If there's one metric that most successful stocks must have, it's margin expansion. In general, investors should avoid businesses with declining profit margins and buy businesses with rising or potentially rising profit margins.
That's why I think there's a strong case for buying shares in industrial technology company Trimble (TRMB 1.57%). Despite some potential near-term headwinds from a slowdown in the economy, the stock looks like a tremendous long-term value, and the 28% decline in the share price over the last year means a lot of the bad news is already priced in.
Trimble's margin expansion plans
Before getting to how Trimble can expand margins, here's a quick look at operating margin progression on a historical and projected basis. Again, there's a general uptrend, and if management can hit its 26% to 27% target by 2027, investors can expect substantial earnings and cash flow growth on the back of revenue expansion.
Data sources: Trimble presentations, marketscreener.com.
How Trimble can expand profit margins
There are two essential parts:
- An ongoing shift in the revenue mix from lower-margin hardware to higher-margin software, services, and recurring revenue.
- A shift in the software mix toward recurring software rather than perpetual software -- a change that results in greater long-term revenue and earnings generation.
Now, I know what you are thinking, and you would be right. There are no shortages of software companies with the promise of margin expansion via shifting to a subscription/recurring-based model.
But here's the thing. The critical point about the company's margin expansion potential is that it's an intrinsic part of the changing nature of its business. Moreover, management can point to clear progression on the matter.
For example, in 2011, Trimble generated $1.64 billion in revenue, with only 20.1% coming from what it defines as software/services/recurring revenue. By 2021 that ratio was up to 55% on $3.66 billion in revenue -- more on why Trimble can increase that in a moment.
Turning to the second bullet point, Trimble has largely completed selling its software model conversions to recurring sales, such that it only sold around $65 million in perpetual software on a "sold alone" basis in 2022, compared to $186 million in 2017. However, it has about $435 million in sales from perpetual software sold as part of a bundle with hardware.
As such, Trimble has an opportunity to transition the sales of hardware plus perpetual software into either sales of hardware and recurring software or a "full-service bundle" encompassing hardware and software paid for on a recurring basis.
Why Trimble's margin expansion is intrinsic to its business evolution
Trimble's origins lie in hardware to help companies and governmental bodies with positioning data. Its four main end markets are construction and infrastructure, geospatial mapping, transportation, and agriculture. For example, you could think of a surveyor on a road project needing precise points, trucking fleets needing routing plans, or the digital mapping of the earth.
However, given advances in digital technology, Trimble has an opportunity to become an increasing part of its customers' daily workflow, which implies a significant opportunity to grow software and service sales.
In plain English, Trimble can move beyond merely positioning and sensing toward more modeling and analyzing data to help support planning and decision-making.
For example, fleet routes can be optimized using real-time data and modeling transportation, making the fleet more productive. In addition, precise monitoring of construction/infrastructure projects can significantly reduce waste and ensure the timely and efficient completion of the project. Deere investors already know about the revolution in precision agriculture and how it's helping to improve decision-making in an industry fraught with uncertainty from planning through seeding, nurturing, and harvesting.
This shift can also be seen in the recent announcement of an agreement to buy cloud-based transportation management software company Transporeon for 1.88 billion euros -- a business with 90% of its revenue recurring.
A stock to buy for 2023
Trimble's revenue growth and margin expansion prospects are real and closely related to the natural evolution of its business. The same Wall Street forecasts I referred to earlier call for free cash flow (FCF) of around $750 million by the end of 2023 as the company, hopefully, overcomes the supply chain constraints that crimped margins in 2022.
It's a figure putting Trimble on 18 times 2023 FCF -- an excellent valuation for a company with such attractive revenue growth and margin expansion prospects.
