Trimble - Q4 2022

Transcript

Operator (participant)

Good morning. My name is Audra, and I will be your conference operator today. At this time, I would like to welcome everyone to the Trimble Q4 2022 Results Conference Call. Today's conference is being recorded. 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 this time, simply press the star key followed by the number one on your telephone keypad. If you would like to withdraw your question, press star one again. At this time, I would like to turn the conference over to Rob Painter, Chief Executive Officer. Please go ahead.

Rob Painter (CEO)

Welcome, everyone. Before I get started, our presentation is available on our website. We ask that you refer to the safe harbor at the back. Financial commentary today will reflect non-GAAP performance metrics, including organic growth comparisons, which will relate to the corresponding period of last year, unless otherwise noted. The Trimble 3-4-3 operating model simultaneously balances a view on looking forward 3 months, Q4, and 3 years. As I think about framing today's commentary on 2022, I think there is a parallel to look back 3 months at our Q4, Q4 to look back at the year 2022, and 3 years back to 2020 when we began our Connect and Scale journey.

COVID, supply chain disruptions, and net divestitures over these last 3 years has created a dynamic that makes it challenging to discern the signal from the noise in any given quarter, especially when looking at the year-over-year trends. Whereas the long baseline reveals the definitive patterns of progression. As I reflect on the Q4 of 2022, let's begin on slide 2 with our key messages, which are consistent with the commentary from the prior quarter. Our key growth metric is annualized recurring revenue, which met our expectations and grew 16% to a record level of $1.6 billion. Congratulations to the team for delivering this record performance, which compares to $1.19 billion of ARR at the end of 2019.

Total revenue for the year was a record $3.68 billion, up 7% over 2021 and up 6% compounded since 2019, growing through COVID and business model transitions. Total revenue in the quarter was $857 million, flat with last year and towards the lower end of our guidance range. The delta between the ARR and the total revenue performance reflects a slowdown in hardware sales through our dealer partners as dealers continued to sell through their inventory while processing mixed macroeconomic sentiment. For perspective, over the last 3 years, the sum of our civil, agriculture, and survey hardware and related software has grown at a 12% compound annual growth rate, with agriculture growing above and survey growing below this baseline.

Gross margin finished at a record level of 61.8%, exceeding our expectations, reflecting software mix, the cumulative impact of model conversions, and abating supply chain disruptions. For the year, we achieved a 60% gross margin, a record annual level, up 170 basis points year-over-year, which compares to 57.7% gross margin in 2019. EBITDA margin of 24.3% met our expectations in the quarter and ended at 25% for the year, up 210 basis points as compared to 22.9% in 2019. Finally, earnings per share of $0.60 was exactly at the midpoint of our guidance for the quarter. Moving to slide 3, let's look at the progression of our Connect and Scale strategy through the lens of our reporting segments, beginning with buildings and infrastructure.

The big event for the team was our Trimble Dimensions user conference in November, where we had over 5,700 attendees from the global engineering and construction industry, which provided a great forum to reconnect with our customers and partners. We launched many new innovations, including the Trimble Construction Cloud, powered by Microsoft Azure, which is an industry cloud built to streamline construction projects by connecting users, data, and workflow. We also announced extensions of our machine control technology platform to new OEMs and new machine types, further expanding our reach to connect the physical and digital worlds. The highlight financial achievement in the quarter was delivering over 20% organic growth in ARR, in addition to record levels of ACV software bookings and record levels of cross-sell bookings. We also had a strong start for our newly acquired B2W business, where we've had some early cross-sell wins.

As we've previously discussed, we continue to allocate incremental capital towards our own digital transformation, as well as our go-to-market efforts, which are generating strong interest from our customers and partners and demonstrating encouraging signs of internal productivity and efficiency. The work we are doing in this business will be highly leveraged across the entirety of the company. In geospatial, revenue is down further than expected as dealers moderated their inventory levels in the face of softening demand and macro uncertainty. Looking at the indicators, we see softness in residential, and while a portion of the expansion of infrastructure is getting consumed by inflation, underlying optimism remains in the market. For perspective, I look at the 3-year CAGR that I talked about on slide 2 in order to calibrate the long baseline performance.

Strategically speaking, in 2022, we continued to launch new innovations in GNSS, 3D laser scanning, and hand-held data collectors, and we achieved a double-digit increase in ARR as our business model strategy takes hold. In transportation, we delivered revenue and ARR growth in line with expectations. In addition to delivering the Q4in a row of operating margin expansion. Connect and Scale progression also came in the form of continued development of connected workflows, such as Connected Maintenance, Connected Locations, and Engage Lane. The big story, of course, in the Q4 was the announcement of the Transporeon acquisition. To refresh memories, Transporeon operates a leading cloud-based transportation management platform, powering a global network of 145,000 carriers and 1,400 shippers. The platform integrates with more than 3,000 systems and powered more than 25 million transactions in 2022.

For me, this is the very definition of a Connect and Scale business. I had a chance to spend a few days in Europe with Stephan Sieber and the Transporeon team in January, my level of conviction of strategic and cultural fit has only increased. We are still working through regulatory approvals, we expect to close the deal in the first half of this year. We're excited to get to work together. In resources and utilities, revenue and ARR growth were led by our positioning services, utilities, and forestry businesses. Our definition of utilities covers our work with electrical and water utilities, our positioning services business can also be thought of as a utility, in this case precision GPS as a utility.

In October, we announced that we crossed a hurdle of 34 million hands-free miles driven with General Motors in their Super Cruise program. Precise GPS technology enables a vehicle to maintain its lane position in various environments, and we are working on several other Tier One and OEM program opportunities. Moving to agriculture, revenue was flat year-over-year and up when excluding Russia and Ukraine. The 3-year double-digit CAGR growth on Slide 2 is instructive for calibrating the long baseline growth of the agriculture business. With a product lens on Connect and Scale, we are now bundling our guidance hardware, software, and our positioning services, providing both easier access to the technology and a better value proposition for our customers. With a go-to-market lens on Connect and Scale, users and customers are at the center of our strategy.

In pursuit of this strategy, we announced this week that we are taking a different approach to our go-to-market relationship with CNH Industrial. Moving forward, our distribution to aftermarket customers after a 12-month transition period will be done entirely through independent dealer partners with the product bearing the Trimble brand. Less than 20% of our revenue in the resources and utility segment goes through CNH to their dealer network today. We expect to maintain this revenue and address aftermarket demand and the needs of farmers through our direct relationships with our independent dealer network. This evolved approach to distribution will also enhance our ability to offer OEM brand agnostic solutions to customers to help them orchestrate their field operations with mixed fleets of equipment.

Our new approach to aftermarket distribution will improve our ability to sell our full range of technology solutions to aftermarket customers, including guidance, selective spraying, variable rate application, water management, and our Connected Farm Works Center software solution. Our evolving strategy will also enhance our ability to cooperate with OEMs across the industry for their needs for factory-fit equipment. Let me now turn the call over to David to take us through the numbers.

David Barnes (CFO)

Thank you, Rob. Starting on slide four, I'd like to begin my financial commentary this quarter by discussing organic growth trends across the components of our business. As Rob mentioned earlier, our recurring revenue businesses grew strongly year-on-year in the Q4 with ARR up 16%. The strength of our recurring revenue offerings in a weakening and uncertain macroeconomic environment validates our focus on the continued evolution of our business model. While our recurring revenue streams were strong in the Q4, revenues of hardware and related software were down. Organic hardware revenue was down 13% versus prior year and came in below our expectations. The factors driving the slowdown in our hardware business in the Q4 were consistent with what we described in our Q3 call.

During the Q4, our dealers continued to reduce their inventory levels, reflecting both our improving supply chain execution and uncertainty in the future economic outlook. The drop in demand was most pronounced in our geospatial segment as our surveying end customers ordered less than they did earlier in 2022. Hardware backlog reduced sequentially during the quarter as expected. From a geographic perspective, revenues were up modestly on an organic basis in both North America and the rest of the world, with strong trends in Latin America, but were down in Europe and in Asia Pacific. Year-on-year, Europe trends were meaningfully impacted by the loss of business in Russia and Ukraine, and were up 1% organically, excluding that impact. With that as a backdrop, I'd like to turn now to our total financial performance for the Q4 and full year 2022.

Starting on slide 5, Q4 revenues of $857 million were flat on an organic basis and down 8% when including the impact of foreign currency and acquisitions and divestitures. Gross margin was up 400 basis points, reflecting both the accelerating mix shift towards software and the positive net impact of our price increases and moderating cost inflation. EBITDA margin was up to 20 basis points, and operating margin was down 20 basis points as increases in our gross margin largely offset higher spending against our Connect and Scale strategy, especially our digital transformation, and higher spending on travel and trade shows. Diluted earnings per share were $0.60. Looking at cash flow, both cash flow from operations and free cash flow were, as expected, down year-on-year, with the single biggest factor being the amortization of R&D for tax purposes.

We did not repurchase any shares during the quarter and do not plan to restart our repurchases until we are well on the way to de-levering following the issuance of debt to fund the Transporeon acquisition. Turning to Slide 6 and results for the full year 2022, we achieved success across a number of critical dimensions. Organic revenue grew by 7%. Gross margin improved by 170 basis points, reflecting the positive impact of our ongoing mix shift. EBITDA margin was 25%, even as we restored spending across a number of areas that had been constrained during the COVID pandemic and as we accelerated investments against our strategy. Cash flow was down year-over-year, principally as a result of an increase in our inventories and a change in U.S. tax legislation, both of which we expect to normalize over time.

As we move to complete the Transporeon acquisition, we take this on with a strong balance sheet. Working capital remains negative. Our year-end net debt to EBITDA ratio stood at 1.4 times, and the ratings agencies maintained our bond ratings and stable outlooks following the announcement of the transaction. Turning now to our quarterly and annual results by segment on page 7. Speaking to the Q4, Buildings and Infrastructure achieved organic ARR growth of over 20% and recurring bookings growth in the high teens. Sales of civil construction hardware were down year-on-year by just over 10%, leading to organic revenue growth for the segment of 2%. Dealers continued to reduce their inventory levels and end market demand moderated.

Segment margins of 25% were down year-on-year, impacted by lower civil construction revenue, our Trimble Dimensions user conference, subscription transition, and Connect and Scale investments. Revenues in the hardware-centric geospatial segment were down 12% year-on-year on an organic basis, driven principally by declining dealer inventory levels and softer end market demand across the surveying sector. Segment revenues were also pressured by lower shipments to U.S. federal customers, which vary meaningfully from quarter-to-quarter and can be difficult to predict. Segment margins remained over 25% despite these headwinds. Revenues in our resources and utility segment were up 6% organically, driven by growth from Cityworks and positioning services sold to agriculture customers. Our agriculture revenue was impacted by the loss of business in Russia and Ukraine with an estimated year-on-year impact of -5% to the segment in the Q4.

Segment margins improved in the quarter sequentially and versus prior year, coming in just under 36%. Our Q4 results in the transportation segment reflect improvement across a number of dimensions. Organic revenue grew 5%, driven by higher year-over-year sales of enterprise and map software solutions. ARR for the segment grew at a mid-single-digit rate in the quarter. Revenue trends in our mobility offerings improved sequentially from prior quarters, driven in part by higher sales to our largest OEM customer. Operating margins of 14.5% were the highest since 2019 and reflect strong performance by our team in managing costs. Let's turn next to our guidance for 2023 on slide 8. The projections I will share with you today exclude the impact of our pending acquisition of Transporeon. Starting with ARR, we expect organic ARR growth at a mid-teens level in 2023.

Our strong outlook for ARR growth is grounded in the solid bookings momentum we achieved in 2022, the potential for accelerated cross-sell as our digital transformation rolls out to a growing portion of our business, and the essential role that our software plays in our customers' operations. The outlook for revenue, excluding future acquisitions and divestitures, is $3.7 billion-$3.8 billion, reflecting an expectation of organic growth in the range of 2%-5%. As a reminder, divestitures of businesses in 2022 will impact total reported revenue growth trends with the biggest impact in the first half of the year. Our cautious outlook for 2023 organic revenue growth is rooted in an expectation of continued dealer inventory reductions over the next several quarters and softer end market demand in an environment of limited GDP growth.

We expect revenue from hardware and related software will be down in the low single digits organically for the year, offset by strong recurring revenue growth. From a margin perspective, we expect that gross margins will improve by over 200 basis points as our business mix continues to shift in the direction of higher margin software. We expect a modest increase in operating margins as we invest against our strategy in an environment where organic revenue growth is harder to come by. I'll note here that our leadership teams have been working hard over the last several months to adapt our spending plans to the current economic climate. Allocating capital against our strategic priorities is always a major focus for us, and the need for sharp focus is never higher than in a time of weak economic growth.

We are confident that we can continue to progress our strategy within the constraints of our operating plan. Income from equity investments is expected to be relatively flat with 2022. Net interest expense is forecasted approximately $70 million. Netting this out, we project to achieve earnings per share in the range of $2.66-$2.86. We expect that cash flow will grow significantly in 2023, driven in part by reductions in inventory levels. We expect free cash flow for the year of approximately 1 times non-GAAP net income. Our cash flow forecast for this year now assumes that amortization of R&D costs under Section 174 of the US Tax Code will not be repealed within a time frame that will allow us to recover the accelerated tax payments that we made in 2022.

While we believe that there is bipartisan support for this change, we are less confident than we were a quarter ago that this legislation will pass soon enough to help us this year. By way of reminder, this issue impacts the timing of tax payments and has an immaterial impact on our tax rate. If Section 174 is repealed within the next several months, our free cash flow would benefit by approximately $150 million. Note that our cash flow guidance excludes the impact of transactional costs relating to the pending Transporeon acquisition. While we are not offering quarterly guidance, a few factors are likely to impact the sequential evolution of our financial results as the year progresses.

We expect organic revenue to be down in the Q1 and flat in the first half of the year, reflecting the strong growth in hardware and related offerings that we saw in the first half of 2022. We expect organic revenue to be up in the mid to high single digits in the second half of the year. Influenced by these revenue growth patterns, we expect operating and EBITDA margins to be relatively flat in the first half of the year and up in the second half. While we expect mid-teens organic ARR growth for the year, growth in the first half is likely to be slightly lower, driven by planned churn from a small number of customers. We expect ARR growth to improve sequentially through the year.

From a segment perspective, we expect organic revenue growth for the year in buildings and infrastructure, resources and utilities, and transportation segments, with the strongest growth in buildings and infrastructure. Revenues in the geospatial segment are expected to decline for the year, with the highest levels of organic decline in the first quarter as we lap strong numbers from the Q1 of 2022. Geospatial trends through 2023 will continue to be impacted by reductions in dealer inventory levels and ongoing softness in demand in a number of the segment's end markets. We expect margins to be stable in buildings and infrastructure and resources and utilities. We project growth in transportation margins, while geospatial margins will be down modestly for the year. Back to you, Rob.

Rob Painter (CEO)

Let me thank our colleagues, customers, and partners for their support and their work in our strategic and financial progression. I'm proud to say that we continue to win culture and innovation awards, and proud to announce that we received approval of our emissions reduction targets by the Science Based Targets initiative. Our objective is a 50% reduction in Scope 1, 2, and 3 emissions by 2030. In addition, we released our first Task Force on Climate-related Financial Disclosures report. In 2022, our highlight financial metrics were ARR growth and gross margin expansion. Our 2022 ACV bookings gives us confidence that we can continue to grow ARR at a double-digit rate in 2023. Hardware demand remains the hardest revenue stream to predict. While the signals are mixed and even a bit confusing in the short term, the long-term secular attractiveness remains.

Our ability to uniquely connect the physical and digital worlds provides a guiding light for our business and remains the foundation of our right to win in our served markets. We have surgically reduced our expense structure and moderated spending across the company to ensure discipline and focus in an uncertain environment. What remains certain is our conviction to grow our business by focusing on our customers and continuing to execute our Connect and Scale strategy. Operator, let's now open the line for questions.

Operator (participant)

Thank you. At this time, I would like to remind everyone, in order to ask a question, press star then the number one on your telephone keypad. We'll go first to Jonathan Ho at William Blair.

Jonathan Ho (Partner and Senior Equity Analyst)

Hi. Good morning. I just wanted to maybe start out with the CNH aftermarket deal. Can you maybe give us a little bit more color on, you know, why it makes sense to do this now and what this could potentially do for the resources and utility segment, you know, particularly as you engage more with the independent dealers?

Rob Painter (CEO)

Hey, good morning, Jonathan. It's Rob. Let me break it down in 3 respects: context, strategy, and next steps. For context, let's talk about Connect and Scale. Our strategy means to connect users, data, and workflow. The users are at the center of our universe. In that, we believe we need to be closer to the customers, that user, that farmer. When we talk to the customers, we work with, by the way, over 100 OEMs today, you know, obviously the farmers themselves, wh at they're asking us to do is to help them manage a mixed fleet. I've personally visited farmers in the last 6 months in Mexico, Chile, Brazil, Japan, Australia, Germany, and here in the U.S. The strategy is we go to market strategies.

We sell through multiple avenues today to reach our customers. We have a direct sales, particularly the enterprise farms. We sell through OEMs. We work with over 100 OEMs, and then we sell through a channel. The channel breaks down into a Trimble channel that we already have today to reach the aftermarket, as well as, selling through CNH dealers in the aftermarket. What we're moving from is where we sell to CNH today, let's call it CNH from Trimble to CNH Corporate to reach the CNH dealer. That's the from. The to-be state, we'll be going from Trimble straight to independent dealers.

Those independent dealers will be capable of selling the full line of Trimble kit, which is more than guidance because we also do variable rate, we do selective spraying, we do water management, and we do software. As we look forward to this, as we work through the transition, you know, we need to sign up the dealers to be independent dealers directly with Trimble. We think it can expand the available set of products and capabilities they have to take to market. We think it'll help us be incrementally closer to the end users of the technology and in a context of customer success, which is part of our strategy.

You know, we think we can help customers and those users become more successful with the technology, because when we're out there in the field talking to them, they are asking for help to integrate and manage a mixed fleet of technology as well as a mixed fleet of equipment.

Jonathan Ho (Partner and Senior Equity Analyst)

Got it. You know, just as a follow-up, I think you've also referenced some additional investments that you'd like to make, you know, for that Connect and Scale, you know, in the 2023 timeframe. Can you help us understand where those investments are going to go and, you know, again, you know, maybe why that makes sense to make those investments now given the macro environment? Thank you.

Rob Painter (CEO)

Sure. We've been investing in this strategy incrementally really for the last couple of the last couple of years. Demonstrable evidence of where we see the attractiveness of it and I'd say momentum for it is in the growth of the ARR. The work we're doing up front really is touching more of our software businesses first, and particularly the recurring revenue businesses that we have. A post of 16% organic growth on ARR, the $1.6 billion, this is supporting growth, continued growth in that. I think from a from a shareholder value perspective, this would be the most valuable revenue stream that we have at the company. The investments, to, they pick up systems, they pick up people, they pick up process. From a systems perspective, think customer-facing, think internal-facing.

That's the scale part of Connect and Scale, enabling us to efficiently and effectively grow. When we look at people, and the work that we're doing, we look at customer success. Customer success is about net retention. That's the metric you look at for customer success. The economics of net retention are very, are very powerful. I'm of a mind, we're of a mind that we continue down this path, and if anything, we continue down this path with more conviction. Behind all of this, there's a strong balance sheet, 24.3% EBITDA in the quarter. We believe this is emphatically the right thing to do at this moment.

Jonathan Ho (Partner and Senior Equity Analyst)

Thank you.

Rob Painter (CEO)

Thanks, Jonathan.

Operator (participant)

We'll go next to Rob Wertheimer at Melius Research.

Rob Wertheimer (Founding Partner and Director of Research)

Hey, good morning, everybody.

Rob Painter (CEO)

Hey.

Rob Wertheimer (Founding Partner and Director of Research)

It seems like there's a lot of structural progress in the quarter on margins and on ARR, which is, I guess, continuing. The surprise, I guess, for us was just a bigger destock in the hardware than we would have thought. I had a couple questions around that. One is, were you able to see those elevated levels of inventory, you know, previously at dealers and, you know, are they normal after what you look in your outlook, or are they, you know, low? I mean, if there's any characterization of that. I guess there's been a debate in construction in North America anyway as to whether large projects will fill in as smaller projects go away. That seems to be the case, but maybe the mix of your customers is more fragmented than the big ones.

I'm just trying to look for context around why that decline, you know, happened and is continuing and how big it is.

David Barnes (CFO)

Yeah. Hey, Rob. It's David Barnes. First point I'll make is that the supply chain, the constraints and then the removed constraints has really moved trends around in our shipments and in our dealer inventory, that were hard to predict and in some cases, challenging to understand. Just by way of reminder, we had unsustainably and undesirably high hardware backlog early in 2022. Our supply chain, even today isn't fully freed up, but to the extent that it freed up, it happened very dramatically at the end of Q2. We shipped a lot of product. You'll recall that the hardware revenue was way up at that time frame. Dealer inventories did grew.

I'll say it took us a while to figure out how quickly the dealers were able to find customers for and deploy that inventory. That happened exactly while some of the end markets that our dealers serve, you know, particularly in the geospatial side. There's probably the highest within Trimble level of exposure, direct and indirect, to residential home construction, which slowed. There's some anxiety about the general economic outlook. These two things happened all together, freeing up our supply chain, very big backlog, lots of shipments, and that created the destocking that we talked about a quarter ago, and it has picked up. We're not through it yet. We think we have a pretty good sense of where our dealers wanna be and where they will be over the, over the sustained period of time.

It's my guess that we'll have a, two more quarters, i.e., Q1 and Q2, of, meaningful, inventory reductions in our dealers, and anything after that will be smaller. The guidance we've given reflects that expectation.

Rob Wertheimer (Founding Partner and Director of Research)

Any guess on if those Q2 happen, would dealers be lower than normal at that point? Maybe you don't have perfect visibility into the channel, I understand.

Rob Painter (CEO)

Yeah. Well, what I'll say is we still do have isolated cases of supply challenges in our ag products. This is one of them. I think at that point there may be some reasons for dealers to have a little more inventory than they would have had pre-COVID. Not much though.

Rob Wertheimer (Founding Partner and Director of Research)

Mm-hmm.

Rob Painter (CEO)

You know, our supply is really good. Hey, Rob, the thing I'd remind you on, as we look at this noise of, Q1to another, big increases in the first half of 2022 and the decline, we just reported, Rob had a good chart in his presentation of the multi-year trend. We're still way above where we were. We do think that, a lot of this is the noise of the resetting of the supply chain. That's the bigger factor really than any fundamental change in demand.

Rob Wertheimer (Founding Partner and Director of Research)

That's perfect. Thank you.

Operator (participant)

We'll take our next question from Chad Dillard at Bernstein.

Chad Dillard (Senior Analyst)

Hi, good morning, guys.

Rob Painter (CEO)

Hey. Hi, Chad.

Chad Dillard (Senior Analyst)

I just wanted to go back to the CNH agreement, and just like better understand the medium-term organic growth potential. Maybe you can talk about like what needs to be done to set up the independent channel, and when you expect that to be in place. Just how much of your product portfolio, you know, you'll be able to sell within that channel versus how much you're able to sell with CNH.

Rob Painter (CEO)

Hey, Chad, this is Rob. I'll start with the quantitative framework. I had a chart on the second slide that showed over the last 3 years, the CAGR of the hardware businesses has been 12%. Those 3 businesses are survey, civil construction and ag. Ag's been above that 12% growth over the last 3 years. Ag grew this year. Ag, it grew even more if you exclude Russia and Ukraine, which we were selling quite a bit of kit into Russia. We'll start to lap that later this year, mid this year. Call that context in terms of the growth that we've had, I'll give you some more context.

When we look at, we look at units, we look at pricing, we look at, share of wallet, we look at market share. We think we're holding our own on a global basis, and probably growing in Europe, holding our own in North America, growing in Brazil. If we look now turn to the, to the CNH, part of your question. We're talking about the aftermarket business, that we have with CNH. That business that we sell through CNH into the aftermarket today is primarily guidance. An opportunity we have as we move to independent dealers. Remember, we have independent dealers today. They're Trimble, full line Trimble dealers today in agriculture.

As we move the business that goes through CNH, that gives us an opportunity to expand the product portfolio to a set of independent dealers. Those independent dealers could very well be dealers we already work with today. It just will happen in a direct with a direct relationship with us at Trimble, or it may be a fully new dealer. We have a 12-month transition with CNH on this part of the arrangement, and it's a very positive conversation, I want to say, that we've been having with the CNH with the CNH team. Optimistic here. It's the right thing to do. It's what our customers are asking for, and it's time to get to work to set it up.

Chad Dillard (Senior Analyst)

That's helpful. Just my second question. I was hoping you could give an update on the digital transformation. you know, what % are you done magazine 2023? can you talk about some of the focus areas for this coming year? if you could quantify just like the incremental cost, to execute you're expecting for 2023?

Rob Painter (CEO)

I'll start with the second part. The incremental cost is about 100 basis points to the bottom line, consistent with what we had this year as well. That's the cost side of the equation. On the focus side of the equation, you know, the digital transformation, there's a, let's say a meta theme. It's more than a system transformation for us. You know, I think about people, I think about process, I think about systems and the systems themselves, and then we think about the go-to-market aspects of the digital transformation. It's primarily focused right now on supporting our software businesses, particularly the software businesses within buildings and infrastructure. That connects with the Trimble Construction One dialogue that we've had with you and others.

First point of reference I look at is continuing to grow the ACV bookings, which is the leading indicator for the growth of the ARR. We look at net retention as a key metric as well with inside that go to market. We look at the organization of the sales team itself and the go to market. So in France, Benelux, you know, we put the construction sales team together, software team, as one organization. We've mostly done that in North America as well. It's getting the sales team aligned to sell a consolidated offering of Trimble Construction One. With Trimble Construction One, it started out as a general targeted to general contractors. We will be releasing more persona-based bundles.

You know, remember we sell to owners in the public sector, we sell to architects, and engineers. We have targeted portfolios to sell to those personas with a go-to-market team, a sales team that comes more and more together as one organization to be enabled and equipped to sell everything that we do. On the system side, in the Q2, we'll have a next, I'll say, big release of the systems. Those systems are meant to increase the efficiency and effectiveness of our own sellers. It moves us closer and closer to having commerce capabilities, e-commerce capabilities from an external with an external lens. On the people side, we continue to invest in customer success.

On the process side, we continue to invest in developing the playbooks, for how we go to market, starting with that software business, but then the next wave after that goes, into software and other parts of Trimble, and then into the hardware that we sell through our dealer channels. You know, I was asked a question, earlier in the call about visibility into dealers and their inventory. This is another reason that we think that these systems investments, are a good thing for us to get increased levels of precision on that visibility. Hope that helps, Chad.

Chad Dillard (Senior Analyst)

That's helpful. Thank you.

Operator (participant)

We'll go next to Kristen Owen at Oppenheimer.

Kristen Owen (Executive Director and Senior Analyst)

Great. Thank you for the question. I wanted to ask about the e-Builder, Viewpoint, SketchUp, contingency. This business is obviously doing quite well and a pretty stark contrast to, you know, some of the more, conservative macro view that you've expressed. Even just on an ARR growth basis, really strong compared to some of the peers in the software space. You know, we've talked about the macro, I'm just wondering from a portfolio basis, if you can speak to the playbook with these businesses, what's working in this environment, and just how you intend to port those lessons learned over once the Transporeon acquisition closes.

Rob Painter (CEO)

Sure. Good morning, Kristen Owen. This is Rob. I'll answer the question. You're correct that contingent of businesses is doing very well, and it's even more than e-Builder, Viewpoint, SketchUp. It's from our Tekla Structures offering, our mechanical, electrical, plumbing software as well, our project management software. Really, the whole contingent is performing. I'll say one thing that is nice on the software side and the recurring revenue is certainly you get a higher degree of predictability. There is not a wholesale in between the retail. You get a clear view of the demand.

Which is why, by the way, on the hardware side, we're looking back at the three-year trend on the CAGR so that we can see the signal through the noise. In terms of what's working with it, I would say it's the value proposition meets the digitization of the market. Call it the secular aspect of digitization. I've had a chance to meet with a number of construction companies during my travels over the last months. Was with one of the largest European contractors in the world yesterday here in Colorado. Digitization and data and sustainability are at the top, very top of the agenda of those customers, they know they need to adopt technology in order to further their strategies.

Most of these, many, most of these companies have solid backlog and they need technology to help them get the work done. From a value proposition perspective, we're hearing strong resonance with the, I'd say, both the integrated and connected offerings, and Trimble Construction One certainly seems to have resonance with the customers that we're talking to. Even in its early form that it is, that we see that. As evidence of that, we had a record level of cross-sell ACV bookings in buildings infrastructure in the Q4. That tells me that there's, it's not just marketing resonance, it actually has resonance in terms of turning into business. The value proposition, it's around a connected offering.

You know, customers increasingly are looking to move from optimizing tasks to optimizing the system. To do that, they need to have more connected data and more connected workflows. We're hearing customers say they because this is where they want to go, they want to buy it from one company as opposed to having to stitch together multiple, let's say, multiple vendors on their own. They like the ease of the dealing with the one company or even the one overall account representative. There's an aspect of ease to doing business with us meets a level of connectivity, which is ultimately they're trying to get to do their work better, faster, safer, cheaper, greener, and it is resonating.

Kristen Owen (Executive Director and Senior Analyst)

Thanks for that, Rob. You know, porting some of those lessons with Transporeon, how you see maybe some of that value proposition or combining the offerings, how you see that bleeding into the transportation business once that acquisition has closed.

Rob Painter (CEO)

Yeah, sorry, I forgot about that. Great, yeah, thanks for the question. On Transporeon, I'd say the great news with Transporeon is they already have that through the 140,000 carriers, the 1,400 shippers in the network, 3,000 integrations with ERP and warehouse management systems, and already last year at 25 million transactions run through the system. It is definitively a platform.

A company really in the mode of Connect and Scale. They have a set of connected capabilities. They're selling it through a dedicated sales force. There's a land and expand play within that. There's strong net retention. There's strong gross retention in the business. Actually, I see as much that we can take from Transporeon to Trimble as much as I think that we could take aspects of Trimble into the Transporeon business.

David Barnes (CFO)

It's one of the many reasons, I'm excited by that is because I think it will be DNA additive to us as were, and I know you know this, as were e-Builder and Viewpoint acquisitions were additive to us at Trimble to take the best of, and take it to other model transitions, that we've done. I see the same thing in store with Transporeon.

Kristen Owen (Executive Director and Senior Analyst)

That's super helpful. I'll leave it there. Thank you.

David Barnes (CFO)

Thank you.

Operator (participant)

As a reminder, if you would like to ask a question, please press star one. We'd also like to ask you to limit yourself to one question and one follow-up to allow everyone an opportunity to ask a question. We'll move to our next question from Tami Zakaria at JP Morgan.

Tami Zakaria (US Machinery, Engineering and Construction Analyst)

Hi. Good morning. Thanks so much. hope everyone is doing well. My first question is the gross margin rate expansion, 200-250 basis points, how much of that is price cost tailwind, how much of that is software versus hardware mix change? Are there any other factors driving this leverage this year?

David Barnes (CFO)

Hey, Tami, it's David. The way to think about that is essentially all of the gross margin improvement is the evolving mix of our business. We are continuing to take price, mostly in hardware, but at a lower rate. That's not real the margin driver. What's driving our margins up is we're becoming more and more of a software business, and those have higher gross margins.

Tami Zakaria (US Machinery, Engineering and Construction Analyst)

Got it. If prices keep coming down, input prices, could that be a source of upside to your gross margin rate?

David Barnes (CFO)

You know what? It's a number of puts and takes in our hardware gross margin. We've already seen a benefit. In the third and fourth quarter of 2022, we got to the point where for our hardware businesses, our price realization more than offset our cost improvements. That's sort of baked into the run rate now. We are continuing to take pricing at a moderate level in our hardware businesses. That ought to help our margins just a little bit on the hardware side. The by far bigger story is the mix shift.

Tami Zakaria (US Machinery, Engineering and Construction Analyst)

Got it. One quick one. I wanted to go back to the destocking comment. Can you talk about what sales to end users look like in the Q4 against the dealer destocking you saw? Did sales to end users overall moderate in Q4 versus the Q3?

David Barnes (CFO)

Yeah. Let me frame it up this way. If we look at our dealer destocking, I would say it had a negative approximately 400 basis point impact on our organic revenue trends, so we reported flat. We would have been roughly up 4% without the dealer destocking. If you look specifically at hardware, our hardware revenues organically were down 13. I think you can infer, Tami, that there was some end market softness, particularly on the geospatial surveying market in Q4, which partly we think is temporal. You know, we had a lot of new products last year, and as in many businesses, when you have new products, you get a spike in orders, and we had a clean supply chain to deliver those through.

We've got a bit of a pullback for that reason. You know, fundamentally, I would say, the secular end market sales to retail trends feel up, maybe not up as much as they were earlier in 2022, but the general direction is up. There's some soft areas, including anything tied directly to residential construction that is clearly contracted. On the balance with what's happening in infrastructure, we think the secular direction of demand is up. With the dealer destocking and the customer ordering patterns earlier in 2022, we're seeing a pullback for those reasons.

Tami Zakaria (US Machinery, Engineering and Construction Analyst)

Got it. Very helpful. Thank you.

Operator (participant)

We'll go next to Jason Celino at KeyBanc Capital Markets.

Jason Celino (Managing Director & Equity Research Analyst)

Hey, guys. Good morning. Just a couple quick ones. I think you mentioned churn in the first half impacting the ARR growth. You know, what type of customers or what segment are you seeing these come from?

David Barnes (CFO)

Yeah. Hey, Jason, it's David. We do expect churn from a handful of customers, principally in our transportation segment. These are customers that made a decision to come off our platforms many quarters ago, and they're just now implementing them. I see that as noise, not signal. Our customer satisfaction and retention in transportation is on a secular positive trend. We just expect to see a number of these probably in the Q1 pull off. That will reduce our ARR growth rate a little bit lower in Q1 from what we expect to see for the full year.

Jason Celino (Managing Director & Equity Research Analyst)

Okay. Maybe if I were to, you know, really simplify it, your construction software portfolio seems to be executing, you know, quite well. It's, you know, completely different drivers than the hardware de-stocking elements. Are you seeing any macro impact on this construction software portfolio? Thanks.

Rob Painter (CEO)

Short answer is no, not seeing an impact on the software portfolio.

Jason Celino (Managing Director & Equity Research Analyst)

Okay. Excellent. Thanks.

David Barnes (CFO)

You're welcome.

Operator (participant)

Our next question comes from Jerry Revich at Goldman Sachs.

Jerry Revich (Managing Director and Senior Equity Research Analyst)

Yes, hi, good morning, everyone. Rob, I'm wondering if you could just talk about the progress on Trimble Construction One, what proportion of new orders does it account for now? You know, when we last caught up, you were seeing triple the ASP versus base orders before. I'm wondering if that trend has continued.

Rob Painter (CEO)

Hey, Jerry. Good morning. On TC1, the Trimble Construction One, the best evidence I can give you on the progress is that comes in the form of the record level of cross-sell and upsell that we had in the quarter from an ACV bookings perspective. The reality is not all of that is the Trimble Construction One branded portfolio. There's sub-aspects where we can just sell across the portfolio, which, I'd say is a subset really of TC1. There's that cross-sell is a percent of the total ACV bookings and buildings infrastructure software was nearly 30%. For us, that's was record dollars, record percentage level.

You know, when we go through the business reviews, you know, we look at almost every account to look at what they're buying and why they're, why they're buying it and looking at the competitive win ratios. What we're seeing is, when we're selling the bundled offerings, whether it's less than the full TC1 offering or it's TC1, is we're seeing the sales cycles reduce, we're seeing the size of the bookings go up, we're seeing the win ratios go up as well. In aggregate, it looks to be a winning formula. I would add to that, Jerry, that it's still relatively early in the game for us.

With the sales kickoff meetings, that we've been having in the last weeks, it is really a big emphasis to the team. To get the offering out to the general contractors, and then the next personas after that in architecture, engineering, owners, and public sector, and then geographically rolling that out as well and aligning the sales team behind that, and then actually doing the sales enablement work underneath the covers, which is critical to help the sellers with their effectiveness. I'd say, Jerry, lots in aggregate or in sum, I think lots of good things happening on this front, and we'll keep updating you here every quarter.

Operator (participant)

We'll go next to Rob Wertheimer at Baird.

Rob Mason (Senior Research Analyst)

Yes. Good morning. First question, I just wanted to clarify a comment from earlier. I think around the cost for Connect and Scale, there was mention of 100 basis points. Is that what is built into the 2023 guidance, or was that the cost for 2022? Maybe just as a extension to that question, can you just talk about where you've settled now on the maybe the model that you plan to implement on the hardware, software bundles that are transitioning those conversions? I think there were several options presented at the Investor Day. I'm just curious. Can you speak to the, you know, maybe what year one, year two economics will look like on those?

David Barnes (CFO)

Yeah. Hey, Rob. It's David Barnes. I'll try both. On the Connect and Scale discrete investments, spending on that 2022 versus 2021 was about 100 basis points, around $40 million. Embedded in our guidance for 2023 is a deceleration in the rate of growth. We'll spend somewhere in the order of another $20 million or a little more than that incremental, 2023 above 2022. We still have more work to do, and we believe this is a high priority investment. With regard to the model options, I'll say the menu that we presented at the Investor Day is still out there. This topic is tied with digital transformation.

Our ability to sell hardware and software bundles together in a recurring basis is heavily dependent on the rollout of our digital transformation. We're doing it in a somewhat agile way now. The bulk of that opportunity is ahead of us, and all the options that we showed at the Investor Day are still options we're considering.

Rob Painter (CEO)

Rob, I'm gonna add just a bit of context too on top of the Connect and Scale investments. 'Cause it's a capital allocation call, we've taken down spend in other parts of the company in part to help fund what we're doing here. We've thought a lot about the cost management aspect of our model. If we look over the last three years, organically, ARR has grown double digit over 12%. Total revenue has grown 6%. The gross margin dollars have grown faster than that as the mix shifts more software-centric. And our total headcount organically has grown 2% over that timeframe. A third of total revenue growth, a sixth of the ARR growth.

It's very much in context of how we're thinking about allocating capital at Trimble and where we're putting it to work.

Rob Mason (Senior Research Analyst)

Well, maybe as a follow-on to that, Rob, you know, Transporeon, you know, following that completion of that, you will be in somewhat of a deleverage mode. How much flexibility are you giving yourself for, you know, to be able to do a transaction like, I guess a Ryvit, or, you know, something along those lines, I guess, you know, on the capital allocation side to supplement Connect and Scale?

Rob Painter (CEO)

Let's say from a flexibility, if we're talking acquisition and deployment of the balance sheet, I would say here in the next 12 to 18 months, not a lot of flexibility because we, you know, our primary commitment is to deleverage. Certainly anything at scale, I would say we've limited some flexibility of the balance sheet. Now if it's not at scale, if it's whether it's a Ryvit-size acquisition or it's Trimble Ventures, where, you know, we've put single-digit millions to work, in that aspect, I would say we do retain some flexibility with caution to, you know, stay close to making sure we understand our model and that we're taking a relatively conservative view of the balance sheet.

Now mapped to the P&L, let's not forget that, you know, in 2022, 38% of our total revenue is now recurring, $1.6 billion that's grown, and we believe will grow double-digit again next year. Our P&L has more visibility than it's ever had, and therefore, the business model's got more resilience. We maintain the investment grade. I look at those factors all together, and I'd say there's, you know, there's flexibility on a smaller size of capital deployment, not a lot of flexibility on transformative size deals for the next couple of years.

Rob Mason (Senior Research Analyst)

Sure. Very good. Thank you.

Rob Painter (CEO)

You're welcome.

Operator (participant)

We'll go next to Arseny Pletnev at Wolfe Research.

Arseny Medovik (VP, Equity Research)

Hi, this is Arseny on for Gal. Thanks for taking my question. Wanted to follow up on a prior question regarding digital transformation. How is the progress for revenue being transacted through the connected digital platform tracking versus your expectations? Where did that shake out as a portion of revenue for FY 22? At the Investor Day, I believe 2% of revenue had been expected to be the target as communicated. Was that met or exceeded? Do the projections shared at your investor base still stand for the portion of revenues expected to transact through the digital platform in the future? Just one brief follow-up. Thanks.

Rob Painter (CEO)

Short answer is yes.

David Barnes (CFO)

Yeah. With the 2%, our business in Europe, and that's live, and working, and we're just about to roll out the next phase principally to our North American software businesses, and with further rollouts from there. We're moving forward.

Arseny Medovik (VP, Equity Research)

Got it. That's all. Thank you. Just 1 follow-up. Has anything changed from the time Transporeon was announced that would maybe alter the expectations for revenue and EBITDA initially communicated at the announcement of the acquisition or everything all good there still?

David Barnes (CFO)

Yeah. Look, the, we communicated the financial parameters there. We still don't own the business. Obviously, we're talking to them, but we have no update to our outlook, and we'll update that outlook once the transaction closes at some point, in the first half of this year.

Arseny Medovik (VP, Equity Research)

Got it. Thank you, guys.

David Barnes (CFO)

Sure.

Operator (participant)

That does conclude our question and answer session. I'd like to turn the conference back to Michael Leyba for closing remarks.

Rob Mason (Senior Research Analyst)

Thank you, everyone, for joining us on the call. We look forward to talking to you next quarter.

Operator (participant)

This concludes today's conference call. You may now disconnect.