By The Valuentum Team
Trimble (NASDAQ:TRMB) is a market leader in a number of large, growing verticals. The firm's core end markets are characterized by being in the early phases of technology adoption. It continues to work to deepen its wallet share of each of the end markets it serves. For example, the company addresses the entire construction workflow and offers efficiency solutions via machine control and positioning technology, as well as Building Information Management software. Trimble offers similar solutions in the areas of agriculture and transportation and logistics, among others.
While Trimble has benefited from strong performance in its 'Building Construction' and 'Transportation and Logistics' segments, the company's geospatial business in the 'E&C' segment has suffered due to the recent collapse in oil prices, as has its 'Agricultural' segment due to weakness in agriculture-related commodity prices. As a result of this pressure, total revenue fell ~4% in fiscal 2015. In addition to the cyclicality of its commodity-driven end markets, the intense competitive nature of its industry provides risk to Trimble's operations. Continual product development will be vital to keep the firm competitive.
Moving forward, Trimble plans to grow revenue by continuing to target underserved market segments and accelerating product development. The firm is also is shifting its focus to grow recurring revenue as a percentage of total revenue, a strategy we very much like and one that will help mitigate cyclicality in its end markets served. Recurring revenue reached ~27% of total revenue in 2015, for example, up from ~9% in 2014. A record backlog in Trimble's 'Mobile Solutions' segment is also encouraging as management continues to work to return to growth in 2016. We'll be monitoring Trimble's performance relative to management's expectations closely.
Trimble's Investment Considerations
• Trimble is best known for its GPS technology, but it offers a wide range of positioning technologies. The company's Field Solutions segment generates nearly 40% operating margins. It generates roughly 55% of its revenue in North America. The company was founded in 1978 and is headquartered in Sunnyvale, California.
• Trimble has made over 100 strategic acquisitions since 2000 to augment organic growth. Generally the targets have been in the technology market or an adjacent industry. 80% of these transactions have been less than $25 million, but the firm has a solid track record of execution following said acquisitions.
• After a down year in 2015, we're expecting a return to growth for Trimble in 2016. The company is anticipating strong deferred revenue and a record backlog in Mobile Solutions to boost results as it continues to shift its business towards software and recurring revenue. In 2015 software/services/recurring revenue accounted for 47% of total revenue, compared to 32% in 2012.
• The company's historical financials are a sight to see. Revenue has advanced steadily to more than $2 billion from roughly $250 million in 1999, while non-GAAP earnings-per-share has leapt significantly from under $0.20 over the same time period. We expect continued top- and bottom-line expansion.
• The firm's markets are highly competitive, and we expect competition to increase in the future, particularly from emerging markets such as China and India. We think gross margins should be watched closely.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Trimble's 3-year historical return on invested capital (without goodwill) is 39.6%, which is above the estimate of its cost of capital of 10.2%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
The concept of an economic moat - or sustainable competitive advantages - focuses purely on the sustainability and the duration of the competitive advantages that a firm possesses. The concept of an economic moat does not consider the cumulative sum of a firm's potential future economic profit creation, but only that at some point in time in the future, a moaty company will continue to have an economic profit spread and a no-moat firm will not.
Let's examine the problem that arises by focusing exclusively on companies that have economic moats, or sustainable and durable competitive advantages.
Image Source: Valuentum
In the chart below, we show the probable path of Trimble' ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Trimble's free cash flow margin has averaged about 14.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Trimble, cash flow from operations decreased about 14% from levels registered two years ago, while capital expenditures fell about 38% over the same time period.
In the first quarter of 2016, Trimble reported cash from operations of ~$113 million and capital expenditures of ~$5 million, resulting in free cash flow generation of ~$108 million, a 12% increase from the first quarter of 2015.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think Trimble is worth $21 per share with a fair value range of $17-$25. Shares are currently trading at ~$26, just above the upper bound of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at the moment.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
We're expecting a top-line growth rate in the mid-single digits for 2016 and 2017, which is consistent with consensus estimates and similar to management expectations for the near term. We're projecting earnings per share growth to outpace that of revenue growth as the firm targets margin expansion in coming years.
Our model reflects a compound annual revenue growth rate of 4.5% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 3.9%. Our model reflects a 5-year projected average operating margin of 17%, which is above Trimble's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.3% for the next 15 years and 3% in perpetuity. For Trimble, we use a 10.2% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $21 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Trimble. We think the firm is attractive below $17 per share (the green line), but quite expensive above $25 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Trimble's fair value at this point in time to be about $21 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Trimble's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $29 per share in Year 3 represents our existing fair value per share of $21 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.