Trimble - Q1 2024

Transcript

Operator (participant)

Thank you for standing by. My name is Krista, and I will be your conference operator today. At this time, I would like to welcome everyone to the Trimble first quarter 2024 results conference call. All lines have been placed on mute to prevent any background noise.

After the speaker's remarks, there will be a question-and-answer session. If you would like to ask a question during that time, simply press star followed by the number one on your telephone keypad. If you would like to withdraw that question, again, press star one. Thank you. I would now like to turn the conference over to Rob Painter, President and Chief Executive Officer. Rob, you may begin your conference.

Rob Painter (President and CEO)

Welcome, everyone. Before I get started, our presentation is available on our website, and we ask that you refer to the Safe Harbor at the back. Our financial commentary will reflect non-GAAP performance metrics, including organic growth comparisons, which refer to the corresponding period of last year unless otherwise noted.

In addition, our P&L commentary will primarily emphasize our as-adjusted numbers, which exclude our agriculture business, better reflecting Trimble on a go-forward basis. Starting on slide four, during the first quarter, we continue to advance our Connect and Scale strategy, which involves digitally connecting workflows within targeted industry segments and creating scale across Trimble through shared technology platforms.

Our strategy delivers outcomes in the form of unique value to our customers and sustainable value creation to our shareholders. We want to convey three key messages today, starting with the solid performance in the quarter where all three segments performed ahead of expectations, as detailed on slides five and six. $2.03 billion of ARR grew 13% organically.

As-adjusted revenue grew 8% organically. As-adjusted gross margins were a record 67.5%. As-adjusted EBITDA margin expanded 290 basis points to 27.9%, and free cash flow was strong at $227 million. We are confirming our previous total year guidance despite unfavorable currency moves, and we will provide an update in our next call as we build confidence in the months ahead.

Key message number two is a strategic portfolio highlight. In the first quarter, we divested certain water monitoring assets, our 21st divestiture in the last four years. On April 1st, we closed our PTx Trimble joint venture.

I'm proud to have established this precision ag joint venture with Eric Hansotia and his team at AGCO. This is a high-character team with a bold vision. These moves simplify and focus our organization and provide cash to strengthen our balance sheet and support our capital allocation strategy. Key message number three on slide seven is that our new reporting segments are in place, which align to our new organizational structure.

We provided historical data on the segments to our investors on April 12th. It takes an enormous amount of work to affect change on this scale, and I'm grateful to our Trimble colleagues for their courage and dedication. The sum of these actions will simplify and focus our business, thereby enabling us to reset to a new and better baseline as we aim to perform to our full potential.

As evidenced on an as-reported basis, our first quarter revenue was 73% software services and recurring and 58% recurring, while on an as-adjusted basis, our first quarter was 77% software services and recurring and 63% recurring. Turning to the segments, let's start on slide eight with our AECO segment. Connect and Scale is well in motion here, and it is working. Connect is about connecting users, data, stakeholders, and workflow across the industry lifecycle continuum.

Our right to win starts with the breadth, depth, and connectedness of our offerings. It bookends by delivering solutions that connect the physical and digital worlds. Scale is about making Trimble easier to do business with and enabling efficient and effective growth. In the quarter, we moved our go-to-market team to an account-based selling model.

We expanded our prepackaged Trimble Construction One offerings, and we released our next version of Systems Transformation, which is providing us new insights into our customers. Mark Schwartz and his team delivered record first-quarter bookings, an 18% increase in ARR, and margin expansion of 430 basis points.

This business is a multiyear overnight success, and we trust the new reporting structure now gives enhanced visibility to the quality of the business we have been transforming over the last few years. To emphasize the point, this is a scaled $1.1 billion ARR segment operating as a Rule of 40+ business, in fact, a Rule of 50+ in the quarter.

Market conditions remain favorable at the moment with strengthened subsegments such as reshoring and onshoring of manufacturing, EV and battery plants, data centers, and renewable energy projects.

The physical side of our business is largely conveyed in our new Field Systems reporting segment with key highlights on slide nine. This business is predominantly hardware, but that discrete word underplays the importance of this business to our strategy. Think of this as industrial IoT, the data collection node in the physical world that provides us the ability to connect the physical and digital worlds.

In this business, we are continuing to transform our selling models, moving towards hybrid models where we increasingly monetize aspects of the solution as recurring revenue. Thus, the segment revenue splits approximately 50/50 as hardware and software. On an as-adjusted basis, which excludes our agriculture business, Ron Bisio and his team grew revenue by 1% while increasing operating margins by 250 basis points to 26.9%.

Software services and recurring revenue are 48% of the business, and ARR grew 14%, evidence of our Connect and Scale strategy in motion in this segment. Market conditions remain mixed and overall slightly positive. We see strength in the same subsegments as AECO, including infrastructure spend.

On the cautious side, we see economic weakness in pockets of Europe and Asia-Pacific, most notably through lower OEM retail unit sales and continued weakness in residential construction. We are closely monitoring U.S. GDP growth along with global interest rate dynamics and how that will impact capital purchases.

Closing our segment commentary on slide 10, Transportation and Logistics began the year with a solid start. We closed the Transporeon acquisition last April. Thus, it is excluded from the organic comparison in the first quarter. On the heels of record fourth-quarter bookings, the Transporeon team delivered a record first-quarter bookings.

Chris Keating and his team reorganized their go-to-market strategy and recommitted to process excellence and organizational focus. They are also delivering innovation, most notably through AI-driven product releases and Autonomous Procurement and Autonomous Quotation, which have found product-market fit.

They predominantly deliver this bookings growth in a European region that continues to experience a freight recession, thus demonstrating that selling a winning value proposition and backing it up with innovation and process improvement can generate positive results even in a tough market environment.

They also delivered a multi-hundred-thousand-dollar annualized contract value global cross-sell win, selling Autonomous Procurement to an existing Enterprise software customer that is notably in North America. We have also begun cross-selling our MAPS solutions into Transporeon's European customer base.

We remain confident this is an exciting Trimble business with a compelling right to win and an attractive business model that enables a series of land and expand product-led growth opportunities. In context of the bookings and ARR growth, we will continue to allocate capital to our go-to-market expansion.

In the rest of the segment, the 4% organic revenue growth was driven by our Enterprise and MAPS teams, which each grew double-digit. Excluding Transporeon, we have delivered consistent margin expansion since the end of 2021. Including Transporeon, the segment expanded margins by 480 basis points in the quarter.

Before I turn it over to Phil for his first call as our incoming CFO, let me once again express my gratitude to David Barnes for his service and partnership over these last few years. Phil, over to you.

Phil Sawarynski (CFO)

Thank you, Rob. We believe shareholder value is ultimately a function of maximizing long-term free cash flow. Connect and Scale is our engine, which in the mid to long term aims to deliver cumulative recurring free cash flow. Slide 11 highlights balance sheet and cash flow dynamics in the quarter.

Free cash flow was strong in the quarter, coming in at $227 million or 1.4x non-GAAP net income. We continue our asset-light model with capital expenditures less than 1% of revenue and negative working capital. Pro forma net debt to EBITDA after the close of the agriculture joint venture stands at about one.

Post the close of the AGCO transaction at the beginning of the second quarter, we have just under $1 billion in cash even after paying down our term debt and the outstanding balances on our credit facilities.

Our strong cash balance puts us in a good position to resume our share buyback activity after we issue the 10-Q. Now a few comments about capital allocation. Our priority remains the same, which is to invest back into our business where we see opportunities for the highest returns.

For example, over the last few years, we have been investing in digital transformation, the fruits of which are being demonstrated in AECO. We continue to transform our processes and systems in AECO, and over time, we will expand this work throughout the rest of the company.

As promised, we retired over $1 billion in debt in early April. In January, we announced an $800 million share repurchase authorization, and in the first quarter, we executed $175 million of buybacks.

On the merger and acquisition front, we will opportunistically pursue tuck-in acquisitions with a bias toward the AECO segment where we can land and expand with capabilities that fit inside the Trimble Construction One offerings. As an example, we acquired a field human resources application in the third quarter of 2023 and doubled the customer account in the first few months under our ownership.

This was enabled by our Connect and Scale strategy via bundled product offerings that we put in the hands of our sellers. We intend to run the same playbook as we think about our acquisition strategy going forward. Before I turn to guidance, an update on the expected timing of the release of our 10-Q filing. Our auditors, EY, informed us several weeks ago that their 2023 audit of Trimble was selected as part of the PCAOB's inspection of EY's work.

During preparation for the PCAOB review, EY concluded that neither EY nor Trimble had sufficient documentation related to certain IT and other controls for revenue-related systems and processes. While EY had deemed Trimble's controls over revenue effective at the time of the 10-K filing, EY's subsequent internal review over the last few weeks has changed their conclusion.

Unfortunately, the result is that our 10-Q filing will be delayed, and we will need to amend our 10-K to revise the internal control disclosures after the completion of EY's additional audit procedures. We have decided to delay our annual shareholders' meeting until EY has completed their work.

It is first and foremost important to note and emphasize that our auditors have not withdrawn their 2023 financial audit opinion. We are committed to working with our auditors to close this out in an expeditious manner.

With that, let's turn to guidance for the second quarter and the remainder of the year. As Rob noted earlier, we are reaffirming all elements of our initial guidance for 2024 despite negative currency moves, with some puts and takes between quarters and with prudence given that we are still early in the year and our global end market environments are dynamic. Several factors influence our outlook for the year.

While we got off to a very strong start in the first quarter, some of our outperformance came from hardware and term license revenue in the first quarter that we previously anticipated would come in the second quarter or later in the year. With this dynamic in mind, we think the best way to understand our trends is by looking at the year through a lens of first half versus second half.

Overall, our outlook for the first half remains consistent with what we shared with you a quarter ago. We expect that as-adjusted organic revenue growth in the second half of the year will be consistent with the first half after adjusting for the impact of the extra week in the fourth quarter. Let's now move to our detailed guidance on slide 12. I will focus again on our as-adjusted view excluding agriculture.

Please note that we have also included slides in the appendix to our presentation that provide more information on our segment and corporate assumptions. Our prior guidance assumed that the agriculture joint venture would close on April 1st, which is exactly what happened. The as-adjusted view removes agriculture in the historical periods, which enables looking at the growth dynamics of our current portfolio in a consistent way.

Our outlook for ARR growth remains strong with continued expectations for 11%-13% organic growth for the year. This is driven primarily by the expectation of mid to high teens growth in AECO ARR. Our total company full-year organic revenue growth outlook remains in the 4%-7% range.

This is driven by AECO growth in the high teens to low 20s, Field Systems growth flat to down in the low single digits, and Transportation revenue flat to up in the low single digits. As a reminder, our 2024 fiscal year includes 53 weeks, which increases full-year and fourth quarter revenue by approximately $85 million, of which approximately $70 million is in the AECO segment. Excluding this extra week revenue growth, in AECO is expected to be up in the low to mid teens.

Our margin outlook for the year is also unchanged, with non-GAAP operating margin expected to be in the range of 24%-25% and Adjusted EBITDA margin in the range of 26.5%-27.5%. This represents year-over-year improvement on both measures of between 100 and 200 basis points.

AECO margins are expected to be up approximately 300 basis points for the year and by about 50 basis points excluding the extra week. This margin expansion reflects both the strong growth in our construction software businesses with high gross margins while continuing to invest in support of future growth opportunities.

In Field Systems, margins are expected to be down approximately 100 basis points due to changes in customer and product mix. Finally, in Transportation, we expect margins to continue to improve with margins up approximately 100 basis points for the year with continued margin expansion in our Enterprise MAPS and Transporeon businesses.

Our EPS forecast of $2.60-$2.80 is unchanged and continues to reflect the benefits of capital redeployment of the proceeds from the joint venture transaction. We've already paid out all of our prepayable debt, and we continue to anticipate that we will execute on up to $800 million of share repurchases over the course of the year.

Relative to our prior guidance, EPS will benefit from lower net interest expense due to the increased cash on our balance sheet offset by lower equity income. From a cash flow perspective, we continue to expect full-year free cash flow of approximately 0.85x non-GAAP net income.

This outlook does not assume a change as it relates to expensing of research and development for tax purposes. Excluding the impact of acquisition deal expenses and the 53rd week, our free cash flow forecast for the year is roughly 1x non-GAAP net income. Note that we expect free cash flow in the second quarter to be the lowest of the year.

Second quarter cash flow is normally seasonally low, and in the second quarter, we will see high acquisition-related expenses related to the closing and transition costs for the agriculture joint venture as well as higher cash taxes. I'll finish by offering a few comments on how our guidance for 2024 breaks out by quarter.

As we discussed, our guidance overall assumes that excluding the 53rd week, our as-adjusted organic growth is relatively consistent between the first half and second half of the year.

For the second quarter, we expect revenue between $845 million-$875 million, which reflects as-adjusted organic revenue approximately flat year-over-year. As-adjusted organic revenue growth year-over-year in all three segments is expected to be lower than the first quarter.

In AECO, these dynamics reflect the timing of the term license sales, which, although considered as part of our ARR calculation, are recognized upfront under the accounting rules and positively impacted the segment in the first quarter.

To illustrate this point further, within AECO, we recognize approximately $85 million of term license revenue in the first quarter, and in both the second quarter and third quarter, we expect term license revenue in AECO to be approximately $30 million due in large part to the normal timing of the term license renewals.

Then, in the fourth quarter, that term license revenue will increase again above first quarter levels due to the inclusion of the 53rd week on January 1st, 2025, in our 2024 fiscal year, which is when many of the term licenses renew. Our ARR measure evens out the lumpy nature of term license revenue, and we believe it is the best measure of growth in AECO.

It's important to note that term license revenue is highly profitable, so the profitability in our AECO segment and at the company level will be highest in the first quarter and fourth quarter and lower in the second and third quarters. In the Field Systems segment, we had strong sales of geospatial technology to government customers in both the second quarter of 2023 and in the first quarter of 2024, which we did not expect to repeat in the second quarter.

Transportation revenues and organic growth will be modestly lower in the second quarter, primarily reflecting reduced low-margin hardware sales in our North American mobility business.

At this point, we expect the total company third quarter revenue will be similar to second quarter revenue, with fourth quarter revenue the high point for the year assisted by $85 million in revenue from the 53rd week. Operating and EBITDA margins for the year are expected to follow these same trends. We look forward to providing you with more details on the drivers and economics of these segments at our Investor Day event in December. Rob, I'll turn it back to you.

Rob Painter (President and CEO)

Thanks, Phil. When we think about our right to win at Trimble, we believe we can uniquely bring together users and connect workflow between the physical and digital worlds across industry continuums. Connect and Scale is our strategy. Our strategy is an industry platform strategy.

Our platform strategy is, in turn, a data strategy. If we are successful in our pursuits, we will collect one of the most complete data sets in and across industries, creating a flywheel of enhanced insights and data connectivity, thereby enabling our customers to transform how they work while building a competitive moat around our business.

Thanks to all our Trimble colleagues for delivering a solid start to the year and for demonstrating resilience and conviction as we continue to transform how we work so that we can transform how the world works. Operator, we can now open the line to questions.

Operator (participant)

Thank you. We will now begin the question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad to raise your hand and join the queue. If you would like to withdraw your question, simply press star one again.

If you are called upon to ask your question and are listening via loudspeaker on your device, please pick up your handset and ensure that your phone is not unmuted when asking your question. Your first question comes from the line of Chad Dillard with Bernstein. Please go ahead.

Chad Dillard (Senior Analyst of US Machinery)

Hi. Good morning, guys.

Rob Painter (President and CEO)

Chad.

Chad Dillard (Senior Analyst of US Machinery)

So I guess my first question, I just wanted to dig in more into the financial controls issue. I was hoping you could give a little bit more detail on just, I guess, what happened in terms of the IT and the impact on revenue recognition. Then, I guess, to what extent, at least right now, do you think this could potentially impact the income statement and just how are you thinking about the timing of resolution?

Rob Painter (President and CEO)

Sure. Good morning. I'm going to turn it to David Barnes. David is staying on with us to see this through to its conclusion. So, David, why don't you?

David Barnes (Former CFO)

Sure. Hey, Chad. So the process is that our 10-K was filed, as you know, in February, and the PCAOB selected EY's audit of Trimble for their review. As the EY team looked over their work papers on the internal control side of things, they concluded that the documentation that they and we had was not sufficient to meet the standards of the audit of internal controls.

Now, Chad, the thing I'd point out is the EY support of our financials is unchanged. This is just about the internal controls. No issues with our numbers have been identified by EY or us. What's happening is EY is going to go through enhanced audit procedures to confirm the numbers, and then we will issue an amended 10-K, which will enable us to issue the 10-Q as well.

We've looked at companies who have gone through this, and it takes probably more than a month. Hard to predict the timing. It's inconvenient, but we, at this point, have no reason to believe that our numbers will change. We're working cooperatively with EY to get through it.

Chad Dillard (Senior Analyst of US Machinery)

Great. That's helpful. Just moving to AECO, can you give a little bit more detail on bookings for that business during the quarter? If you can, just talk about what the take rate is on your bundled offering.

Rob Painter (President and CEO)

So bookings in the quarter continue to be strong. So put together really a couple of years now of strong progression in the bookings. The ACV bookings were over 20% growth in the quarter. So we like what we're seeing in terms of the progression there. Within that, Trimble Construction One is clearly an offering that we've been talking a lot about over the last, I'd say, year, year and a half.

The bookings grew faster than that within Trimble Construction One. So Trimble Construction One, we're continuing to increase the level of adoption through that as we've transformed our selling organization and the processes and the systems to go along with that.

So giving an example, in North America, I think about 80% of our bookings were Trimble Construction One bookings within the quarter. Those grew at a level of almost 2x the bookings level growth on a year-over-year basis. So strong progression, Chad.

Operator (participant)

Please limit yourself to one question and one follow-up. Your next question comes from the line of Jason Celino from KeyBanc Capital Markets. Please go ahead.

Jason Celino (Managing Director and Equity Research Analyst)

Hey. Thanks for taking my question. Maybe double-clicking on that a little bit. When you think about the growth that you're seeing in AECO, and maybe if you go a step deeper on TC1, is there a way to think about it versus net new versus expansion?

Rob Painter (President and CEO)

Jason, the breakdown on that is about 2/3, 1/3. 2/3 existing logos, 1/3 new logos. So if we take new logos, what we see is that the offering is expanding the addressable market. In some cases, that's allowing us to go, I'd say, more in the small, midsize end of the market with the offering.

Then on the, let's call it, the mid to upper end of the market, we continue to see customers wanting to buy into an ecosystem and we think that's driving a good amount of the growth. Team's doing a great job executing.

Jason Celino (Managing Director and Equity Research Analyst)

Yep. I mean, it seems like you're executing quite well. I know the demand environment doesn't make it easy. But maybe relative to 90 days ago, maybe can you just give us an update on how some of that end market or macro kind of sentiment is within that segment? Thanks.

Rob Painter (President and CEO)

Yeah. Good question. So on the macro side within AECO, what I would comment on is that we see good growth and onshoring, reshoring of manufacturing and you see that in Europe and North America. Renewables, data centers, these are strong growers in North America, and those bookings and ARR growth supports that.

Residential with interest rate environment is on the other side of that trade. That aspect of the market is a bit more challenged. We actually also, Jason, have quite a bit of data within our own systems, as you know.

We're managing nearly a third of U.S. construction through our systems. So we can see that hiring is up in the market here in North America in the non-residential space. We can see geographically that there's been the largest growth in the Midwest, followed by the Southeast with Florida, Carolinas, and Georgia.

Operator (participant)

Your next question comes from the line of Jonathan Ho with William Blair. Please go ahead.

Jonathan Ho (Partner and Senior Equity Analyst)

Hi. Good morning. Just wanted to start with a little bit more of a high-level question. As we look at Trimble moving forward, just given the model and mixed changes here, at what point should we expect ARR and total revenue growth to converge a little bit more?

Rob Painter (President and CEO)

Hey, Jonathan. Good morning. It's Rob. Good question. We actually already see that in AECO. So you can see the growth in the quarter, for example, was 18% on the ARR as well as 18% revenue. If you look in Transportation and Logistics, you actually have the same phenomenon: total revenue up for ARR, up for so it correlates to the amount of recurring that's in that.

The one that will be disconnected and would remain so for, I think, a number of years would be Field Systems, which is predominantly a hardware business. I think the recurring is, I call it, in the 20% range on that. So those will remain separated and thus leave a separation at the total company level.

Jonathan Ho (Partner and Senior Equity Analyst)

Got it. Just as a follow-up, can you give us a little bit more detail on Transporeon and what may be changed there to drive the much-improved results? Thank you.

Rob Painter (President and CEO)

Yeah. Good question as well. So another strong quarter of bookings growth, that's two quarters in a row of records for the business: a record Q4 and then a record with a Q1 as well. What I would say is a few things to add on to that. So the team began successfully cross-selling Transporeon solutions to existing Trimble Transportation customers here in North America, which exemplifies go-to-market synergies and we think we're just getting started.

Conversely, we've been selling some of our MAPS solutions into the European market. Those bookings growth were both with the shippers and carrier customers and that's important because the team's continuing to grow network participants on all sides of the Transportation management platform, which effectively connects the buyers and the sellers of freight. Dozens of new logos were added in the quarter.

I like what we're seeing from new product development as well with Autonomous Procurement and Autonomous Quotation. So I'd say a number of things coming together, the team's executing quite well, in which is still a very difficult economic or difficult freight market economy, doubly so in Europe.

Operator (participant)

Your next question comes from the line of Jerry Revich with Goldman Sachs. Please go ahead.

Jerry Revich (Managing Director and Senior Equity Research Analyst)

Yes. Hi. Good morning, everyone. I'm wondering if we could just talk about the 2Q margin outlook. So you both said an outstanding first quarter and I understand the comments about thermal license sales, but historically, you just don't have that type of margin step-down that you're guiding to, 2Q versus 1Q.

So I just want to make sure we understand how much of that is making sure that we can beat numbers like we did this quarter versus a meaningful slowdown in any part of the business because, obviously, the performance in the quarter was really strong.

Phil Sawarynski (CFO)

Hey, Jerry. It's Phil. Thanks. And good question because I know there's a lot of moving parts in our outlook. So yeah, if you think about Q1, as I talked about, the term licenses are largely a Q1 dynamic and that's that $50 million drop from Q1 to Q2. So if you look at the margin basis, I think it's around a 400, a little bit more than a 400-point drop.

So the large part of that, I'll put it into actually four buckets. Half of that or a little over half of that is because of the dynamic of the term license. If you remember, the term licenses actually get recognized all upfront. So that's high-margin revenue. Then as you move into Q2, the other two pieces are, one, we have our merit raises that take effect in April. So that's about 100 basis points.

Then another 100 basis points is some additional OpEx, primarily around the AECO business and the sales and marketing and R&D spend that we've talked about, incremental spend there to continue to drive that growth engine. Then the remainder is the term license to bridge that 400.

Jerry Revich (Managing Director and Senior Equity Research Analyst)

Okay. Then can I ask separately on the ARR, nice acceleration in performance in the quarter really across the segments? As we think about what the Transporeon rolling into the mix will look like, and it feels like you're looking for an acceleration based on the outlook in slide 15 across the segments, putting the pieces together across the total company.

Could we see ARR accelerating on an organic basis in the mid- to high teens from an exit rate standpoint beyond the full-year guide? Just thinking about what 4Q might look like given the cadence that you described in the slides.

Phil Sawarynski (CFO)

Transporeon will certainly help at the company level in terms of bringing up the ARR growth potential. The other side of that is the mobility business. So the net of that gets to the guide that we put forward, Jerry.

Jerry Revich (Managing Director and Senior Equity Research Analyst)

Rob, is it fair to say that there's an acceleration, though, 4Q above the full-year ARR guide?

Rob Painter (President and CEO)

At this point, no. No. We're maintaining the outlook on that. I mean, it would bias more than above to the mid, but we're going to leave that guide where we are right now.

Jerry Revich (Managing Director and Senior Equity Research Analyst)

Thank you.

Rob Painter (President and CEO)

You're welcome.

Operator (participant)

Your next question comes from the line of Kristen Owen with Oppenheimer. Please go ahead.

Kristen Owen (Executive Director and Senior Analyst)

Hi. Good morning. Thank you for taking the question. Rob, you called out the Rule of 40 balance for AECO and I think just in this previous question, said about 100 basis points going to reinvestment in that business.

Just wondering if you can talk about sort of balancing that lifetime customer value versus your customer acquisition cost, how you think about investment versus growth to build out the opportunities set in that business.

Rob Painter (President and CEO)

Yeah. Hey. Good morning, Kristen. Great question. Let me take that twofold. First, with the, call it, the 100 basis points of investment, OpEx investment into the AECO segment that Phil referenced, more than half of that is at the sales and marketing level. So that's putting feet on the street, sellers to go get the business that we think is there.

About a quarter of it is in R&D as we continue to drive connectivity and interoperability between the solutions, driving workflow capabilities as well as AI investments we're making into the products. Then the remainder is in G&A, which is really the systems investments and the systems investments, which are enabling a lot of this to happen.

So then at the level when we think about the return on investment that we're making to put into the business, we look at that lifetime value over their customer acquisition cost and the easy heuristic is when we're at a ratio above three, that's telling us to lean forward and invest into the business. We're well above that as a, call it, as a floor of our thinking.

So when we do that math, this is actually, it's a pretty straightforward exercise to say we should be leaning into investing in this business to go after the market, especially when we're delivering well above the Rule of 40 and, in fact, above Rule of 50 in the-

Kristen Owen (Executive Director and Senior Analyst)

Okay. Thank you. That's helpful. When I think about the overall size of that market opportunity, I mean, obviously, the business is going through a transformation at this point in time, TC1 really just starting to ramp.

If we look at sort of the five-year model for Trimble, how do you think about your mix of market opportunity for continuing growth in AECO? Is it within your existing customer base? Is it new products? Is it new logos? Just help us understand what sustains this growth on a go-forward basis.

Rob Painter (President and CEO)

Yeah. It's a great question. So on a multi-year basis, I would frame this market as the largest available TAM that we have to service. We know the multi-trillion-dollar size of global construction. We're playing both in vertical construction, horizontal construction. We know it's a market that's large, global, underserved, underpenetrated, has challenges with productivity at the intersection of productivity and sustainability, which our solutions positively affect.

We see more and more customers wanting to buy into ecosystems and our right to win, we think, begins with the breadth and depth of solutions we have across the continuum of the lifecycle. Furthermore, if you subscribe to a notion that the world's becoming more data-centric, more data-driven, then you will like the touchpoints we have across this industry where we can, we believe, move from optimizing tasks to optimizing systems.

So we think we're well and uniquely positioned to do so. With respect to how we then think about existing versus new logos, within the existing customer base we have, we think that there's hundreds of millions of dollars of untapped ARR to mine through cross-sell and upsell, given the breadth of that installed base that we have.

With the systems investments that we're making, it becomes more efficient to go to market. Some of those investments are starting to create the ability for customers to self-provision licenses. More e-commerce capabilities are starting to come to market.

That, in turn, creates a more efficient go-to-market motion into the smaller end of the market. So that, we think, would be another TAM that we can unlock through the nature of the business model and the efficiency of which we go to market.

We for sure think that we can continue to win new logos along the way as customers and the market overall continues to adopt and continues to digitize. I would expect within that five years that the majority of that revenue would come through the existing base and those land and expand motions.

So that's the expectation I'd want to set there. So continue to feel very, very positive about the work in this business and the progress that we're making and we'd like to think that we're just getting started.

Kristen Owen (Executive Director and Senior Analyst)

Thanks so much.

Operator (participant)

Your next question comes from the line of Rob Wertheimer from Melius Research. Please go ahead.

Justin Pellegrino (Equity Research Associate)

Morning, everybody. This is Justin Pellegrino on for Rob. I just wanted to look at the equipment side. What does a typical downside in the equipment side look like versus where we're at now? Are we most of the way into a normal downturn? Just any color there would be helpful. Thank you.

Rob Painter (President and CEO)

Sure. Good morning. Thanks for the question. Well, we certainly are following what the OEMs are reporting on their unit sales, both at a retail side and a wholesale demand level. There's for sure a correlation within Field Systems, Field Systems business we have in the OEM. So we have OEM exposure, let's say, in Field Systems that we really don't have nearly as much of in the other two segments of the business.

What we would see through our own numbers is that the European economy is more challenged. We've seen some of the prints out there on units in, let's say, Europe and construction, although interestingly enough, our Europe business and Field Systems performed quite well, relatively well in the first quarter. So it's not a perfect, let's say, R-squared on that correlation.

We're also fundamentally architected to serve the aftermarket and to serve the mixed fleet within that. So there's also another, I'd say, call it the mindset that we have is not to be driven by what are new unit sales, although we do obviously sell onto new units, is we see many, many hundreds of thousands or millions of machines that would benefit from having Trimble technology on it.

Machine types like excavators remain low single-digit penetration with technology. So we think there's enormous opportunities to drive technology adoption into the base of machines that are out there. That's just the civil construction side of the business. So in Field Systems, survey and mapping is an important business for us and I would say we disconnect that from the unit sales coming out of the machinery manufacturers.

There, a surveyor fundamentally creates a digital model of the physical world. That work could be an oil and gas workflow. It could be cadastral survey. It could be in a residential application. It could be in our national parks. There's a wide variety of applications in that market, which would be independent of machine units. Hope that helps provide some color.

Justin Pellegrino (Equity Research Associate)

Yeah. Thank you.

Operator (participant)

Your next question comes from the line of Rob Mason from Baird. Please go ahead.

Robert Mason (Senior Research Analyst)

Yes. Good morning. Rob, you noted the Transporeon business had a win in North America. I'm just curious, if I think about when you bought the business, I'm not sure that was the thesis there was heavily predicated on North America penetration.

Now that you've owned it for about a year, I'm just curious how you're sizing up the opportunity to bring Transporeon or at least parts of Transporeon to North America. Perhaps any comment on any commercial efforts you have around that as well.

Rob Painter (President and CEO)

Yeah. Good morning, Rob and thanks for the question. You're right about the original thesis of it is we didn't, let's say, create our model fundamentally around bringing the European applications into North America. We saw that as additive opportunities and we for sure saw that we could do it. We just didn't predicate the deal on that being the fundamental thesis.

So yeah. Hey, good news, or the example, the customer I talked about in the prepared remarks, it's a multi-hundred-thousand-dollar ARR win that we have and it actually is using the Autonomous Quotation product that we talked about earlier as well. So not even, let's say, the let's call it the older or existing application capabilities we had in the business. It's actually a new one. So we find that very interesting to think about.

What’s most unique about what we have is special about the North America install base; it’s carrier-centric as the nature of our customers. So when we look at capabilities to bring into North America on the carrier side, that would look like Autonomous Quotation and it’s really creating automation around spot transactions.

So that’s something that makes sense for our sellers to be able to introduce to the existing customer base. In addition, we’ve talked before about Engage Lane in North America and the marketplace in Europe.

We’ve brought those organizations or those teams together into one team to create a global, what’s called global scale and global opportunity around that. So that’s another example. Then the third example is real-time visibility. We’re doing that as one business now, not separately in Europe and North America. So those would be additional capabilities than we want to penetrate here into the North America.

Robert Mason (Senior Research Analyst)

Yep. Okay. Just as a follow-up, again, as we go through this year, I guess we'll get recalibrated to the new go-forward segments and the business without Ag. But I was just curious in particular on the hardware and perpetual software gross margin trend. It's trended lower over the last 12 months but my suspicion Ag had something to do with that. At 44% in the first quarter, how does that look on a go-forward basis without Ag as we go through this year?

David Barnes (Former CFO)

Yeah. It's a good question. Rob and Phil can chime in after I set this up. You're right. There is an Ag dynamic there in the numbers that you see. But in addition to that, we think about transitioning more of those hardware models into an element of recurring revenue and that will naturally have a gross margin impact.

So think about a system that might have sold for, let's call it, a $40,000 system and that, for us, from a call it an accounting perspective, has an element of hardware and software that's in that.

Let's say that that traditionally was splitting, let's call it, $25,000 of hardware and $15,000 of software, so a $40,000 sale. That might now convert to $25,000 for the hardware upfront and a subscription of $5,000 a year. In that case, that will have near-term headwinds to the gross margins.

Now, we're not flipping a switch and going 100% that direction, Rob. But you can see from the ARR growth that was 13% ARR growth in the first quarter, that it is a model that we are moving towards. So on a longer-term basis, that could be 200-300 basis points of a headwind. Phil, do you want to add anything to that?

Phil Sawarynski (CFO)

No. I think that's right, Rob.

Rob Painter (President and CEO)

Thanks.

Robert Mason (Senior Research Analyst)

Okay. That's very helpful. Thank you.

Operator (participant)

Your next question comes from the line of Josh Tilton with Wolfe Research. Please go ahead.

Joshua Tilton (SVP of Equity Research)

Hey, guys. Happy Friday. Can you hear me?

Rob Painter (President and CEO)

Yes. Hi. Good morning.

Joshua Tilton (SVP of Equity Research)

Good morning, guys. So just my first one's kind of a clarification. I appreciate all the color around the term impact to AECO. I guess what I'm trying to understand is, because of 606 accounting, will there always be a term component in the AECO revenue line item each quarter, basically every time you renew something or even sign a new deal?

Then my follow-up just for the clarification is, is the reason why we have so much extra rev in the AECO segment because of the extra week, because there's just a bunch of renewals that will have term licenses tied to those renewals that will land in the extra week of the year? Am I thinking about this correctly?

Phil Sawarynski (CFO)

Yeah. Hey, Josh. It's Phil. So your second question is the easy one. Yes, you are thinking about it correctly. Our 53rd week encompasses January 1 of 2025 and a large portion of our term licenses renew around that date. So you are correct in thinking that the 53rd week, roughly $70 million of the $85 million there are the term licenses that renew.

On your first question, yes, there is an element of term licenses within AECO that we've had and we'll continue to have. That's largely in our structures business and some of it has to do with the complexity and the horsepower around the offering itself where it's challenging to move that more into the cloud. So you will see that dynamic going forward, at least for the foreseeable future.

Joshua Tilton (SVP of Equity Research)

Just to be clear, term is not tied to all contracts in AECO, just some of them.

Phil Sawarynski (CFO)

Correct. It's a limited subset of the total AECO offerings.

Joshua Tilton (SVP of Equity Research)

Okay. Super helpful. Then I guess my follow-up one is just very high level. We've definitely had a lot of positive inbound since you guys have given this new segmentation. But I guess when you guys are sitting around the table right there, did anything change in terms of how you guys think about the business and plan about thinking about the business going forward that aligns with this segmentation?

Or is it kind of just business as usual for you guys there and this segmentation is more for us investors to better understand what's already been going on behind the scenes?

Rob Painter (President and CEO)

Yeah. Hey, Josh. It's Rob. I'll take this one. I think it's a really good question. It's not just business as usual. It really does change how we're thinking about the business, how we're running it, and some of, I'd say, some value creation opportunities that this unlocks. This does simplify and focus the company and I think provides a great new baseline for us as we move forward in executing the strategy.

If we look at the AECO assets and that segment as an example, this is a business that is now operating over $1 billion in ARR. It's a scaled ARR software business. This mandate in the business enables the team to take, I'd say, the processes and the systems capabilities across a broader swath of the business than what we were doing than what we were doing previously.

If I look within Field Systems, as an example, this is the first time in decades that we've had our survey business and our civil construction business under one leadership. That is providing a sharper focus and, frankly, a level of accountability to sharing R&D capabilities, being more thoughtful about our positioning technologies and how we're using them across the business.

It's driving better outcomes in terms of attaching things like our positioning services business to the hardware that we sell in survey and civil construction. Then super importantly, at a go-to-market level, the similar competency within this is selling, simply put, selling hardware through a global dealer channel. So we're bringing more efficiency in how we go to market. That is to say, we have one leader in Asia-Pacific, one in the European region, and one in the Americas.

So three leaders from these regions overseeing the scope of what we do in survey and civil. Previously, that would have been six people instead of three. So that, for us, is providing better and more consistent management at the dealers.

Then it enables a different way to think about capital allocation where we can put some of those resources into helping dealers plan their long-term business health and their strategies to complement the work you're doing in the short term to help them identify the market opportunities and make the number. Transportation, arguably, had the least amount of change and there it would feel probably a bit more like business as usual.

Joshua Tilton (SVP of Equity Research)

Super helpful. I guess just last one to kind of tie that all together. As investors, we see this change. We see the change in the segmentation. You told us how it's definitely not business as usual. There are new and exciting things going on. What are we going to see in 12 months?

Maybe 12 months is too soon. Over the three-year time frame, what should investors be judging you on, looking at you at, to say, "This metric was this much better because of all the changes we made"? Where are we going to see all the positivity that you talked to come through in the numbers?

Rob Painter (President and CEO)

Yeah. No, I like the question. I used the words in the prepared remarks about a multi-year overnight success. This journey is 1,000 little steps. We launched Connect and Scale in January 2020. I think what we have now creates a new baseline. Let's also look at the facts in the fact base, I should say. In 2018, we had $1.1 billion of ARR.

We closed Q1 at $2.03 billion of ARR. In 2018, we were 31% recurring revenue as a business. As adjusted Q1, we're 63% ARR. We had EBITDA of 22.6% in 2018. We closed Q1 at 27.9%. Structurally, our gross margins in 2018 were 58% and Q1 adjusted, they're 67.5%. Over the last five years, we produced 44% operating leverage. We haven't just decided that this is the direction that we're going. We've been working on this for a number of years.

So now as we take this as the baseline, I think probably one of the better things that as an outcome of the resegmentation is that transparency and that visibility to the investment community, which is what you're highlighting. It is very obvious to see in that AECO business now.

This is a scaled ARR business operating well above Rule of 40, growing ARR in the high teens, produced 37.4% operating income in the first quarter. I'm emphatically positive and proud of the team and what they've accomplished on that. So I look forward in a three-year time frame. We talk about ARR and free cash flow.

To me, those are the big bookends. They're not the only bookends, but they're two of the biggest bookends that we have to drive value. So I'd say in the three-year time frame, you should be looking for continued ARR growth.

We should be able to continue to progress the structural gross margins as software I would expect would outgrow hardware over that time frame. That structural gross margin improvement is an enabler of an ability to drive operating leverage. We drive operating leverage. That means we're driving increased levels of EBITDA.

Then as Phil said in his prepared remarks, I think cumulative free cash flow is the game and the long-term game. So we'd be looking to continue to progress the free cash flow in the business relative to the net income that we have. That's the quantitative framework I'd have around that. Hope that helps.

Joshua Tilton (SVP of Equity Research)

It definitely did. Sounds fired up. Thank you so much.

Operator (participant)

Your next question comes from the line of Tami Zakaria with J.P. Morgan. Please go ahead.

Tami Zakaria (Executive Director)

Hi. Good morning, Rob, Phil, and David. Thank you for taking my question. So I have a follow-up on that Transporeon comment. The Autonomous Procurement solution you sold to a North American customer, can the same salesperson currently selling the existing Trimble solution sell the new Transporeon solution to the customer?

Basically, I'm trying to understand how does the backend of all of this work in terms of the customer rep for each of the two solutions, the billing, etc.? Then how did the ACV go up after selling this versus what it was before?

Rob Painter (President and CEO)

Hi, Tammy. Good morning. This is Rob. I'll take that one. So it's a multi-hundred thousand dollar ARR. It's over $400,000 ARR in that example that I use. So therefore, the ACVs over the $400,000 or $400,000 as well.

In terms of the go-to-market motion, think of it as a named account seller who's responsible for the account in North America, bringing in a sales engineer, a sales specialist from Transporeon who knows the depth of the functionality to be able to, I'd say, be conversant with the customer and the value proposition and how to use it and that's actually very similar, Tammy, to Trimble Construction One when we're selling a breadth of offerings.

We'll often have what we now do have named account sellers. Then we can bring in the technical specialist to really know the depths of a given, I'd say a given solution to make sure that customer can get the most value out of that. Did I answer your question?

Tami Zakaria (Executive Director)

Yes, it does. Thank you. The second question, after this formation of PTx Trimble, how do you view the organic growth algo potential of this new streamlined portfolio that you have? Basically, I'm curious to know whether you think it's now the right time to refresh the 2027 targets.

David Barnes (Former CFO)

Okay. So, hey, on the 2020, well, the multi-year targets, we're going to have an investor day in December. Phil mentioned that in his prepared remarks. I think we had been saying second half of the year, but we're narrowing that to December. So that's the formal update. I appreciate that in the interim, there'll be questions of how do we think about that progression of the business and the model.

I think that we can continue to provide color in the next couple of calls. But what we already know is the baseline and I want to highlight that. We know we have a baseline from the quarter, or you could actually say take the year of where we're guiding for the level of EBITDA for the company between 26.5% and 27.5%.

We've talked about the ARR growth. They're guiding 11%-13% organic. So if you take the EBITDA that we have and you continue to play forward the growth we expect and apply operating leverage on that, it's not that hard to see that we could look at about 100 basis points of gross margin improvement a year.

That could look like 100 basis points on the bottom line on a year-over-year basis and if that plays through, then you can get to a 2027 in a ± frame. Then we'll put the finer points and the details around that in 2020, sorry, in December for 2027 or wherever we decide to set the next multi-year mark.

Tami Zakaria (Executive Director)

Perfect. This is very helpful. Thank you.

Rob Painter (President and CEO)

You're welcome.

Operator (participant)

That concludes our question and answer session. With that, that concludes today's conference call. Thank you for your participation. You may now disconnect.