FLIR Systems, Inc.
Q2 2018 Earnings Call Transcript

Published: 25 Jul 2018

[Operator:]

Greetings and welcome to the FLIR Systems Second Quarter 2018 Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow with formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce Jay Gentzkow. Please go ahead.

[Jay Gentzkow:]

Good morning, everyone. Please note that our earnings press release and presentation slides that will be referred to on this call are available under the Events & Presentations section of www.flir.com/investor. Before we begin this conference call, I need to remind you statements made on this call other than historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and are based on our current expectations. Words such as anticipates, estimates, expects, intends, and believes, and similar words and expressions are intended to identify forward-looking statements. These statements are subject to risks and uncertainties that could cause actual results to differ materially. Please refer to the press release we issued earlier today for a description of factors that could cause actual results to differ materially from those forecasts. The forward-looking statements we make today speak as of today and we do not undertake any obligation to update any such statement to reflect events or circumstances occurring after today. We will be discussing our results for the quarter primarily on an adjusted non-GAAP basis. We believe that non-GAAP information is useful because it can enhance the understanding of our core ongoing operating results and facilitate consistent comparison of results overtime. A full reconciliation between GAAP and adjusted measures is in our press release this morning. Let me now turn the call over to Jim Cannon, President and CEO of FLIR Systems. Jim?

[James Cannon:]

Thank you, Jay, and thank you, everyone for joining FLIR second quarter 2018 earnings call. With Jay and me today are Carol Lowe, our CFO; Todd DuChene, our General Counsel; Travis Merrill, President of our Commercial Business Unit; Frank Pennisi, President of our Industrial Business Unit; and David Ray, President of our Government & Defense Business Unit. The second quarter was another successful quarter from a growth and profitability standpoint. We grew our top-line double-digit organically, meaningfully expanded gross and operating margins, created strong operating leverage down to the bottom-line and improved cash flow generation. I’ll start the review of the second quarter on slide three of the presentation. This morning we reported second quarter revenue of $453 million, which was an increase of 4% over the second quarter of 2017. When you exclude the second quarter 2017 revenue of the Security business, we divested in early-February, organic top-line growth was 11%. Adjusted gross profit also grew 11%, expanding 330 basis points over the second quarter of 2017. We also saw adjusted operating income growth of 26%, expanding 390 basis points in comparison to last year. We demonstrated strong leverage, by growing operating income well ahead of revenue growth. Adjusted earnings per share for the quarter was $0.55, which represents 31% growth versus last year’s adjusted earnings per share of $0.42. EPS was favorably impacted by 100 basis point decrease and our effective tax rate in the quarter versus our operating plan expectation. Due to geographical mix of taxable income. Operating cash flow for the first six months of 2018 increased to $153 million and grew 46% over the same period of 2017, driven by improved profitability and lower working capital levels. Total company 12 month backlog finished the quarter at $596 million, equal to the balance at the end of the first quarter. The team has been deliberately working to lower backlog in certain divisions, utilizing the FLIR Method, particularly in instruments and integrated imaging solutions. These efforts are aimed at reducing lead times to more consistently position the division closer to a book and build level. We remain confident in our ability to continue to grow our long cycle backlog. While we expected first half 2018 growth to be stronger than the second half performance exceeded our expectations. As a result, we are updating our outlook for the full year 2018 results shown at the bottom of slide three. We now expect revenue to be in the range of $1.78 billion to $1.8 billion and full year adjusted earnings per share to be in the range of $2.17 to $2.22. When you exclude the results of the divested Security business from 2017, these ranges represent organic revenue growth of 7% to 8% and adjusted earnings per share growth of 15% to 18%. This outlook assumes our effective tax rate will be 20.5% through the remainder of 2018. We also announced today a quarterly dividend of $0.16 per share, which will be payable on September 7th to shareholders of record as of August 24th. Moving to slide four, we launched a host of new products in the quarter, which we’re very excited about. The Commercial Business Unit’s Raymarine business introduced the XL version to its Axiom line of multifunction displays. Designed for premium yachts and glass bridge installations the Axiom XL offers the largest screen size in the Axiom family and the superior performance and simplicity that the award winning Axiom line has delivered since it was introduced last year. In May, the Raymarine business also introduced the Magnum high performance open array marine radar, including many of the same radar technologies trusted by the United States Coast Guard. Magnum provides enhanced target tracking, reliable performance and superior image detail packaged in a sleek open array pedestal, built to withstand the harsh marine environment. Also in May, the Commercial Business Unit Security division launches Saros, FLIR's next generation outdoor security camera line. Saros combines various parameter protection technologies, including multiple Lepton thermal sensors into a unified solution to deliver accurate, actionable alerts and verified alarm data. The Saros camera line represents the new security paradigm for wide area commercial businesses to utilize reliable, state-of-the-art outdoor intrusion detection in a cost effective manner. In June, the Government & Defense Business Unit announced our latest Nano UAS, or Unmanned Arial System the Black Hornet 3. This third generation of the Black Hornet PRS or Personal Reconnaissance System adds longer range indoor flight capabilities and incorporate sharper image processing featuring our Lepton Thermal Micro Core. At 32 grams, it's still the world's smallest, combat proven Nano-UAS equipping warfighters with immediately actionable intelligence, target acquisition and reconnaissance capability. The Black Hornet 3 is representative of FLIR’s new focus on providing full solution technology, and we look forward to playing a role and helping modernize our military customers. At the Special Operations Forces Industry Conference, or SOFIC, the Government & Defense Business Unit announced three new products for use by global militaries and government agencies, including border petrol and the dismounted warfighter. Two additions to our Ranger Family of radars, the R8SS-3D in the R8SS offer mid-range detection capabilities, filling a critical mission gap. The R8SS-3D detects both air and land objects and can report the altitude and location of small drones that ranges of up to 2 miles. Both the R8SS-3D and the R8SS the latter of which offers land detection only can detect over 500 threats and their exact location simultaneously. The third product announced is the latest in the FLIR Recon series, the Recon V UltraLite. This lightweight thermal monocular weights less than 3 pounds and can be used as a handheld device or mounted to a fixed location for advance surveillance capabilities. These new products demonstrate our commitment to delivering the most advanced equipment to our military customers, our heroes. In June, the Industrial Business Unit OEM business announced the availability of a machine learning thermal dataset for development with Advanced Driver Assistance Systems or ADAS, featuring a compilation of more than 10,000 thermal images, it's the first of its kind to include annotations for cars other vehicles, people, bicycles and even dogs. The machine learning thermal dataset enables automotive researchers and developers to accelerate testing of thermal sensors on self-driving systems. Recent high-profile autonomous driving related accidents show a clear need for affordable intelligent thermal sensors to enable safer autonomous vehicles. Also in June, the Industrial Business Unit's Instruments division introduced FLIR InSite, a new mobile application and web portal for organizing client information and thermal inspection data in one location. Ideal for electricians, electrical contractors and thermography service professionals, the InSite workflow management tool reduces inspection preparation time, increases efficiency and helps to deliver results quickly. As we move more towards intelligent imaging solutions InSite empowers inspection professionals to deliver a better customer experience and visually demonstrate the value of their services. Let me now turn the call over to Carol and have her review the second quarter financial and operational highlights. Carol?

[Carol Lowe:]

Thank you, Jim. On slide five you’ll see our second quarter financial results. Please note with the exception of cash flow all of these financials are on a non-GAAP basis. Reconciliation to GAAP data is included in the filed appendix. Consolidated revenue for the quarter was $453 million a 4% increase year-over-year and 11% on an organic basis. Geographically and on an organic basis revenue growth in the U.S. was 14%, while Asia was up 22% year-over-year with strength across all business units. Europe and Middle East regions were largely flat compared to the prior year and Canada and Latin America revenues declined by 7% compared to prior year due to expected Government and Defense delivery timing. Revenue to the U.S. government was 27% of total revenue and increased 8% versus the second quarter of 2017. Adjusted gross margin improved 330 basis points year-over-year to 52%, driven by product mix, new products and the FLIR Method’s impact on sensor yield improvements. Overall adjusted gross margin improved across all three business units. It was also our sixth consecutive quarter of gross margin expansion. Second quarter adjusted operating margin was 23% 390 basis points higher than last year, driven by the improved gross margins and controlled operating expenses growth relative to top-line growth. Adjusted net income for the second quarter of 2018 was up 33% to $77 million and adjusted earnings per share was $0.55, 31% higher than prior year. Adjusted net income was favorably impacted by a 540 basis points decrease in our expected tax rate versus Q2 of the prior year. This was primarily due to the enactment of the U.S. Tax Cuts and Jobs Act, as well as a geographical mix shift of our taxable income. We now expect our effective tax rate to be approximately 20.5% for 2018. Cash flow from operations for the first half of 2018 increased to $153 million, a 46% increase over the same period last year, driven by earnings and improvement in working capital levels. During the first half of the year we repurchased 2 million shares at an average price of $50.52. With these repurchases and $44 million in dividends paid we returned $144 million to shareholders during the first half of 2018. Despite these uses of cash, we increased our cash balance by $56 million during the second quarter to $508 million. At the business unit level we saw double-digit growth in Industrial and Government & Defense and strong growth across all three of our business units on an organic basis. Business unit level operating margins increased 350 basis points over the second quarter of 2017. As Jim mentioned, we have revised our guidance for the full year. Revenue expectation is now $1.78 billion to $1.8 billion. And full year adjusted EPS expectation is now $2.17 to $2.22, representing organic revenue growth of 7% to 8% and adjusted EPS growth of 15% to 18% when you exclude the divested security businesses. This guidance incorporate our first half performance in comparison our operating plan and a lower than expected tax rate. We continue to expect slower growth in the second half than we saw in the first half. And we begin to lap the strong performance in the second half of 2017. Turning to slide six to review how each of the business units contributed, organic revenue and operating income increased across the board. On the left side of the slide, second quarter revenues for the Industrial Business Unit was $188 million, up 14% from Q2, 2017. Broad product line growth year-over-year drove this increase, with particular strength in optical gas imaging, automotive and industrial UAS. Operating income for the industrial business was $58 million, 23% higher than the prior year. Operating margin improved 230 basis points year-over-year, mainly due to product mix and productivity gains driven by the FLIR method. The Government & Defense Business Unit have revenue growth of 11% year-over-year. Deliveries of gimbaled systems for the EO/IR-FP program, DR-SKO shipments and UAS system helped drive this top-line growth. Government and Defense operating profit increased 19%, compared to the second quarter of 2017. Healthy product mix and controlled operating expense growth resulted in positive operating leverage in the quarter, with operating margin expanding 210 basis points. During the second quarter, Government and Defense bookings grew 6%, driven by orders for gimbaled systems and handheld recons. While year-over-year backlog declined 12% to $352 million, mainly due to timing of orders and the DR-SKO program our book-to-bill of over one-time for the quarter is a strong indication of our continued focus on winning new programs and executing our growth strategy. Notably in the quarter, we booked a $2.6 million order for the Black Hornet Nano-UAS system from the U.S. Army for the first phase of the Soldier Borne Systems program, a franchise program for FLIR Government and Defense that continues to cement our worldwide leadership in the Nano-UAS market. On the right side of slide six is a summary of the Commercial Business Unit. Commercial second quarter revenue was down 17% year-over-year, due to a prior year comparable that included the security businesses that were divested early this year. Excluding the divested revenue from 2017 Commercial second quarter revenues grew 5% over last year. Continued market embrace of the Raymarine Axiom line of multifunction displays was the primary driver of the performance in the second quarter. As a reminder, the second quarter is the strongest calendar quarter for the maritime division. We also showed revenue growth in both Outdoor and Tactical System and Intelligent Transportation Systems division. Primarily driven by increase thermal product sales. Operating income for Commercial business increased 12% year-over-year, operating margin improved 430 basis points over the prior year, primarily due to product mix including a prior year comparable that included the previously mentioned lower margin Security businesses, as well as productivity gains driven by the FLIR Method. As part of our continued effort to fuel, feed and focus our business, we have made the decision to reorganize our Outdoor and Tactical System or OTS division in the Commercial Business Unit. Utilizing the FLIR Method to reduce complexity, strategic initiatives are underway including product portfolio simplification, facility consolidation, channel optimization and shifting the focus of the business, primarily to professional end users, including law enforcement and government agencies. While this will require a near-term investment, we believe it will yield revenue growth and stronger profitability in the long-term, this will position the business for sustained success. This concludes my summary of the financials and the business unit. I’ll now pass the call back over to Jim.

[James Cannon:]

Thank you, Carol. The quarter was a success on many fronts. We delivered strong organic revenue growth, expanded margins, created solid operating leverage and improved our cash flow generation. This enabled us to raise our full year top and bottom-line guidance. Our performance is a testament to the team’s execution and commitment. But we still see areas where we can improve as a company. Our working capital turns improved slightly in the quarter, but we have work ahead to achieve our commitment of 4.5 times by 2021. And there are still many opportunities for continuous improvement by leveraging the FLIR Method, as we progress on our journey to become a world-class operating company. With the second half of 2018 already underway, we’re committed to sustaining our momentum to deliver for our customers, employees and shareholders. I want to thank everyone who attended our Investor Day in New York in May. It was an outstanding turnout and we were thrilled to have the opportunity to communicate our strategic priorities. Our strategic priorities to fuel, feed and focus our business with the FLIR Method as the foundation, as well as our financial objectives for the coming years. We’re certainly enthusiastic of what’s ahead for our company. In closing, I want to remind everyone of our daily tasks to consistently exceed our commitments with integrity and our purpose, which is to innovate the world’s six sense in order to save lives and livelihood. We operate with our be FLIR values to be brave, be bold, be ready and be ambitious. These values are center of the FLIR Method and they drive speed, innovation, integrity and a winning culture. I’ll now open up the call for Q&A. Operator?

[Operator:]

Thank you. We’ll now be conducting a question-and-answer session. [Operator instructions] Our first question is coming from Noah Poponak from Goldman Sachs. Your line is now live.

[Noah Poponak:]

Hey, good morning, everyone.

[James Cannon:]

Good morning, Noah.

[Noah Poponak:]

Jim, I wanted to follow-on the free cash flow and sort of the comments you made just in your closing remarks there, where you indicated that you had sort of started to get some working capital improvement, but maybe a long way to go on that. Because the free cash in the quarter is really strong, I mean, if I just annualize that quarter that would your 2021 target. And your 2021 target looks to imply only kind of 3% to 4% growth in the free cash flow dollars annually from here to there depending on where you are in this year. And so maybe give us -- put a little more color around why it was so good in the quarter? And then, I know you just gave the number, but how you’re feeling about that 400 given that it actually kind of looks a little light relative to where you’re trending there?

[James Cannon:]

Well, we’re certainly going to work hard not stop at 400 if we can exceed that number, but I would say in the quarter and in the first half really driven by the increased profitability. We’re not seeing yet the kind of improvements that we want to see through the FLIR Method in working capital. So we really had very modest improvements in working capital turns in the first half and certainly in the quarter, but beginning to make some momentum. Lot of room as we talked about at the Investor Day with our inventory levels not arbitrage between AR and AP. But though the work that we’re doing with the FLIR Method is really not manifested itself there. So really the performance in the first half is driven by the increased profitability. Carol, you have anything to add?

[Carol Lowe:]

Jim I agree 100%, Noah, I will note that as you start to focus on working capital you usually will identify a few areas of some low hanging fruit and especially on our receivables as we focused on some past few balances. Again as we’ve discussed before or not because there was risk from a bad debt exposure, but just the discipline around it the teams did a good job at going after some of those past dues and reducing the percentage there. So we benefited in addition to the strong profitability for the quarter, getting the benefits of some of that low hanging fruit. And going forward, we know the challenges get tougher especially as we focus on improvements in our inventory turns.

[Noah Poponak:]

Got it, that’s helpful. And then, Carol, can you quantify how much Lorex revenue comes out in 2018 versus 2017, just like in square up the organic versus the reported for the year?

[Carol Lowe:]

So the total revenue for the divested Security businesses was approximately $140 million in 2017 and there’s only -- there’s about $9 million that made up Q1 of 2018 and we divested of the business in early February 2018.

[Operator:]

Thank you. Our next question is coming from Drew Lipke with Stephens. Your line is now live.

[Drew Lipke:]

Yes, good morning Jim, Carol. Thanks for taking the question.

[James Cannon:]

Morning, Drew.

[Drew Lipke:]

So you called out strength in automotive and industrial and you also highlighted industrial UAS, I think, this is the first time I can recall auto being a driver here. And I know these are you franchise opportunities for you and it sounds like maybe this would be more material contributors maybe sooner than expected. I'm curious how material were each of these and how quickly should we expect that growth to ramp for both of these franchise opportunities?

[James Cannon:]

Well, as we’ve discussed at Investor Day ADAS is a key area of focus for us not just with thermal sensors, but also with our Intelligent Transportation Systems business working on infrastructure smart and connected infrastructure, through technologies like V2X to be able to communicate to the vehicles to see oncoming threats as well. We’ve done a lot of work to put more business development effort and commercial effort behind that ADAS team and there’s much more to come. While the results are beginning to manifest themselves certainly not to where we aspire them to be quite yet, you mentioned the Industrial UAS business that’s something that from albeit at a small base we saw a lot of growth from that small base in the quarter where it is beginning to indicate that we’re having good success developing that market. And that’s not just sensors that we’re selling to other UAS manufacturers it’s complete solutions that we’re providing to first responders for example fire fighters or search and rescue personnel. But Frank is here the President of the Industrial Business Unit. Frank do you want to add some commentary?

[Frank Pennisi:]

Sure, in the short-term in the automotive category because of the fact we’re the only auto qualified sensor we’re in 500,000 cars today that gives us a scale advantage that allows us to get into more and more price points. So consequently, we can grow in the existing automotive market as well as get us qualified to get into the ADAS market. We reorganized our team to be able to do so. Because it’s the check of its ability to see the rain and fog and shadows and sun glare four times further than headlights. It’s also wanted to more affordable ones. It's allowed us to put out analytics, it's allowed us to complement the V2X solution in ITS. And it allows the target not only the tier 1s, and the OEMs, but also the commercial taxies, commercial trucking and autonomous military prospects as well. Those are going well, we're seeing good progress with our reorganized team, we're raising our awareness, we're investing in that throughout the remainder of the year. And as you're well aware, the ADAS opportunity in the class 4 and 5 fully autonomous type vehicles aren’t really going to start materialize until 2021, 2022, 2023, but we're making sure that we're going to be a part of that when it happens.

[Drew Lipke:]

That's helpful. And then maybe follow-up for Carol, you have this $87 million net cash position now. You stepped up repurchase activity to some degree. How should we think about the cash build and the optimal capital structure here in light of both acquisition opportunities in the pipeline today and just share repurchases as we go forward.

[Carol Lowe:]

Drew, as we stated before, we'll continue to be opportunistic as it relates to the share buyback, the primary focus is definitely around the M&A. We continue to have a pretty robust pipeline and are always looking at different opportunity and studying them. And so that's where the focus will be. The other thing to note that a meaningful portion of that cash actually sits outside of the U.S. And we always want to be -- make sure we're very efficient in how we repatriate those dollars to make sure they're also left in regions where we believe we have M&A opportunities.

[Operator:]

Thank you. Our next question is coming from Michael Ciarmoli from SunTrust. Your line is now live.

[Michael Ciarmoli:]

Hey, good morning guys, thanks for taking the question and nice quarter. Carol, maybe just on the guidance. And I get it on the tougher year-over-year comps 2017 versus 2018, but even the high end of the guidance, I mean, it only implies about 1% growth second half versus first half. I mean are there any indications that these growth trends you're seeing in all of the business segments either change or slow or is there -- was there just a roll-off of some of the government strength in the back half of the year that we should know about. Just trying to understand why there is so much deceleration from first half to second half. It doesn't seem like you guys would lose any momentum here.

[Carol Lowe:]

Okay. So -- and Jim is going to have more color on this, I'll give a few numbers as a reference point. And then he can add more color from a business perspective. But just as a reminder, we can't lose in spite of the fact that for the Security businesses that were divested, I referenced earlier to Noah’s question the $140 million for the full year 2017, but it's important to note that 65% approximately of that businesses generated revenues actually fell in the second half of 2017. So that present somewhat of a headwind. We talked about the fact that our maritime business is -- it does have more seasonality than the other businesses and the second quarter and the first half it is much stronger than in the second half of the year. Also the DR-SKO, while the numbers for the full year 2017 compared to 2018 should be very comparable. There is a shift in terms of how it's earned throughout the year, with the second half of 2018 falling below what was delivered in 2017. So those are some big impacts from a pure number standpoint. And Jim, if you had other color you'd like to add about just the business outlook in total.

[James Cannon:]

Yes, I think that's a good summary certainly on the revenue comparable to prior year. A couple of other things in the second half as we go into it that I want to highlight. And Carol mentioned in her prepared remarks is the OTS reorganization. So we're taking a pretty bold move a part of our strategy to fuel, feed, focus a part of focusing the business is the reorganization of the OTS business, shifting to government law enforcement, other government agencies, facility consolidation cost associated with that. We also have a bit of tariff related inflation that's beginning to creep into the business in maritime and instruments components, while not significant in the second quarter, there’s a bit uncertainty in the second half. And then the other two are investments that we’re making in our compliance programs to make sure that we’re 110% moving quickly to adhere to the consent agreement. And fuel these strategic investments we talked about, one of the primary ones being ADAS as we mentioned a bit earlier. So all of those things in sort of concert is what we have baked into our considerations for the second half.

[Michael Ciarmoli:]

Got it, that’s helpful. And then just last one maybe for David. I would have thought the defense bookings perhaps might have been higher on a sequential basis; maybe can you give us some color on what’s happening from the DOD perspective, now that the budgets in place are you seeing any -- that short cycle contracting velocity pick up or sort of what’s the pipeline look like here?

[David Ray:]

So, let me just state for the current quarter, I am really excited about the team hitting the greater than 1.0 book-to-bill. I think that’s a leading indicator and predictable backlog growth. And so the team has really -- as part of our strategy really looking to drive consistency in that 1.0 book-to-bill throughout this quarter and future quarters. I think the budget is firming up for 2019, I think it’s a good thing for us, when you look at the modernization account. More so from the standpoint of assurance that these franchise programs on our modernization and readiness that we’re pursuing as part of our franchise efforts are stable and in place and we’re expecting those proposals Q4 and Q1 of next year. Our goal this year is to continue to be predictable around 1.0 a better book-to-bill. I think that drive predictability in our backlog growth and then wining most franchise programs continue to drive at the higher rates as we move into the year. But today where I am sitting with respect to Q2, our ability to hit our 1.0 book-to-bill or better and our ability to hit that on a successive level is really going to be key to driving that backlog and driving that predictability around bookings.

[James Cannon:]

And I’ll just add as we mentioned at Investor Day, a lot of the franchise programs that we’re targeting are late 2019, 2020, 2021 programs. In the meanwhile as DR-SKO comes to a close towards the back half for this year, we’re really pleased to see that for the first time in a long time, DOD will have a budget before the end of the fiscal year and those $69 billion of overseas contingency operations fund in that budget. So we’re going to compete hard to make sure we can bring the best solutions to our DOD customers as they face ever evolving and growing threats.

[Operator:]

Thank you. Our next question is coming from Asher Carey from Robert. W. Baird. Your line is now live.

[Asher Carey:]

Hey, good morning guys, thanks for taking my call.

[James Cannon:]

Good morning, Asher.

[Asher Carey:]

I wanted to ask about machine vision in your near-term opportunities to gain scale there. You have mentioned that M&A pursuits are still priority, but there are also some headwinds in the space, can you provide some more color around the opportunities that you’re seeing there? Are there more Point Grey type deals are these niche technology type transactions?

[James Cannon:]

That’s a great question, machine vision is the particular interest for our Industrial Business Unit and the Point Grey acquisition now remained our IIS business, you know at FLIR we love Acronyms, has done fabulously since acquisition, last year in particular its organic growth was tremendous, fueled by mobile and smartphone production and launches. To the point that we got to a backlog that we really couldn’t sustain we had to reduce. I mentioned earlier, two businesses in particular IIS and Instruments, we leverage the FLIR Method to reduce lead times, try to get backlogs back where we are that book-to-bill business. Now that said, even with a really tough comparable to prior year, our IIS business is growing organically this year. So while we have seen some other competitors in that space have flattish growth because the comp again is so strong, our businesses is continuing to grow and benefiting from the lead time reductions that we’ve had. We are acquisitive in that area and we’re looking for opportunities, it’s a very fragmented market space in some cases, with a lot of regional players involved as well. But you can expect to see us continue to be very active, looking for more Point Grey like targets to consolidate the market space.

[Asher Carey:]

Great, thanks Jim.

[Operator:]

Thank you. Our next question today is coming from Jim Ricchiuti from Needham and Company. Your line is now live.

[James Ricchiuti:]

Thank you. Good morning. I was just wondering if you could talk a little bit more about the FLIR Method. And whether you can give us some sense as to where you're might be seeing some of the more significant early benefits to margins in the three segments with respect to the initial implementation.

[James Cannon:]

I could talk the rest of the day about the FLIR Method. It's something I'm really excited about. And I’m most excited because of the effect that its having in our various teams. The folks in our factories, in our distribution and supply chain that actually do the work every day to get things done. There has been various efforts launched across the company and the FLIR Method has six components. But the first component we’re really focusing on is introducing lean manufacturing and lean practices to drive productivity and lead time reduction. We committed to 150 basis points improvement, 50% reduction lead time and a 10.5 improvement that we want to attributable to the FLIR Method over the horizon of the strategic plan that we communicated at the Investor Day. In the quarter, can I point to a big movement because of the FLIR Method in margin? Hard to put your finger right on it, but for example yesterday, we're hearing Bill Rick [ph] went down to the shop floor to look at the result of some [indiscernible] events that the teams have been driving. And they're significantly reducing lead times and driving velocity, starting closest to the customer and working backwards. So it's got that pull effect as we do it overtime. Probably the most notable example and we mentioned it I believe at Investor Day and perhaps on our earlier call I've referenced it earlier is with the growth that we had at IIS we just couldn't meet the demand and we created this backlog that created some customer dissatisfaction. And we went into one camera line in particular that was producing between 500 and 700 cameras and we've almost now more than doubled that output. Without having to add any sort of capital or incremental resources. So we're still early days, but it's taking these little wins these base hits and turning the little numbers into big numbers, that I believe as we exit 2018, we enter into 2019 will give us carryover to begin to really get some momentum. Because the company that we are today won't be the company that wins three years from now. As we've mentioned, we've got to move from sensors to sensing to intelligent sensing that means new muscles around artificial intelligence, machine learning and ADAS, et cetera, et cetera and those take investments. And the FLIR Method is critical to drive margin improvement so we can self-fund those investments in the business. But it's something again I'm really excited about and I’m most excited because I talk to folks in the business. And the empowerment it gives them to own their workspace and make improvement is contagious.

[James Ricchiuti:]

Thanks. And if I may one final question, I'm still a little surprised to see you talk about the growth, the organic growth in the IIS business and the Point Grey business. And just in light of the weakness in the smartphone market. Can you say where that growth is coming from?

[James Cannon:]

Well, I mean, certainly the smartphone market is not comping itself. It's coming from a whole host of different machine automation, industrial automation outside of just smartphone production. There is a lot of move to automate various manufacturing processes for quality control, et cetera, or as production moves back into higher cost countries, automation is how many of our customers remain competitive. So we’ve seen kind of the growth, I can't point perhaps to one place, but just in general around the trend for more automation and the need for machine vision.

[Operator:]

Thank you. Our next question is coming from Louie DiPalma from William Blair. Your line is now live.

[Louie DiPalma:]

Hi, good morning. Carol, at the Analyst Day, you discussed your 2021 goal for the operating margin to expand to 23%. And this quarter you nearly reached that mark. With your growth initiatives for ADAS, machine vision and the defense franchise programs, should we still expect FLIR's research and development expense to remain in the 10% of revenue range, or are you planning for R&D as a percentage of revenue to trend higher over the next several years?

[Carol Lowe:]

So, thank you, Louie. And we’re not really planning on that amount to trend higher, as we have talked about the $180 million that’s been invested in total from an R&D engineering perspective. If you look historically and the fact that prior to this year we were generating around 2% growth in most years, we don’t consider that a good return on investment for the dollars that have been spent. So, it’s really more about how those dollars are going to be allocated, as we go forward to make sure we can move faster on the opportunities that will generate the highest return as well as continuing to support and maintain the strong technologies and solutions that have us at the point where FLIR today as a very strong market leader in all the markets that we serve and support.

[Louie DiPalma:]

Okay. And on a different topic for Jim, in January FLIR announced the partnership with NVIDIA and Intel as part of the ADAS software development kit. And I was wondering how that partnership and the interest in the development kit has progressed. And also on the call, you mentioned that the different ADAS opportunities probably won’t be material until 2021, 2022 or 2023. And I was wondering in terms of a timeline when do you think like OEM vendor selection will take place for ADAS?

[James Cannon:]

That’s a great question. And some of that I wish I knew the answer to. There is obviously white hot interest in that space, when there’s going to be big Tier 1 selections and decision on technology is a hard thing to predict. But if I backup a bit, the automotive developers’ tool kit, the work that I mentioned earlier with machine learning that we offer to researchers and automotive developers with annotation to note various objects from pedestrians, to dogs, to bicycles, et cetera all of that is to help continue develop awareness around thermal sensors that we think are one of many technologies that need to be incorporated to really get to the level of autonomy that the automotive manufacturers are striving to do. I will say, I think that developments in commercial trucking and unman military applications may develop themselves in the market quicker. There is a heavy emphasis on unmanned applications, unmanned ground combat vehicles, obviously we know that one of the biggest threats that our warfighters have faced have been IEDs as they move along roads and if that’s done with unmanned vehicles there is obviously a great opportunity to save lives in that regard. You also don’t have the concerns that you do about operating in a city where you have a lot of vehicles that aren’t communicating or pedestrians et cetera. So, not able to answer definitively when, the big automotive OEMs are going to make decisions in selection criteria, but we are putting a lot of effort in to providing education for those researchers and developers. Because again we do believe we know thermo is a compelling technology to have offered there. And as we talked about earlier we’re also building out our business development commercial capabilities around that effort as well.

[Operator:]

Thank you. Our next question is coming from Jeff Kessler from Imperial Capital. Your line is now live.

[Jeffrey Kessler:]

Thank you for taking my call, good to talk to you folks again.

[James Cannon:]

Good morning.

[Jeffrey Kessler:]

Hi. At the last couple of large trade shows that we attended, at the beginning it was fairly high scenario, you have obviously -- you have got on your website development of the dual Lepton core Saros camera and off shoots of it, which can play both in the Security world and I know you talked a little bit about this, but also it can play in the -- you want to call the safe cities and it can play in the world that’s developing in the larger state cities programs, which are springing up. I am wondering if you could comment about the technology behind getting two sensors, again two sensors in getting a much higher definition for a sensor in the same price in these cameras and where and what goal -- what verticals and what goal niches inside of these verticals you can sell this into because from a take technology point of view it sounds great where is the market for this?

[James Cannon:]

Absolutely, we’re really excited about the launch of Saros and if I back up from a broader perspective and you mentioned it we’re excited with the amount of collaboration that’s happening between our Security teams, our intelligent transportation teams and our machine vision teams others as well. But we’re seeing for example now from our Government and Defense radar businesses technologies that can come into intelligent smart and connected cities for ITS. As I referenced earlier ITS that that smart connected traffic management business that we’ve got also has synergies with ADAS, with V2X and certainly with Security as you mentioned. Our team work very hard to be able to incorporate the dual Lepton sensors as the trigger initiators, the key detectors for the Saros camera. And when you think about false alarming and verified responses, I mean, they can be programmed so that small movements aren’t setting off the sensor that other motion activator to the technologies would have will know it’s a person. That illuminate LEDs begin to roll and collect video to have that verified response. And as you state there’s a wide range of markets that we’re going after. Certainly outdoor parameter security, commercial applications where they have wide area surveillance it could be an equipment yard, could be critical infrastructure, airports, water treatment facilities, power plants, there’s a whole host. I'm going to put one on my back door, so again the market opportunity is really abound with what we can do. And I’ll say while our teams have worked hard for a long time we’re really now starting to see the technology roadmaps and the commercial efforts begin to coalesce between our smart safe city team, between for example the government defense radars business, ITS and our core security market. But we’re really proud of that Saros product and stand by for more to come.

[Jeffrey Kessler:]

And just to follow-up to that realizing that it is a different sensor, but for the last couple of years the Boson has been a big part of the growth, are there -- are you able to essentially stratify the way you put these sensors into various product lines so that you can start -- so you can offer the end-user an array of technology depending on what they need. In other words giving the end-users whether they’d be commercial or agencies of government more choice or are you going to be primarily focused on Saros for these types of programs?

[James Cannon:]

No we’re going to very much offer choices to customers. Needs that they have that might be bespoke or unique we’ve got a range of different camera cores to satisfy those requirements. So we’re absolutely going to remain focused on what’s the right product for the right solution for that customer need. Boson as you know is really ramping in production now, we’re really again proud of that product as well, but never satisfied. We’re going to always continue to push SWaP-C in our uncooled thermal camera cores.

[Operator:]

Thank you. Our next question is coming from Josh Sullivan from Seaport Global. Your line is now live.

[Josh Sullivan:]

Hey, good morning Jim, Carol. Nice quarter you here.

[James Cannon:]

Morning, Josh. Thank you.

[Josh Sullivan:]

The ADAS machine learning effort FLIR InSite web portal, two efforts you highlighted with software needs. You feel FLIR’s internal software assets are robust enough at this point do you need to bolster those. I think you mentioned some self-funding for those programs or can you get to where you need to go with some of these joint ventures you’re doing?

[James Cannon:]

Yes, well, I mean you essentially gave the answer there. It’s a bit of both, we certainly have right now our own organic capabilities and we’re investing in more. When we think about the talent that we’ve got to have as we go forward certain areas have to evolve. We’re over strength in some places under in others. So as we move forward we’ll make organic investments to build out our software AI machine learning capability in competences. But that takes a lot of time, to go out recruit, retain all those things, so as you know we’ve augmented that with these minority investments we’ve made. We’ve made a handful so far again there are companies that we may never own, but we want to invest in. And we want to partner with them to get really unique technologies. And in all of the cases that we've done so far that's exactly the kind of talent that we've partner with. Companies that have robust software and AI capabilities so that we can rapidly develop our technology roadmap, but at the same time organically these are skills that we have to have in long-term. So we're making those investments now to create the conditions to attract the very best talent that we can in that regard.

[Josh Sullivan:]

Okay. And then, I mean, you had some product launches this quarter, which now look like they're beginning to reflect your efforts for a more integrated FLIR profile. How should we think of the product refreshes kind of across the portfolios, portfolio Recon V as well as the industrial portfolio? Should we see an accelerated product churn over the next 12 months? Just how you're thinking about that?

[James Cannon:]

So I don't think I would say you’d see an accelerated product churn. Frankly, when it comes to product, a lot of what I've told the team is we want to do less better. We want to understand the real needs of our customer with the example of InSite. That's a perfect example of where you've got electrical contractors, electricians, it's app and a web portal that really helps them organize their work, communicate to their customers better. It's moving from sensors to sensing again to intelligent sensing solutions. So as we move forward, I don't know if you’ll see an acceleration, but we certainly intend for you to see products that we're bringing to market where we're working hard upfront on the user need and solving a real mission requirement that they have across all of our business units.

[Josh Sullivan:]

Okay, thank you.

[Operator:]

Thank you. We've reached end of our question-and-answer session. I’d like to turn the floor back over to management for any further or closing comments.

[James Cannon:]

Again, I want to thank all of you for joining our call today. As always, I especially want to thank the over 3,500 FLIR team members across the globe for their continued passion and dedication to our task and purpose. I look forward to speaking with all of you again soon. Thank you.

[Operator:]

Thank you. That does conclude today's teleconference. You may disconnect your lines at this time. And have a wonderful day. We thank you for your participation today.