Trane Technologies PLC

NYSE:TT

Earnings Call Analysis

Company Forecasts Strong 2024 Growth

The company is well-positioned for healthy growth in 2024, with strong demand for its sustainability-focused solutions and robust bookings expected to continue. Despite anticipating a normalization in the residential business, growth in commercial HVAC is compensating for this decline. Third quarter performance outpaced expectations, leading to raised revenue and EPS guidance for 2023, with organic growth now forecasted to be between 8% and 9%, and adjusted EPS approximately $9. Strong execution and a near-record backlog support these projections, while the company anticipates powerful free cash flow of around $2 billion.

Anticipating Healthy Growth and Focused Innovation in 2024

Looking ahead to 2024, the company reveals optimism rooted in its current performance and strategic positioning. They cite exceptional execution and a robust backlog which grants visibility into healthy growth for the next year. Sustainability remains a core focus with strong demand expected to continue, despite a potential slowdown in order growth due to the law of large numbers. The political climate, especially policy and regulatory changes, plays to the company's strengths as a climate innovator, indicating a stable environment for future success.

Outperformance in Specific Business Segments

Americas commercial HVAC showcases strength, with the company developing innovative solutions across various verticals such as data centers, education, and high-tech industries, all contributing to significant growth. The applied business stands out with its longer cycle, enhanced margins from service opportunities, and strong customer relationships, which drive sustainable long-term growth. The residential business is on track to stabilize, while commercial HVAC robustly compensates for any residential declines. The transportation refrigeration segment matches expectations with a 40% increase over two years, indicating a steady performance in that area.

Steady Financial Expectations and M&A Contributions

Financially, the company is set to raise the bar higher for 2023, with organic revenue growth projected between 8% and 9%, marking an increase from the earlier guidance. Adjusted EPS is lifted to approximately $9 as Q3 outperformed expectations, with strong leverage into the fourth quarter. Free cash flow is equally impressive, with around $2 billion forecasted for the year, aligning with the goal of top-tier performance in financial metrics. The company's merger and acquisition strategy is deliberate, contributing about 3% in Q3 and expected to contribute around 2% in Q4, reflecting a well-thought-out plan for growth and innovation.

Operational Efficiency and a Balanced Capital Allocation

Operational continuously improves as supply chain issues wane and productivity improves, thus supporting the company's organic leverage target for 2023. There's a clear commitment to a balanced capital allocation strategy ensuring excess cash is optimally deployed for maximum shareholder return. This includes business reinvestment, maintaining a strong balance sheet for market adaptability, and strategic acquisitions or share repurchases when valuations fall below intrinsic value. Significantly, the company plans to return value through dividends, mergers and acquisitions, and share repurchases totaling about $2.5 billion in cash by the end of 2023.

Resilience and Forecasting in Uncertain Markets

The company maintains an unwavering stance in their forecasting, with no changes in market forecasts for transport refrigeration in North America and EMEA, intending to surpass market performance. They also highlight potential volatility in projections by ACT for 2024, and hint at internal assessments to validate these assumptions. They emphasize resilience and the ability to manage any business headwinds that may affect gross margins.

Preparation for Long-term Prospects

The company is making strides toward aligning itself with long-term growth trends, particularly in their commercial HVAC business which constitutes a majority of their revenue. Innovation and policies favor the company, and they plan to move into 2024 with a solidified stance in residential business, well ahead of inflationary pressures and supply chain challenges. Investments in productivity, such as factory automation, are set to yield additional gains. They remain cautiously optimistic about transport refrigeration projections, committing to outperforming the market and maintaining fiscal health.

Earnings Call Transcript 2023-Q3

[Operator]

Good morning, and welcome to the Trane Technologies Q3 2023 Earnings Conference Call. My name is Cheryl, 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] I will now turn the call over to Zac Nagle, Vice President of Investor Relations.

[Zac Nagle, executive]

Thanks, operator. Good morning, and thank you for joining us for Trane Technologies' Third Quarter 2023 Earnings Conference Call. This call is being webcast on our website at tranetechnologies.com where you'll find the accompanying presentation. We are also recording and archiving this call on our website.

Please go to Slide 2. 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 Dave Regnery, Chair and CEO; and Chris Kuehn, Executive Vice President and CFO. With that, I'll turn the call over to Dave. Dave?

[David Regnery, executive]

Thanks, Zac and everyone, for joining us on today's call. I'd like to begin with a few comments on our purpose: to boldly challenge what's possible for a sustainable world. Our purpose is at the heart of our strategy, which is aligned to powerful mega trends like energy efficiency, decarbonization and digital transformation. Coming off the hottest summer on record, we see policies aimed at decarbonizing the built environment continuing to expand. We see growing sustainability commitments for our customers, our suppliers and for our investors. We see corporations not only setting goals but taking action.

We are their partner of choice. And we have the technology to help bend the curve on climate change, and that's exactly what we're doing. We are scaling today's technology and relentlessly innovating for tomorrow to meet our customers' needs to dramatically reduce emissions. This enables us to consistently outgrow our end markets and deliver differentiated financial results. The end result is long-term value creation for our customers, our shareholders, our employees and for the planet.

Moving to Slide #4. Our global team performed extremely well in the third quarter, setting us up for a strong 2023 and positioning us well for 2024. We delivered strong organic growth of 9% and leverage throughout the P&L, resulting in adjusted EPS growth of 23% and powerful free cash flow. We continue to see very strong customer demand for our products and services, with the enterprise bookings at an all-time high of nearly $5 billion in the quarter. Bookings were exceptionally strong in our commercial HVAC businesses globally, with organic bookings growth of low to mid-teens in all segments.

Our Americas commercial HVAC business was once again a standup with organic bookings up mid-teens in the quarter and up approximately 65% on a 3-year stack. Enterprise backlog ended the quarter at $6.9 billion, with the composition shifting increasingly towards commercial HVAC. Year-to-date, backlog in commercial HVAC is up approximately $800 million. Over the past 3 years, our commercial HVAC backlog has nearly tripled, up approximately 170%. As residential and Thermo King have normalized, the backlog burn in these businesses has been completely offset by growth in commercial HVAC backlog, including a large percentage of long-cycle applied systems.

We continue to drive strong demand and a healthy pipeline of projects in key growth verticals across our commercial HVAC businesses. We're leveraging the power of our direct sales force, which brings specific expertise on how to customize solutions and leverage policy, programs and incentives to optimize customers' paybacks, total cost of ownership and performance. Our leading innovation and unique direct go-to-market strategy enables us to quickly pivot and win in the highest growth verticals as markets evolve.

We have a resilient and diverse portfolio, and our business operating system is designed to deliver consistent top quartile performance. As our residential business has normalized and transport markets have softened, our overall business has delivered strong results and is on track to deliver high single-digit organic revenue growth and 20%-plus adjusted EPS growth for the year, our third consecutive year of 20% or higher adjusted EPS growth.

We're on pace to deliver free cash flow equal to or greater than 100% of net earnings and continue to execute our balanced capital allocation strategy with high levels of business reinvestment, a strong and growing dividend, strategic bolt-on M&A and share repurchases. Our strong execution, robust bookings and revenue growth and exceptional backlog gives us confidence in raising our 2023 guidance and confidence in our ability to deliver strong performance in 2024 as well.

Please go to Slide #5. Demand for our innovative products and services continues to be broad-based across our segments, highlighting the strength of our global portfolio. Organic bookings were up 8%, led by our commercial HVAC businesses. In the Americas, commercial HVAC was very strong across the board. We discussed booking strength on the prior slide but revenues were exceptional as well, up in the low 20s percent range with equipment up approximately 30% and services up low teens. Our residential business continues to normalize as expected with revenues up low single digit.

Consistent with our prior comments, the nature of our transport refrigeration business is lumpy, and our performance in Q3 was in line with our expectations on both bookings and revenues. Revenues were a bit lower than our guidance of down 10%, driven by the timing of customer deliveries between Q2 and Q3 but remained strong against a tough 60% prior year growth comp. On a 2-year stack, revenues were up more than 40% in the quarter.

Americas backlog is approximately 3x historical norms with the largest component being commercial HVAC applied systems for 2024 and beyond. Applied systems are the most complex and innovative systems and the largest driver of our service business in commercial HVAC.

Our EMEA business was right on track with our expectations. Bookings were strong in both businesses, both up low teens. Commercial HVAC revenues were robust with mid-single-digit growth on tough prior year comps. TK EMEA revenues were up versus a down market. Backlog remains strong, approximately 60% higher than historical norms and predominantly commercial HVAC.

Our Asia Pacific business performed well with strong bookings growth in China and the rest of Asia. Asia revenues were slightly lower against a tough prior year comp of nearly 30% growth. Our outlook for the region continues to be positive. The verticals we play in remain strong with good opportunities for future growth. Asia segment backlog continues to be robust as we approach 2024, approximately 70% above historical norms and predominantly commercial HVAC.

Now I'd like to turn the call over to Chris. Chris?

[Christopher Kuehn, executive]

Thanks, Dave. Please turn to Slide #6. The scoreboard for the quarter highlights strong execution top to bottom. Organic revenues were up 9%, adjusted operating and EBITDA margins were up 130 basis points and 100 basis points, respectively, and adjusted EPS was up 23%. At an enterprise level, we delivered strong organic revenue growth in both equipment and services, up high single digits and low teens, respectively.

We continue to highlight our exceptional services growth because our services business continues to differentiate us in our industry. It makes Trane Technologies more resilient with higher recurring revenues at higher margins over time and represents about 1/3 of our enterprise revenues. Over the past 6 years, including 2020, our services business delivered a revenue growth CAGR of up high single digits, and we're driving even stronger growth in 2023. Our high-performance flywheel continues to deliver results with relentless investment in innovation driving strong top line growth, margin expansion and EPS growth.

Please turn to Slide #7. As an enterprise, we delivered about 5 points of volume and about 4 points of price in the quarter. Strong volume growth, positive price realization and productivity combined to more than offset inflation in the quarter. The supply chain continues to stabilize, enabling improving productivity as we move throughout the year. In the Americas segment, we delivered about 7 points of volume and 4 points of price that accompanied strong leverage and margin expansion led by our commercial HVAC business, more than offsetting volume declines in transport.

The EMEA segment delivered very strong organic incrementals and margin expansion, with organic revenues up low single digits in the quarter. The segment also delivered approximately 12 points of M&A growth in the quarter, which impacted reported leverage, given year 1 integration costs. The Asia segment delivered strong margin expansion and organic leverage in the quarter on slightly down revenues.

For the enterprise, we earmarked an additional 30-plus basis points for incremental business reinvestment in 2023 to accelerate the timing of key projects across the enterprise. This nearly doubles our average run rate of approximately 40 basis points annually or a total of 70-plus basis points in 2023. We're extremely pleased we've been able to make these incremental investments in 2023 while driving strong leverage. We see a tight linkage between investments in innovation and market outgrowth, and we're taking opportunities to go further and faster in 2023. Now I'd like to turn the call back over to Dave. Dave?

[David Regnery, executive]

Thanks, Chris. Please turn to Slide #8. Overall, our positive outlook for our segments and our end markets is largely unchanged from the prior quarter. And as we move into the fourth quarter with continued high levels of absolute demand, exceptional backlog and strong execution, we're gaining additional visibility into healthy growth in 2024.

Across the enterprise, there are some key themes. Strong demand for our sustainability-focused solutions remains high. While we expect the law of large numbers to kick in at some point and for order growth to decline, absolute bookings are expected to remain robust, given our new baseline is at a very high level. Across our businesses, we see the stacking effect of supportive policy and regulatory changes that play to our unique strength as a leading climate innovator. In addition to all the tailwinds at a national level in both the U.S. and Europe, we see activity at the state and municipal levels, and our direct sales force is able to help customers leverage these programs.

In Americas commercial HVAC, our business is extremely strong as we've outlined. We're winning with customers and developing innovative solutions in data centers, education and high tech, just to name a few strong verticals. And we're driving tremendous growth in our applied business, which makes up the majority of our backlog. Applied business is the most differentiated and complex and it's where our competitive advantages shine. It's long cycle with higher-margin service opportunities, representing a multiple of initial purchase price over the life of the system. Additionally, this business helps to forge long-term relationships with customers as they move from project to project over a multiyear period.

We have the most comprehensive portfolio of products in the industry, which enables us to compete and win across all verticals, driving leading long-term sustainable growth. There's no change to our residential business outlook. We expect residential to continue to normalize through the fourth quarter and for the normalization process to be largely complete in 2023. Also, as expected, strength in commercial HVAC is more than offsetting the decline in residential in 2023.

Our transport refrigeration business was largely in line with our expectations in the third quarter and up more than 40% on a 2-year stack. We expect to outperform the market for the year. ACT is projecting a dip in 2024 and a bounceback in 2025 and continued growth afterwards. However, ACT's forecast has been volatile in recent months, and we are in the process of validating assumptions versus our internal forecast and other sources. We'll update the market when we hold our year-end earnings call.

In our EMEA segment, the third quarter was also in line with our expectations for both businesses. As we highlighted in our second quarter call, EMEA HVAC has very tough comps in both the third and fourth quarters, up high 20s and low 40s, respectively, and revenue growth is expected to be more moderate in the second half. The 2-year stack for Q3 is up more than 30%. Our transport refrigeration outlook is unchanged.

Likewise, our Asia Pacific segment, our outlook for the full year is unchanged. Revenue in the second half is expected to be flattish, purely related to tough prior year comps while bookings continue to be strong. Now I'd like to turn the call back over to Chris. Chris?

[Christopher Kuehn, executive]

Thanks, Dave. Please turn to Slide #9. Strong execution, record bookings and near-record backlog puts us in an excellent position as we move into the fourth quarter. We're raising our full year revenue and EPS guidance for 2023. Organic revenue growth is expected to be between 8% and 9%, up from our prior guidance of up approximately 8%, reflecting strong Q3 performance and a largely unchanged outlook for a robust Q4. We're raising our adjusted EPS guidance to approximately $9, up from a range of $8.80 to $8.90, mainly reflecting a flow-through of our third quarter outperformance versus our guidance and continued strong leverage of 30%-plus for the fourth quarter.

We're pleased with our free cash flow performance of approximately $1.3 billion year-to-date. And on the full year, we continue to expect to deliver powerful free cash flow of equal to or greater than adjusted net earnings or approximately $2 billion. As we've highlighted before, we pay close attention to our investment peer group and consistently target top quartile financial performance, including adjusted EPS growth and adjusted free cash flow conversion. We believe our guidance places us in a strong position to deliver against that target in 2023.

As we said in our last earnings call, we expect an increased M&A contribution in the second half versus the first half due to the timing of acquisitions. We had approximately 3 points of M&A in the third quarter and expect to have approximately 2 points of M&A in the fourth quarter as 1 acquisition passes the 1-year mark and is included in our base. There is no change to our full year guidance of approximately 2 points from M&A. Please see Slide 19 of the presentation for additional details related to guidance to assist with your models.

Please go to Slide #10. We remain on track to deliver $300 million of run rate savings from business transformation by 2023, including $60 million which will be realized in 2023. We continue to invest in these cost savings and high ROI projects to further fuel innovation and other investments across the portfolio. Our continuous improvement mindset is an integral part of our business operating system, and it's designed to drive gross productivity each year to offset other inflation.

While it's been extremely difficult to realize meaningful levels of productivity in recent years, given the supply chain and other macro challenges, productivity is improving as supply chain challenges abate and is contributing to our 30%-plus organic leverage target in 2023.

Please go to Slide #11. We remain committed to our balanced capital allocation strategy 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. In 2023, we received upgrades to our credit ratings, which are now Baa1, BBB+, reflective of our strong balance sheet and cash flow generation. Third, we expect to consistently deploy 100% of excess cash over time. Our balanced approach 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 #12, and I'll provide an update on our capital deployment for 2023. Year-to-date, as of the end of October, we've deployed $1.6 billion in cash with $513 million to dividends, $535 million to M&A and $550 million to share repurchases. We have significant dry powder with over $2.6 billion remaining under the current share repurchase authorization, and our shares remain attractive, trading below our calculated intrinsic value. Our M&A pipeline remains active, and we have deployed or committed approximately $900 million year-to-date as of the end of October to bolt-on leading technology acquisitions and equity investments.

Our latest acquisition, Nuvolo, was announced in early October. Nuvolo will augment our energy services, enterprise management and digital capabilities in commercial HVAC. We expect the Nuvolo transaction to close in the fourth quarter. All in, we're on track to deploy approximately $2.5 billion in cash in 2023. Our strong free cash flow, liquidity and balance sheet continue to give us excellent capital allocation optionality moving forward. Now I'd like to turn the call back over to Dave. Dave?

[David Regnery, executive]

Thanks, Chris. Please turn to Slide #14. Transport refrigeration market forecasts for both North America and EMEA remain unchanged, and we expect to outperform each market in 2023. Our performance through the third quarter is on track to meet these expectations. The slide shows key data points on the markets and on Thermo King specifically to provide additional transparency and reference information.

Please go to Slide #15. As discussed, ACT's projections for 2024 have been volatile, and we are focused on conducting a thorough analysis of the markets. In the interim, we've included ACT's most recent forecast for 2023 through 2028 for your reference.

Please go to Slide #16. We expect to provide 2024 guidance on our fourth quarter earnings call. However, given increasing visibility, we believe it may be constructive to discuss key dynamics at play that give us confidence we'll see healthy growth in 2024. Our commercial HVAC businesses, which make up roughly 65% of our total revenues, are executing well in healthy markets, and the agility of our sales teams to quickly pivot focus to growing vertical markets is driving record bookings and backlog. Our applied backlog is a standout and provides a long higher-margin service tail that makes our business stronger and more resilient.

Secular mega trends continue to support growth, and policy and regulatory stacking is amplifying these tailwinds with the majority of these programs still ahead of us. We expect to enter 2024 with our residential business largely through the normalization process and on path to our long-term target of GDP-plus growth. We continue to lead with innovation, which yields healthy pricing opportunities, and our business operating system is primed to stay ahead of inflationary pressures.

The supply chain has vastly improved and pockets of remaining challenges continue to abate. Our culture is lean-based and we're excited about the productivity we can unlock as we move into 2024. We've also been heavily investing in productivity-enhancing projects such as factory automation, which we expect to unlock further value. ACT is forecasting a dip in North American trailer production in 2024, a snapback in 2025 and growth thereafter. While we're in the process of further assessing their forecast, our North America transport refrigeration business is approximately 10% of our total revenues. We expect to execute well, manage the business tightly, outperform the end markets and, if necessary, manage deleverage within gross margin rates.

Lastly, while we don't talk about our service business a lot, we're quietly putting up double-digit growth in 2023 on top of a 6-year compound annual growth rate of high single-digit growth. Our service business is strong, resilient and poised for growth, and we continue to build out our energy services and digital capabilities and offerings, which represents a big current and even larger future opportunity.

Please go to Slide #17. In summary, we are well positioned to drive significant value over time. We are proud to have been named one of Fortune's Best Workplaces for Women and one of the World's Best Companies by Time Magazine. Our culture and people fuel our innovation and help us to fulfill our purpose every day. This steadfast focus on purpose, our leading innovation, our proven business operating system enables us to execute our strategy and stay nimble across our resilient portfolio. This, in turn, enables us to consistently deliver a leading revenue and earnings growth profile and powerful free cash flow.

With our strong performance, elevated backlog and continued high levels of customer demand, we are confident in once again raising our full year revenue and EPS guidance and reaffirming our free cash flow conversion target. We have the team, the strategy and the track record to deliver strong performance in 2023 and differentiated shareholder returns over the long term. And now we'd be happy to take your questions. Operator?

[Operator]

[Operator Instructions] Your first question is from Scott Davis of Melius Research.

[Scott Davis, analyst]

I'm kind of getting sick of congratulating you on good quarters, but this is one of the better ones.

[David Regnery, executive]

Please keep it up.

[Scott Davis, analyst]

You're making Lehigh proud, Dave. All good. Guys, when you think about the backlog that you have and the demand environment in commercial, is this the type of environment where you can really be selective on projects and kind of cherry pick the stuff that as really the margin, price margin structure that you want? Or are you still -- or is that not kind of how it works and you're just out there bidding on a wider array of stuff but just bidding at a higher price? I was just trying to get a sense of that interplay between project selectivity and really just the supply-demand imbalance that's out there right now.

[David Regnery, executive]

Yes, Scott, it's a good question. We have strong core business right now. And we spend a lot on innovation and we price our innovation to ensure that we get proper returns. So I would say it's leading more with innovation, and we're constantly looking for how we can improve our portfolio, how we can improve the efficiency of our products, how our products can use next-generation low-GWP refrigerant. That's all inclusive in our business operating system when it comes to innovation. And that's what's really leading our markets right now.

And I would also tell you that having this, and I know I've told you this before, but this direct sales force and being able to educate them on new innovations real time and having them take those messages to the influencers on jobs is very, very important when you go to close especially some of these large applied jobs.

[Scott Davis, analyst]

Yes, that's helpful color. I have to ask this question. You have a competitor who had a ransomware issue in the quarter. Did that help you guys as it related to bidding on things and such or was that a nonevent?

[David Regnery, executive]

It was not -- it was a nonevent so I hope everything is okay there, but it was a nonevent.

[Operator]

Your next question is from Julian Mitchell of Barclays Capital.

[Julian Mitchell, analyst]

I think, Dave, you emphasized a couple of times the strength in applied bookings and the difference versus light commercial because of the service element. So maybe just a follow-up on that point would be around sort of what's the rough split today of, say, the revenues in your commercial HVAC business between applied and light commercial? And just wondered when you're looking at the revenue outlook next 12 months, do you anticipate much of a difference in revenue trends of applied versus light commercial maybe because of stimulus impacts or the scale of the respective backlogs? Any sort of perspective around that, please.

[David Regnery, executive]

Yes. Julian, we don't look at just light. We look at units are in total so it would be light and large. And historically, it's been about 50-50 in our equipment business. But obviously, in the third quarter, we had very, very strong demand in our applied business. So think of data centers, high tech, education, we're very strong. We had solid performance in other verticals, too, like health care, life science, government, industrial. And then there were some weaker verticals as well. Think of traditional office, warehousing and retail and those weaker verticals where you tend to see more unitary than applied systems.

[Julian Mitchell, analyst]

That's very helpful. And then just my follow-up. It's more of a sort of silly short-term one, but only 1 quarter left in the year. Your sales guide, I think your Q4 sort of construct on guidance is the same as it was back in July, and you just kind of flowed through the Q3 beat to your full year guide. But if I wanted to look at the Q4 for what that's worth, the revenue guide implies nearly, I think, sort of 8%, 9% sequential sales decline from Q3, which seems a bit heavier than normal. Is that just kind of noise around backing out from the year? Or is there anything specific maybe in transport or something like that, that's weighing on Q4?

[Christopher Kuehn, executive]

Julian, it's Chris. I'll start off. The Q4 implied guide is kind of around mid-single digits organic revenue growth, and it is a little bit of a stepdown versus Q3. But if we put a few reasons behind it, one is when I think about the toughest comp of the year, our commercial HVAC businesses, this is really the toughest comp across the board going into the fourth quarter on a year-over-year basis.

Second would be the contribution from price. We would expect to be a bit lower in the fourth quarter than the third quarter. We commented price delivered around 4 points of growth in Q3. You probably dialed that into about 2-ish points of growth in Q4, so there's about 2 points right there sequentially. And then maybe just to round out another response here, really be around residential as it continues to normalize. We did a little better in the third quarter on revenues. Our constructive view around residential for the full year hasn't changed with revenues down around mid-single digits.

So we're very focused on making sure inventory in the channel is positioned well for the start of 2024. So we would expect that normalization to continue really into the fourth quarter. So hope that gives you a little bit of some view here on how we think about Q3 to Q4. But let's not forget maybe the first point, the commercial HVAC on tough comps, we had 40% growth in EMEA last year, 30% growth in Asia last year, really toughest comp of the quarter.

[Operator]

Your next question is from Andy Kaplowitz of Citigroup.

[Andrew Kaplowitz, analyst]

Impressive quarter. Dave, with the understanding that orders can be lumpy, it appears that you actually had a positive inflection in orders in Americas commercial HVAC in the quarter despite concerns of higher U.S. rates. So did you see larger mega projects start to hit a little more frequently in the quarter? I know you mentioned strength in data centers. Did you see like some of your bigger verticals actually heat up a bit as the quarter went on? And would you say that, that gives you more of a probability of ending backlog at the end of this year closer to $7 billion and $6 billion as I know you're guiding?

[David Regnery, executive]

Yes. I mean, we're still tracking a lot of "mega projects", and we're defining a mega project, again, as a project where the total revenue -- total size of it is over $1 billion. We're still tracking a lot of those in our pipeline. So yes, we had a little bit of activity in the third quarter but we just had some really nice growth. And as I said earlier, data centers, education continues to be very strong. And then we had like what I would call solid performance over a lot of different verticals, health care, life science, government, industrial. Those are all very solid performance in the quarter.

So I think a lot of the mega projects are yet to come, which is still good news. And I think I've told you on our second quarter call, our ability to track these projects and to triage them on a global basis because some of these big mega projects, you have decision-makers that are in different parts of the world. And you have -- you could have the owner in Korea, you could have the engineer in Seattle, Washington and the project is in Texas. And we're able to triage that and work with the customer and show the value that we can provide. So we're super excited about a lot of the mega projects that are still in the pipeline.

[Andrew Kaplowitz, analyst]

And then Chris, could you give more color into the organic leverage you've been delivering. Organic leverage in the mid-30% range is obviously a good result for Trane. We know you're guiding to 30% for Q4 and 25%-plus long term. But maybe you could talk about whether you have an extended period of productivity projects along with good price versus costs that could help your margin performance well into '24, given I think it was more difficult to engage these projects during the pandemic?

[Christopher Kuehn, executive]

Yes, Andy, it's a great question. And I would say we go into every year looking at incrementals in the 25% or better category, right? And we'll dial that in as we get a little closer to 2024. But we continue to see this dovetail of the contributions from growth price normalizing, with the gross productivity getting better as we work through the quarter this year -- the quarters this year. The supply chain has continued to improve. With that, the volume growth has continued to grow each and every quarter.

We delivered around 5 points of volume growth here in the third quarter. And with that, the inefficiencies, as you said, it was hard to get that productivity the last couple of years. The inefficiencies have gotten less. So there's a lot of room to go here. We're starting to see some of the benefits of that in 2023, but this will be a continued opportunity for us as we go into 2024 really and beyond.

We're really getting back to the DNA of the company, right? The ability for us to drive the lean culture and look at cost takeout and ultimately lean through with automation in our factories, these are all investments we're making this year. And we're able to pivot the workforce to focus on that versus the supply chain challenges over the last few years.

[David Regnery, executive]

Yes, Andy, I had the opportunity to visit several of our locations during the quarter. It was just such a great feeling to feel the flow that's happening in the operations today versus where we were a year ago, where we were looking at the yard full of product that had to go back on the line to be reworked. So that's all helping with the productivity.

So we're really starting to hit our stride here in our operations, which is a great job by the team because they've had some tough times they're working through the supply chain. But I'm glad to say that they're operating extremely well right now.

[Operator]

Your next question is from Gautam Khanna of TD Cowen.

[Gautam Khanna, analyst]

Great quarter. Just wanted to get your sense on, you mentioned the transport refrigeration, you opened the order books in October. Any early read on how demand looks and how far out you're booking into 2024 right now?

[David Regnery, executive]

Yes. I mean, like I said, we did open the order book in October. As expected, Gautam, I mean, the Thermo King business has performed very well for us over a number of years. And with our current guide, we're forecasting that we're going to outperform the markets again in 2023. So it's a great business. We have a lot of innovation that we're pumping through that business right now as we electrify our portfolio of products.

Great team, and it's -- I'm pretty excited about where we are with Thermo King. I know that ACT is forecasting a bit of a dip in 2024. We're validating that. There's some things that don't align up with our internal forecast, but we'll validate that in the short term and update everyone as we report out our fourth quarter earnings.

[Gautam Khanna, analyst]

Okay. Can you comment on how far out you guys are actually booking into '24 at this point or...

[David Regnery, executive]

It's always within a 12-month period. So these orders don't get booked way out. But in fact, in the prior years, we would only open up the book for 6-month increments. So just because we wanted to make sure we are pricing right when we were in a higher inflation market.

[Christopher Kuehn, executive]

Yes. I think for Americas, it [indiscernible] through middle of '24, Gautam. And I think for Europe, it may be open for a bit longer than that. But to Dave's point, the order book would really only be for 2024 at this point.

[Gautam Khanna, analyst]

And just 1 quick follow-up on resi. Any evidence of people deferring replacement and instead repairing units? Are you seeing any uptick in those products?

[David Regnery, executive]

Yes. I was with the resi team recently. We're not seeing that, no. So I think the short answer is no, we haven't seen that yet.

[Operator]

Your next question is from Chris Snyder of UBS.

[Christopher Snyder, analyst]

I wanted to ask on commercial HVAC. Orders this quarter clearly bifurcated from the broader industry. And the company has always prided itself on driving innovation. So I guess my question is the world moving to emissions targets and just higher electricity prices globally, are you seeing customers more so appreciate the innovation and efficiency that you are providing to them? And do you think that could result in a higher rate of share gains moving forward?

[David Regnery, executive]

Chris, hope all is well with you. Great question. Look, we always lead with innovation. I think our customers always appreciate higher efficient products, greener products using low-GWP refrigerants, so we pride ourselves on that. Look, we do a lot of innovation around verticals, and I don't talk a lot about that for obvious reasons. But if you think of data centers, we had a very strong quarter in data centers.

A lot of that has to do with the innovation that we're providing working with the customer. So these are unique solutions for them and then they scale it through all the data centers that they're building. So we'll continue to do that in the future. We'll continue to sell our energy efficiency to our customers. And we'll continue to make sure that we have a connected solutions so that our service business can continue to expand in the future.

[Christopher Snyder, analyst]

I appreciate that. And then maybe following up, Dave, you mentioned in the prepared remarks that orders need to go down at some point due to the law of large numbers. So the other question is wouldn't you need like a step change negative in the macro to see that? Because it feels like the lead time compression headwinds are kind of largely in the rearview at this point. Commercial is healthy. Resi seems to be turning. And you mentioned before, the mega projects really haven't ordered yet. It's mostly still in the pipeline. So I mean, what do you need to see on a macro standpoint to have material order declines off these levels?

[Christopher Kuehn, executive]

Yes, Chris. It's Chris. I'll start. This is why we want to make sure it's important that investors look at growth rates as well as backlog position and just absolute bookings levels, right? I think the trends around decarbonization, and as you mentioned just before, customers putting out emissions targets, we see these as long-term tailwinds. Growth around data centers appears to be a multiyear tailwind as we think about the need for data and for saving data and to process data. So we see this as some longer-term tailwinds.

When we think about the beginning of the year, we guided ending backlog down to around $6 billion, and that would have implied bookings down around 5%, 6%. But even on a down 5% or 6%, that would have been still very elevated levels in terms of absolute bookings, and we continue to see that strength here through the third quarter. So I would say the trends, we don't necessarily see, as abating. Could we find some quarters where the backlog will start to normalize or bookings growth will be negative? I guess we could.

But I would just encourage people to look at absolute bookings levels because when you look at 2-year stacks, 3-year stacks around bookings growth, they're significant. You think about commercial HVAC in the Americas, a 3-year booking stack of over...

[David Regnery, executive]

65%.

[Christopher Kuehn, executive]

65%. So the fact is if we went down 5 points in a given period, you still have to subtract that from 65% points of growth. So maybe a bit of a long answer to your question, but where we're confident we've got a long-term tailwind here.

[Operator]

Your next question is from Joe Ritchie of Goldman Sachs.

[Joseph Ritchie, analyst]

Nice quarter. So yesterday, Eaton resized the mega project funnel up 25%, now tracking almost close to like $900 billion. And they suggested that about 20% of the projects have kind of broken ground and a lower percentage, they've actually bid. I'm curious, like I know that you guys have your own funnel and you guys are also tracking projects over $1 billion. But does that all kind of jive with what you're seeing in your pipeline broadly? Or any other color around that would be helpful.

[David Regnery, executive]

Yes. I haven't read Eaton's reports so I can't comment specifically. I would just tell you that we have a lot of projects in the pipeline right now that we're tracking. I think it's always -- you always have to be a little bit careful when you track 1 company versus another company is when orders are procured by different companies could vary. So Eaton maybe a bit before us.

But I guess the good news is we still see a lot out there. It sounds like Eaton does as well, and we're very, very confident with many of the solutions that we have that we're talking with customers about and we feel that many of these projects, we're in a unique position.

[Joseph Ritchie, analyst]

Yes. Maybe following up on that, Dave. [indiscernible] had any concerns? I know you're not seeing it really in the order book today, but are there any concerns out there on project financing or things putting to the right, just given the rate environment that we're in?

[Christopher Kuehn, executive]

Joe, it's Chris. No, we're not. I think while certainly interest rates have gone in the negative direction on paybacks, I would tell you that the change in paybacks is minor when we think about the energy-efficient systems that we're able to quote customers. A payback may have gone from 2, 2.5 years to 3-ish years now with interest rates. So the fact is there's still very strong paybacks when you're implementing some of these solutions. So we're not seeing that right now.

[Joseph Ritchie, analyst]

Got it. That makes sense. And I guess maybe 1 last 1 quickly for you, Chris. I know that we're kind of not ready to bless any 2024 numbers at this point. But as you kind of think through both pricing and mix for next year, just any thoughts -- initial thoughts on how that should kind of play out across the Americas business?

[Christopher Kuehn, executive]

Yes. We'll dial it in a little bit further, Joe, as we get a couple of months from now. But we do target, from a price inflation measure, let's say, a spread of 20 to 30 basis points in a normal year. We'll dial that in as we get closer to next year. To Dave's earlier point, we're making sure we're pricing for innovation and also long-term customer relationships.

So I'm confident that we'll have a good set of numbers there. We're going to target positive on a dollar basis and a margin basis on price versus inflation. And we've been able to demonstrate that for the last 3 years, so I have a lot of confidence our teams will be able to do that going forward.

[Operator]

Your next question is from Steve Tusa of JPMorgan.

[C. Stephen Tusa, analyst]

I'll echo, those orders, pretty strong for sure. What were -- there's been a lot of strength in light commercial. How strong was your light commercial business, large and light?

[David Regnery, executive]

Our revenue was up, in the Americas, was up over 20%. Equipment was up over 30%. Applied was stronger than unitary.

[C. Stephen Tusa, analyst]

Applied was stronger than unitary?

[David Regnery, executive]

Yes, yes, yes. Both were strong but applied was stronger than unitary. I mean, you could look at the verticals that really had the strength in it, Steve. You have data centers, high tech, education. Those tend to be more applied systems. And even the verticals that were solid like health care, life science, again, those tend to be the more intricate projects where you need really a design system, which is our applied systems.

So we're pretty happy with the performance that we saw in the third quarter. And again, not to iterate, but these implied, I know you know this, but this is where you get the long service tail. And so this is going to continue to fuel our service business in the future.

[C. Stephen Tusa, analyst]

Yes. Can you just give us maybe a little -- I know you kind of -- you haven't done this before, but like you've mentioned these 4 verticals in every slide presentation for like the last several years. Obviously, you guys are doing a great job there. Can you just give us -- given it's so important now, I mean, commercial HVAC 65% of your revenue base. Can you just give us some sort of color on how much those 4 verticals represent now? I mean, is that like 50% of your portfolio? Like just roughly how much those growth verticals represent?

[Christopher Kuehn, executive]

They're strong, Steve, is what I would answer. We track about 14 verticals in the Americas. And certainly, office and warehousing would be areas, retail, that'd be a little bit weaker today. I know the office vertical has a number of things kind of buried in it today. We've been lobbying to try to break that out, just given demand on warehouse and data centers. But I won't dial it in specifically but we like our positioning here. And what I think is, again, most important with the direct sales force is their ability that if a vertical is slower like office, the ability to pivot into another vertical is really...

[David Regnery, executive]

That's exactly where I was going to go, Chris. I mean, these verticals, we track 14. You could even get 18 if you do a little subdividing there. But there's oftentimes when 1 vertical is stronger than another vertical for an extended period of time, I'll use warehousing as an example. Two years ago, 3 years ago, warehousing was extremely strong. We pivot our sales force to focus on warehousing. We develop programs for them, and they go capture share in those particular verticals.

Right now, the strength in data centers, I don't see that going away in the near term. High tech, we have all the mega projects that are really in front of us. And education, education has been strong. Obviously, ESSER funding is helping that. I think ESSER funding is probably in the fifth or sixth inning, but we've been extremely strong in education for an extended period of time.

[C. Stephen Tusa, analyst]

One last 1 for you. Your peers have talked about this refrigerant change in resi driving some pretty nice price mix, 10% to 15% or something like that over the next couple of years, perhaps a bit more back-end loaded into '25, given the change comes then. Can you just give us your latest and greatest lens on price and mix from that transition and what potentially you could see in '24 and '25 on that front for resi?

[David Regnery, executive]

Yes. The short answer is we're dialing it in. But I mean, if you think about the whole refrigerant change, right, we've been leading with refrigerant change really the industry, I think we've been at it since about 2013 with next-generation refrigerants. So we're more than ready for this transition away from 410 to, in our case, 454B. Our designs are complete, our manufacturing is ready to go. We're going to start up production here in early Q2. So all systems goes there.

There are some definitions, Steve, that we're still working with the EPA to make sure our interpretation is correct. And then really our focus is going to shift to the channel. I'm sure we have a clean phase in, phase out of inventory. We will be manufacturing both 410 product and 454 product in 2024 and probably even into 2025, at least our interpretation right now, what we're seeing with the EPA.

As far as price, we're still dialing that in. The 454 product is going to be more expensive. Obviously, it's a slightly flammable refrigerant so you're going to have to put different sensing equipment around the union. So we'll get more data on that in the coming weeks here, and we'll update everyone on our fourth quarter call.

[Operator]

Your next question is from Jeff Sprague of Vertical Research Partners.

[Jeffrey Sprague, analyst]

Not as good as you guys but doing well. I wonder if we could just dig a little bit more into just customer behavior and backlogs. As big as the backlogs are versus history, right, if I think about 90% of $6 billion, maybe it's $6 billion-plus, right, but that would be, call it, my math, roughly half of your 2024 commercial revenues are in backlog.

I mean, that's a good healthy number. But given the size and scope of some of these projects, maybe goes back a little bit to one of the earlier questions. I'm not sure why backlog would really go down much from here. Do you actually see customers just kind of changing their order patterns or there's kind of something else that would suggest that backlogs really do need to kind of go back down towards where they were historically?

[Christopher Kuehn, executive]

Jeff, I'll start. I mean, I think the lead times are still a bit extended in applied systems, getting better certainly from where we were beginning of the year. Same in unitary, getting better. So I think as the lead times come in a bit, you may see where the backlog contracts a bit over time. It is elevated today. You're right, 90% of the backlog would relate to our global commercial HVAC business.

And when you think about our commercial businesses, including Thermo King, it's over 95%. So it gives us a lot of visibility into what we think 2024 would be with some healthy growth. But let's see how the policy stacking effects that continue to positively affect us and order rates. Mega projects, as Dave said, are ahead of us here in terms of bookings. And applied, these are long-cycle kind of projects. Let's see how this plays out. We think it can be elevated for longer, but it will start to normalize at some point.

[David Regnery, executive]

Yes. I think the only thing I would add to that, Jeff, is I'll go back to data centers again, and kind of our strategy was to work with the data center engineers and develop solutions that are optimal for them. Once we do that, they do tend to lock in for an extended period of time with you. So they'll provide orders beyond your lead times just to ensure that they have slots available and we don't disappoint missing a shipment.

[Jeffrey Sprague, analyst]

And can you gauge in any way what percent of this forward project pipeline is tied to various stimulus programs, be they IRA, CHIPS, other things and what's coming down through the state promulgations?

[Christopher Kuehn, executive]

Jeff, I would say from an IRA perspective, that's really all in front of us. I don't think that's necessarily in the backlog today. But from an ESSER funding for several years now, we've had projects and making sure that over the summer months when schools are open, we're ready to service and upgrade equipment. So I think that's certainly been the backlog for a while.

Data centers continues to elevate and we see it as a long-term tail. But CHIPS and Science Act, we don't have that dialed in but that would be one where I guess you could specifically say this is driving this demand. But in the data center, there's no -- that's more about just pure demand for data centers right now.

[Operator]

Your next question is from Nigel Coe of Wolfe Research.

[Nigel Coe, analyst]

So going back to the commercial HVAC growth in Q3, which was obviously spectacular, but especially in the Americas, the pickup Q-over-Q was quite something. So you called out obviously the strength in the verticals. Was there any kind of supply chain sort of loosening or kind of flush there that maybe drove that? Understand demand is very strong. And then within that, education, I think there's some concerns out there with the stimulus funding kind of reaching a peak, perhaps that maybe education falls off in '24. So any visibility on education would be helpful.

[David Regnery, executive]

Yes, I'll start with the latter. The education, we haven't seen a cooloff yet. We still have a lot in our pipeline as well. There's still a lot of money to be spent out there. As I said, I think if we had a -- we were playing baseball, I'd say we're in the sixth inning. There's still some funding to come there. We've been strong there for an extended period of time. The other question was...

[Nigel Coe, analyst]

Yes. Just obviously, supply chain constraints have been a factor in the applied business, yes.

[David Regnery, executive]

The supply chain, it's -- I wouldn't say it's normal but it's pretty close to normal. We always have some noise that you're going to see in the supply chain, but our teams have done just a great job there. So I wouldn't say it was -- I would not say our third quarter performance was because supply chain suddenly got better because it's been [indiscernible].

[Nigel Coe, analyst]

Okay. And then on the comment...

[David Regnery, executive]

We're executing very well on the front end of our business. We're executing very well on the operations side of our business and you really see it in our results.

[Nigel Coe, analyst]

Okay. Just quick -- another crack at the pricing question. Chris, you mentioned [ 23 ] basis points spread versus inflation is what you target. It does feel like some of your competitors are taking a much more aggressive policy towards pricing. So I'm just curious on 2 aspects. Number one, the potential to really be a bit more aggressive on price as you go into '24. And then secondly, as this commercial HVAC backlog starts to convert, is there sort of embedded pricing in that backlog that's going to emerge over the next 12 months?

[Christopher Kuehn, executive]

Yes, I'll start with your second question, Nigel. As we think about the backlog that runs out 1 year, 1.5 years, we're making sure that we've got the right cost escalators built in. And it could be a reference to an external index or it could be where we've put cost inflators into the project to ultimately make sure we're pricing effectively. So I think we've got that embedded in the backlog right now on a best view. And the teams have done an outstanding job with this over the last 3-plus years in the inflationary environment to stay ahead on inflation.

Yes. Look, I think pricing will remain a way for us to continue to drive with our innovative products, making sure we're pricing effectively. It's going to be healthy. I just want to get 3 more months ahead of us here before we dial it in for 2024. But I am confident that as we think about the cost environment and the innovation of our products, we're going to make sure we're pricing effectively.

And again, making sure we've got long-term customer relationships here, as Dave described, with the applied business, we want to make sure that the services business continues to grow with that, which we can and it will. And that, of course, brings with itself healthy margins. So we're well positioned for next year. Just give us a little more time to dial that in.

[Operator]

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

[Deane Dray, analyst]

Maybe to circle back on China, you had good bookings. It was impressed that even though you had lighter margins -- lighter revenues, the margins were much stronger. So how did China play out for you?

[David Regnery, executive]

I'm very happy with our performance in Asia Pacific overall, so thanks for the question. You think about -- I'll start with orders, right? I mean, orders were up in the low teens, up 12%, okay, for the region. And China had high single digits and the rest of Asia had mid-teens, so very strong performance on order rate.

On revenue, we were flattish, down a bit. But remember, last year, we had 30% growth in Asia Pacific so it's really just a comp issue. The team there is performing very well. I was very, very happy with the incoming order rates in that region. And the pipeline is strong as well.

[Deane Dray, analyst]

Great. And just as a follow-up to that September customer experience event in New York, can you give us a sense of the -- on the applied business, both the backlog and the funnel, how much is -- are customers opting for this thermal management feature? We still -- since you're like using the baseball analogy, is it -- are we in the early innings of adoption? Where does that stand?

[David Regnery, executive]

Yes, thermal storage. Yes, I mean, we have adoption that's continuous there. We've been selling thermal storage systems for quite some time. I do think that one of the elements of IRA that could accelerate that is that would be included there. And we're still dialing in what that exact rebate would be and how it will be applied. But that could be significant and really drive that.

And just so everyone's aware, thermal management -- our thermal storage systems are great ways for energy efficiency but they're also great ways to help balance the grid. And if you have a need and a peak period to shut off power or limit power, this is a great way to do it because you burn ice versus running your compressors on your chillers. So we're excited about the technology. We've had it for a while, and IRA could be a catalyst to even have it grow faster.

[Operator]

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

[Andrew Obin, analyst]

A question on gross margins, I guess. Look at my model, I think gross margins are hitting all-time highs. And I know you guys don't look at other companies but we do. And I'm just wondering how much price cost, the spread between price cost is a benefit. And I guess the bigger question is, have we rebased gross margins? Because clearly, you guys have done a lot of work on cost cutting, right? It seems that you have an aggressive stance on maintaining the spread. But also how much of it is timing, right? It's just the peak between the balance between price and cost. So if you could just talk about, are we in the new normal with gross margins or should we expect the gross margins normalize somewhat going forward?

[Christopher Kuehn, executive]

Andrew, I'll start. As I think about the third quarter, we really were able to execute across all parts of the P&L to drive leverage and gross margin expansion. So the price execution versus inflation, as I said earlier, it was positive on a margin and dollar basis. There are areas, though, of inflation, especially in tier 2 around wage and energy inflation that are impacting the business. So it was a positive.

The incrementals on volume and 5 points of volume in the quarter so we like those incrementals. And we've continued to invest in the business as well, right? We're still targeting for the full year around 70 basis points of incremental investment above a 40 basis point normal. So all parts of the P&L are really working. But I would tell you the productivity opportunity for us as price comes back to a bit more of a normalized level, that is really the opportunity for us going forward to really continue to drive 25% or better incrementals.

[David Regnery, executive]

And we really like our mix and service.

[Andrew Obin, analyst]

So services was driving high gross margins as well?

[Christopher Kuehn, executive]

It's a contributor, right?

[David Regnery, executive]

It was a contributor. It was a system of things that does it, but we really like the mix we have with our service business.

[Andrew Obin, analyst]

Great. And just a follow-up question on Nuvolo, right? I think JCI also bought a workplace management software company. Fortive has a presence. Can you just talk about what excites you about this vertical and maybe also remind us how big is software as a business for you at this point?

[David Regnery, executive]

Yes. Nuvolo is a cloud-based connected workplace and enterprise asset management company, and it's leveraging the ServiceNow platform. Look, we look at this as a way to augment our current digital capabilities. Just to remind everyone, we have over 36,000 connected buildings. We have well over 1 million connected assets. So we think this is a great company, great leadership, great technology, and we're excited to get this closed and have it be part of the Trane Technologies portfolio, and it's going to really help us grow our digital business at a nice clip.

[Andrew Obin, analyst]

And how big is the digital business now?

[David Regnery, executive]

I won't be specific on that. I would say that this acquisition is less than 1% of the enterprise revenue.

[Operator]

We have completed the allotted time for questions. I will now turn the call over to Zac Nagle for closing remarks.

[Zac Nagle, executive]

Thanks, operator. I'd like to thank everyone for joining on today's call. As always, we'll be available in the coming days and weeks to answer any questions that you may have, so please don't hesitate to reach out. Stay safe, and we look forward to seeing everyone soon.

[Operator]

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