does that look like? So HVACs and all the sensors and data that they now get off of it is going to plug up into a building management system. So there is a software component in order to gain visibility. I also think that this digital connectivity, so over the past 10 years, we've really gone to where now every piece of equipment rolling off the line is digitally connected.

18:33And what it really offers is the ability to remotely diagnose and watch equipment in the field to be able to better proactively service that equipment. But it also gives the OEMs, train plus their competitors, a head start with that visibility to capture the service and aftermarket from the independent service providers, which has been a great tailwind for those businesses. What does that, and you could split it between commercial and resi if it's drastically different on both sides, but what does that revenue mix look like in terms of new equipment versus replacement? In residential, for train, it's primarily an equipment business, very replacement driven again.

19:14In commercial HVAC, so the 60 % of train that is commercial HVAC, half of that or a little more is aftermarket and service. And that's increased. So it's about 32 % of the total company mix in 2022. And that's up about 1000 basis points since the global financial crisis. And is the expectation that that will continue to grow for the business? Absolutely. Like I mentioned, it's leveraging digital and the direct channel to capture the service relative to the independent service providers. And it's allowed the services piece of the business to compound at a high single digit CAGR for a long period of time.

19:50Honestly, it's still early innings in terms of the market share opportunity there. So that should be the expectation. What's the average life cycle for a commercial unit we'll start with? So a chiller, for example, can last anywhere from 20, 25 years. And what is a chiller? Just to ask the dumb question. A chiller is going to be the large piece of equipment that's circulating refrigerant. It's either the refrigerant's either interacting with water. In the case of a water -cooled chiller, that's then going through the building and going through the evaporating coils and cooling the air that's going to go through your building.

20:25Or it's interacting with air in an air -cooled chiller. There used to be this, I don't know if it was an urban legend or not, but at the Goldman office, there was this story that they overnight would have this humongous ice cube made when the energy costs were significantly lower. And that huge ice cube would eventually melt during the day. And that would be used as part of the AC system. Is that roughly feasible as something that would happen in a chiller system? Or is that just pure urban legend? That is different from a chiller. But it's funny that you say that because Trane does own that business, which is a form of energy storage in a sense.

21:03But yeah, the chiller is the big piece of equipment that's essentially the commercial version of that ducted split system you have at your house. Much more complex, but that's the way to think about it. It's the workhorse of the HVAC. So those can last 20 to 30 years. And then I'm sure there's maintenance involved with those systems. Duck work can obviously always have issues. But you're basically getting some type of ongoing aftermarket maintenance type revenue associated with whatever unit you install. And then potentially over a 20 to 30 year period, you might see the replacement as well. Exactly.

21:38And just in terms of the growth drivers, the chillers in broadly HVAC equipment has become so much more energy efficient that the value proposition to replace an old chiller is actually very compelling. where you can have an economic payback that makes a lot of sense, but also make a meaningful dent in your company's carbon emission goals. Maybe we can talk about the demand side of things for commercial a bit as well. I would think about just new construction, obviously replacement as well. That's interesting to hear that the replacement angle is slightly adjusted when it comes to the payback period looking differently when a system is more energy efficient.

22:18I'm sure there's some ESG factors involved here as well. But what are the biggest drivers to you when you think about demand side from the commercial side of the equation? Definitely. I'll actually just put, I think, at a high level, we can talk about resi and commercial HVAC together here. So there's three buckets of tailwinds to industry growth that I think about. So the first is that heating and cooling buildings makes up 15 % of global greenhouse gas emissions. And addressing that's going to be a key lever to reducing our carbon footprint in society. The second is leveraging digital and services, which we touched on.

22:53And then the third is this new one called indoor air quality post -pandemic. I'll expand, but on the first one, decarbonization. So Trane actually has their internal target to reduce the carbon emissions of their customers' footprint by a gigaton by 2030, which is a billion metric tons or 2 % of world emissions. There's very few companies in the world that can have that type of impact, and it speaks to an important growth driver. So in commercial HVAC, for example, it's a really high non -zero sum value proposition. They can sit down with the building owner and say, you have a 20 -year -old chiller.

23:27We can replace that, greatly reduce the carbon footprint of your building, but with an economic payback of usually three to five years for a system that's going to last 25 years. So that's a 25 to 50 % IRR. It's the stuff that I, as an investor, would love our CFOs to be investing in. And that value proposition is really, I believe it's pretty new and it's definitely accelerated over the last maybe seven to 10 years. So that's been a driver of growth. And then also under decarbonization is that HVAC is an industry that very much benefits from regulation, both in the form of sticks and carats. So on the stick side, they're always increasing standards for these systems to make them more energy efficient, which is driving a mixed benefit.

24:11Think of it as price, but it's more mixed. And then the next big one is in 2025, there's a refrigerant transition in North America residential, where we're moving to a mildly flammable refrigerant, which means there's going to be new systems and safety incorporated in these systems, making more expensive. And it's probably going to be a 10 % plus increase to the cost of a unit. And that's a mixed benefit for the industry. And that's not new. That's been helpful over the past decade. But then also in terms of carrots, so HVAC, there's incentives for heat pumps in the IRA. They expanded the incentives for investments that reduce the energy intensity of buildings within IRA.

24:48ESSER funding for K -12, HVAC has been a huge beneficiary of that. That's the decarbonization piece, which I think is very compelling. Digital services. So again, it's very fragmented in services with the independent service providers. As we've connected all these units and have that visibility, it's a great outcome for the customer that they like because they can be more proactive and keep their system closer to spec. It gives the OEMs visibility to capture that share and be early. And then indoor air quality is something I know I'd never really thought about pre -pandemic, but coming out of the pandemic, definitely front and center for any building owner is, do I have the right amount of outdoor air coming in every hour?