FLIR Systems, Inc.
Q3 2018 Earnings Call Transcript

Published: 30 Oct 2018

[Operator:]

Greetings, and welcome to the FLIR Systems Third Quarter Results Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce Jay Gentzkow, Head of Investor Relations. Thank you. You may begin.

[Jay Gentzkow:]

Good morning, everyone. Please note that our earnings press release and presentation slides 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 over time. A full reconciliation between GAAP and adjusted measures is in this morning's earnings our press release. I'll now turn the call over to Jim Cannon, President and CEO of FLIR Systems.

[James J. Cannon:]

Thank you, Jay, and thank you, everyone, for joining FLIR's third quarter 2018 earnings call. With Jay and me today are Carol Lowe, our CFO, Todd DuChene, 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 and Defense Business Unit. I'm also pleased to welcome Tony Buffum, who joined FLIR this month as Senior Vice President and Chief Human Resources Officer. Tony will lead the company's global HR team and drive all facets of change management and culture. Tony brings a wealth of experience and knowledge and we're thrilled to have him. As announced earlier this morning, we reported another solid quarter operationally and financially. Gross margins, operating margins, and operating cash flow reached quarterly levels we haven't seen in over five years. We also realized another quarter of double-digit EPS growth. And we maintained organic revenue growth in all business units despite challenging year-on-year comparables. Additionally, we're making meaningful progress on our continuous improvement initiatives through The FLIR Method. I'll start with third quarter review on slide 3 of the presentation with a few financial highlights. Carol will provide more color later during our prepared remarks. This morning, we reported third quarter revenue of $435 million. Excluding revenue from acquisitions and divestitures, organic top-line growth was 3%. A very strong quarter in 2017 led by broad-based growth across all business units made for a difficult year-over-year comparable, but we're proud to deliver our fifth consecutive quarter of organic growth despite the lumpy nature of our end markets. While adjusted gross profit was flat versus third quarter 2017, adjusted gross margins improved significantly, up 330 basis points. Gross margin expansion was due to favorable product mix and productivity initiatives driven by The FLIR Method. Adjusted operating income increased 5% over the third quarter of 2017. Adjusted operating margin also improved, up 260 basis points in comparison to last year. While we're enthusiastic about achieving margin performance we haven't seen in years, we plan to continue balancing margin expansion with investments necessary to position FLIR for long-term profitable growth. This investment is especially key to franchise program wins, an essential part of the strategy we shared during our Investor Day in May. We'll share more information on our strategic investment plans during our fourth quarter earnings call in February 2019. We also demonstrated solid operating leverage with adjusted earnings per share growing 10% in the quarter compared to Q3 2017. Operating cash flow reached $122 million for the quarter, the highest quarterly cash flow in over five years. Operating cash flow for the first nine months grew 32% over the same period of 2017. Total company 12-month backlog finished the quarter at $591 million, down 1% compared to the balance at the end of the second quarter. While we grew backlog by more than 5% in our Government and Defense Business Unit during the quarter, our Industrial Business Unit continues to methodically lower backlog utilizing The FLIR Method to reduce customer lead times and more consistently position the business closer to a book and bill level. Turning to our outlook for the full year 2018. We continue to expect revenue to be in the range of $1.78 billion to $1.8 billion and full year adjusted EPS to be in the range of $2.17 to $2.22. These ranges represent organic revenue growth of 7% to 8% and adjusted EPS growth of 15% to 18%. We also announced today a quarterly dividend of $0.16 per share which will be payable on December 7th to shareholders on record as of November 23rd. Turning to slide 4. We've made significant progress on our strategic priorities to fuel, feed and focus the business with The FLIR Method as its foundation. Perhaps, our strongest quarterly progress since introduction, I'd now like to update you on two key components of that strategy. Let's start with fuel on slide 5. We've advanced many near-term opportunities to gain scale in the business. To highlight a recent franchise win in the quarter, the Government and Defense Business Unit received an award totaling $28.7 million for the Next Generation Chemical Detector 3 or NGCD 3 in support of the U.S. Army's Multi-Phase, Chemical Agent Detector program or MPCAD. FLIR's MPCAD solution will provide the war fighter with chemical threat confirmation in the field and better enable the joint forces to combat chemical weapons of mass destruction. This franchise program win enables our team to further fulfill its mission to protect the lives and livelihood of soldiers, sailors, airmen and marines. They are our heroes. Turning to slide 6. We also strive to innovate differentiated technologies to secure market positions and fuel future growth. I'd like to highlight one key product introduction from each business unit since our last earnings call. Last week the Industrial Business Unit's Integrated Imaging Solutions business or IIS announced the FLIR Firefly, the industry's first deep-learning enabled machine vision camera. The Firefly integrates Intel's Movidius Myriad 2 Vision Processing Unit to enable deep neural networks for on-camera inference. Combining a new affordable machine vision platform with the power of deep learning automates complex and subjective problems for image analysis professionals such as recognizing faces or classifying the quality of a solar panel during the manufacturing process. At the Association of the United States Army's Annual Meeting and Exhibition (sic) [Exposition] in Washington DC, the Government and Defense Business Unit launched the Black Hornet Vehicle Reconnaissance System or VRS. The Black Hornet VRS takes the combat-proven Black Hornet UAV and integrates it with military vehicles. War fighters will have the ability to conduct real-time non-line-of-sight covered reconnaissance while remaining in the protection of their vehicles for increased situational awareness. The Black Hornet powered VRS is representative of our continued focus on delivering full solution technology and we look forward to playing a role in helping modernize our military forces. Finally, in October, the Commercial Business Unit's Maritime division delivered a Marine industry first with the introduction of ClearCruise Augmented Reality Navigation Technology. ClearCruise Augmented Reality or AR brings a new level of navigational awareness to users of the Axiom family of multifunctional displays. With ClearCruise AR, Axiom users can make smarter decisions with physical navigation objects overlaid directly on Axiom's HD video display, giving captains greater confidence and peace of mind when navigating busy or unfamiliar waterways. Turning to slide 7. We also continue to feed, feed longer-term market opportunities through technology investments and consolidating stronger positions in attractive markets. As an example, we've been aggressively investing in FLIR's unmanned solutions platform since identifying the unmanned market as a strategic priority. FLIR's unmanned solutions exemplify our transition from intelligent sensors to intelligent sensing solutions. At our Investor Day, we announced the intention for a new unmanned systems and integrated solutions division in the Government and Defense Business Unit. That division is now fully operational with leadership in place and we're strategically investing to capture the military's unmanned solution needs. Other recent unmanned solution successes include the previously mentioned Black Hornet 3 nano UAV and subsequent Black Hornet Vehicle Reconnaissance System. We also announced the DroneSense-FLIR Edition, a drone-flight management software platform designed for public safety applications following a strategic minority investment in DroneSense earlier this year. Another strong quarter of results in unmanned solutions for both Government and Defense and Industrial Business Units is a byproduct of these strategic investments. Moving to the right of slide 7, we announced two exciting partnerships that will feed our business with differentiated technologies. In the quarter, we made a strategic minority share investment in CVEDIA. CVEDIA is an exciting young company that uses gaming engines to create synthetic images. These images allow developers to train artificial intelligence systems faster and more economically. Together, we've generated thermal synthetic images creating a differentiated and valuable feature that augments the rich and distinctive data our sensors already produce. We see CVEDIA software playing an important role in many FLIR applications including unmanned solutions. We also acquired Acyclica in mid-September. Acyclica is a leading developer of automotive roadway and intersection data generation and analytic solutions. These solutions provide real time traffic flow information, strengthening our differentiation in Intelligent Transportation Systems or ITS by adding dynamic traffic data in a cloud-based analytics engine to FLIR's ITS solutions. Now part of the ITS division within the Commercial Business Unit, the capabilities of the Acyclica team in data analytics and software platforms can be scalable across numerous other FLIR businesses. We will continue to feed targeted opportunities with long-term growth trajectories that are accretive to FLIR. We look forward to sharing more progress on these strategic priorities in the future. Let me now turn the call over to Carol for her review of third quarter financial and operational highlights. Carol?

[Carol P. Lowe:]

Thank you, Jim. On slide 8, you'll see a summary of our third 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 $435 million, a 6% decrease year-over-year. Excluding acquisitions and divestitures, organic revenue increased 3% over the same period. As Jim mentioned, organic revenue growth was impacted by a challenging year-over-year comparable as we've began to lap strong performance by all business units that began in the third quarter of 2017. Sales to the U.S. government increased $27 million or 23%. This growth is largely attributed to deliveries under the EO/IR Force Protection program as well as cooled military camera cores supplied by our Industrial Business Unit. U.S. government revenue represented 33% of total revenue compared to 25% in the third quarter of 2017. Adjusted gross margin improved 330 basis points year-over-year to 52%. The increase in adjusted gross margin was driven by favorable mix and productivity gains driven by The FLIR Method. This was our seventh consecutive quarter of adjusted gross margin expansion and highest quarterly adjusted gross margin since 2013. Third quarter adjusted operating margin was 24%, 260 basis points higher than last year. We created solid operating leverage to achieve adjusted net income of $80 million up 10% for the third quarter of 2018. Adjusted EPS was $0.57 also 10% higher than prior year. Adjusted net income was favorably impacted by a 430 basis point decrease in our effective tax rate versus Q3 of the prior year. This was primarily due to the enactment of the U.S. Tax Cuts and Jobs Act as well as a jurisdictional mix shift of our taxable income. Due to changes in our estimate of the impact of the new U.S. tax legislation on foreign and domestic profits, we now expect our full year 2018 effective tax rate to be approximately 21% excluding discrete items that impact the GAAP tax rate. During the third quarter, the Swedish tax authority issued a proposed tax assessment to one of our non-operating subsidiaries in Sweden. The proposed assessment of approximately $ 300 million concerns the use of tax credits applied against capital gains recognized in the 2012 tax return. We believe the proposed assessment is incorrect and the assertions therein are inconsistent with applicable tax regulations. We intend to vigorously defend the company against the proposed assessment. During the quarter, we generated cash flow from operations of $122 million. This brings our cash flow from operations for the first nine months of 2018 to $276 million representing a 32% increase over the same period last year driven by earnings and working capital improvements. Year-to-date, we repurchased approximately two million shares at an average price of $50.52 per share. With these repurchases and $66 million in dividends paid, we returned $166 million to shareholders during the first nine months of 2018. Despite these uses of cash, we increased our cash balance by $85 million during the third quarter to $593 million positioning us well for future capital deployment including execution on a number of acquisitions and investments in our current pipeline. At the business unit level, we again saw organic revenue growth across all three businesses. Business unit level operating margins increased 160 basis points over the third quarter of 2017 as a result of favorable mix and productivity gains driven by The FLIR Method. Turning to slide 9, I will highlight performance from each of our business units. Beginning with the Industrial Business Unit, third quarter revenue was $177 million, up 4% from the third quarter of 2017 driven by strength in automotive, industrial UAF, and optical gas imaging products. Operating income for Industrial was $56 million, 3% higher than the prior year. Operating margin was in line year-over-year with productivity gains driven by The FLIR Method offset by a lower margin product mix. The Government and Defense Business Unit saw revenue growth of 1% year-over-year. Deliveries of gimbal systems for the EO/IR-FP program, UAS systems and higher revenue were top-line strength. Revenue growth was partially offset by a challenging year-over-year comparable due to a large international order for airborne systems in the third quarter of 2017. Government and Defense operating income increased 2% compared to the third quart of 2017. Healthy product mix contributed to a 30 basis point improvement over the prior year. During the third quarter, Government and Defense backlog reached $371 million to end the quarter, a 6% increase over the second quarter of 2018. Bookings grew 25% over Q2 2018, driven by orders from the recently won Next Generation Chemical Detector program from the U.S. Army. Book-to-bill was just over 1.2 times for the quarter. The Commercial Business Unit third quarter revenue was down 31% year-over-year, due primarily to $43 million of revenue in Q3 2017 from the security businesses divested earlier this year. Excluding acquisitions and divestitures, Commercial third quarter revenue grew 6% over last year. We saw continued strength in Maritime's Axiom multifunctional displays and our intelligent traffic solutions. Operating income for the Commercial business decreased 27% year-over-year. This decrease was due primarily to $3 million in prior-year operating income from the divested security businesses. Operating margin improved 60 basis points over the prior year. I will now pass the call back to Jim.

[James J. Cannon:]

Thank you, Carol. Overall, we're encouraged by the results thus far in 2018. As we position the company for a strong finish to the year and look ahead to 2019, we'll continue to emphasize execution in our core businesses and delivering on our operating performance objectives. As we've stated, we'll seek to balance growth, operating leverage, and investments in the business. In closing, I want to remind everyone of our daily task, to consistently exceed our commitments with integrity and our purpose, which is to innovate the world's sixth sense 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 at the center of The FLIR Method and they drive integrity, speed, innovation, and a winning culture. I'll now open up the call for Q&A. Operator.

[Operator:]

Thank you. [ Operator instructions ] Thank you, our first question comes from the line of Noah Poponak with Goldman Sachs. Please proceed with your question.

[Noah Poponak:]

Hey. Good morning, everybody.

[Carol P. Lowe:]

Good morning.

[James J. Cannon:]

Good morning Noah.

[Noah Poponak:]

I wonder if it might be possible to – I don't know if you have the numbers there in front of you. Hopefully, you do. I know you've spoken generally to the near to medium-term temporary issue in Government and Defense of the programs that roll off and therefore create a temporary year-over-year growth rate headwind. Is it possible to actually just kind of level set us on what they are, what they were in the quarter, how much they declined in the quarter, and then how much they declined over the next few quarters and when they stop? I don't know if we've ever super-precisely heard those numbers, just to get everybody on the same page on that issue.

[James J. Cannon:]

Yeah, sure. I mean, happy to provide color for certain. In the quarter, obviously, the EO/IR-FP program that was a big driver that was awarded last year is coming to an end. There are a few more systems that we're going to ship in the fourth quarter and DR-SKO, which you know has been a long-tenured program for us and driver for us, we have one more tranche that we expect and then there may be more based off need and requirement, but that will certainly lapse. So we've got that arbitrage until some of these larger programs of record we're competing for franchise wins pick up. But I guess two points I'll bring up and then hand it over to David to talk in any more color is the book-to-bill was at 1.2 in our Government and Defense Business Unit, so we're continuing to drive smaller wins, and for the next two years, OCO dollars are in that base DOD budget. So that's a great area of opportunity for us to go win business to mitigate the arbitrage of some of these larger programs closing before others pick up. David, you want to add some color?

[David Ray:]

Jim, I think you hit it spot on. Our 1.2 book-to-bill for the quarter was very enlightening. That's two quarters in a row we've been above 1.0 book-to-bill. That's the leading indication of backlog growth with, as you mentioned, E0/IP-FP going down. DR-SKO, we expect another booking in Q4 on DR-SKO that will take us into mid -2019. Also think there are upgrade opportunities with that program, but all in all, our book-to-bill in the last two quarters and moving into the future are really is an indication of our backlog growth that mitigates that in the short-term as we execute on some of these franchise programs we plan to win in 2019.

[Noah Poponak:]

Okay. The international airborne program that was a headwind year-over-year in the quarter, how much was it down?

[James J. Cannon:]

Well, that was a delivery we had to the Mexican Navy and it was about $30 million.

[Carol P. Lowe:]

Yeah, it...

[Noah Poponak:]

It went from $30 million to $0 million.

[James J. Cannon:]

$18 million

[Carol P. Lowe:]

Yeah. It was $18 million for the quarter, $18 million and then $0 million in the quarter for that specific program.

[Noah Poponak:]

Sorry. So what was it in the year-ago quarter?

[Carol P. Lowe:]

$18 million.

[Noah Poponak:]

And what was it in this quarter?

[Carol P. Lowe:]

$0 million.

[Noah Poponak:]

And then can you give me those numbers on DR-SKO?

[Carol P. Lowe:]

So DR-SKO for Q3 2017 and Q3 2018 are approximately flat at $14 million to $15 million between the two, year-over-year.

[Noah Poponak:]

And then what do each of those programs do year-over-year next quarter?

[Carol P. Lowe:]

So it's less for 2018 for the DR-SKO. It's about half and it was about $20 million Q4 2017.

[Noah Poponak:]

Got it. On your point on bookings and the backlog there, I hear you on where the book-to-bill came in in the quarter which does make it look like that's maybe picking up for you. But on the other hand, I think it is a pretty consistently seasonally strong quarter, the third quarter. And if I look at a trailing 12 months number, I think it's still below 1.0. Or if I just look at the Government and Defense backlog at the end of the quarte, it's at the same number as where you ended 2016. And I know you have these program specific situations but just directionally that's not really true for too many defense companies given what's been happening with the budget. And so just wonder if there's anything unique to that maybe with the program specifics. Or if you are looking for a meaningful change in the backlog in the immediate term?

[David Ray:]

So two things. So I'm particularly proud of the 1.2 book-to-bill and especially when you look at the comparable to 2017. The EO/IR-FP program that we talked about was booked in that quarter. That was a substantial booking and the fact that we've covered most of that with the growth that we've had in this quarter is an indication of our portfolio diversity. So that gives me great confidence that as we look forward to executing our strategy, not only are we focused on programs that really replace those types of bookings in the current surveillance business, but we have a portfolio that's diverse enough for us to, as we invest in the future, really position for new opportunities as mentioned around NGCD 3 that we talked about earlier. Going forward when we think about the year, we'll continue to go and really hit hard the mid to smaller programs as we wait for some of the larger franchise programs to materialize. I think what we benefit from is our relative balance with respect to domestic and international bookings and how we're positioned in those areas. A lot of our mid to small bookings that we're going to book in Q4 next year and Q1 of the following year are international in nature and we think that gives us a great hedge against the upcoming headwinds that may be seen in 2021 and beyond relative to the budget. So the portfolio diversity we have as a business geographically and the fact that we've been able to replace pretty much the bookings of that large EO/IR-FP program of last year really, I think, gives us a positive momentum as we execute our strategy that Jim laid out earlier.

[Operator:]

Thank you. Our next question is coming from the line of Michael Ciarmoli with SunTrust Robinson Humphrey. Please proceed with your question.

[Michael Ciarmoli:]

Hey. Good morning, guys. Thanks for taking the question. Maybe just to stay on Noah's line of questioning. I mean, so how should we calibrate in this sort of environment, as you were just talking about, with the defense budget, the book-to-bill? What's sort of a realistic longer-term growth trajectory for that business, contemplating the headwinds? And maybe if you can even give us some color on the Next Gen Chemical Detector. You've got that initial booking. You're calling it a franchise opportunity but can you give us a sense of what the tail might look like on that potential program?

[James J. Cannon:]

Well, as we said in our Investor Day, we expect all of our business units to grow at an annual CAGR of 5% or greater. Also as we've mentioned, we began this focus on franchise programs, larger programs of record, about nine months ago, almost a year ago. And it takes time to develop those programs, to put those captures in place. In the meanwhile, a lot of the wins that we're having and the book-to-bill being greater than 1.0 were driven by smaller and in many cases very profitable opportunities we have with technology we've developed. I'll point to a lot of the conversation we had about unmanned solutions. The VRS solution, the Vehicle Reconnaissance System, for example, is not a part of a big program. It's a technology we're bringing to market and we expect and already have a lot of enthusiasm as most of our forces fight mounted and they need some kind of point of battle non-line-of-sight reconnaissance system. And FLIR traditionally has always competed in bringing these technologies to the war fighter and winning smaller wins if you will, a lot of it through OCO funding. And for the next two years, again, that OCO funding is in the base budget. The big program wins, the military are awarding now, again started years ago in many cases. And if you look at the six modernization priorities that the Secretary of Defense has outlined, we line up very nicely with many of those like next-generation vertical lift, next gen manned unmanned ground combat vehicle, soldier lethality in particular as we continue to push size, weight, power for uncooled IR cores and focus on unmanned solutions and other sensors, et cetera. So again when I think about this space in the near-term, I see us continuing to grow the business, continuing to grow backlog. It'll be lumpy. We want all the businesses to contribute greater than a 5% CAGR. And then as we get out into late 2019, 2020, 2021 and 2022 where we have very specific programs that we're developing and compete on, we expect and hope to get larger wins if you will.

[Michael Ciarmoli:]

Got it. That's helpful. And then just maybe you mentioned competition there a couple of times. Any thoughts whether there are opportunities or potential pressure from two of the bigger infrared players maybe thinking of L3 and Harris coming together? Does that potentially create challenges for you? Does it create some opportunities? If the customer is looking for another vendor for things like goggles, can you maybe just give us some color on thoughts on that consolidation in the space?

[James J. Cannon:]

I don't want to speak to that consolidation specifically other than to say our strategy remains intact and relevant and we're very enthusiastic about it.

[Michael Ciarmoli:]

Okay. And then maybe just one more for Carol. On the op margins, the last two quarters I think running at 23.5%. The long-term target is 23%. What other levers are you guys pulling, or maybe even what inning are you in here? And I noticed the big – there was a big drop in R&D, I guess down $4.4 million sequentially. It's under 10%. It looks like a six-quarter low. Should we expect R&D to kind of trend at these levels? Maybe just some color there.

[James J. Cannon:]

Yeah. I'll say a few words then hand it to Carol. As we mentioned in the prepared remarks, we're balancing margin expansion with investment back in the business. What you've seen with R&D spending is not indicative of a long-term trend. Instead, we're trying to focus the R&D much more. We've got a very broad base of businesses and serve a very wide range of end markets. And so this year we're trying to concentrate some of the R&D effort around what we believe are more attractive longer-term markets like unmanned or intelligent transportation smart and connected cities or ADAS applications coupled with that. So you will see more focus in how we distribute the R&D spending. I don't think any big deviation from what we've spent in the past historically and we had a great quarter in terms of operating margin rates. But to be the company we want to be three years from now and have that concentrated strength in augmented reality and artificial intelligence and machine learning to make our sensors smarter and more mission-capable, we're going to have to make additional investments.

[Michael Ciarmoli:]

Got it.

[Carol P. Lowe:]

And I'll add to that just to kind of call out everything that we highlighted in the prepared remarks around the benefits that we're getting for The FLIR Method and that impacts not only our gross profits and gross margins but also operating income, operating margins. But we also had a timing benefit relative to our general and administrative expenses just the timing of certain accruals and – that you'll see a little bit more heavily weighted expense for corporate expense in the Q4 2018, so it's just timing. And our total corporate expenses are still running that $70 million to $75 million kind of flat year-on-year.

[Michael Ciarmoli:]

Got it. That's helpful. Thanks a lot guys.

[James J. Cannon:]

Thank you.

[Operator:]

Thank you. The next question is coming from the line of Louie DiPalma with William Blair. Please proceed with your question.

[Louie DiPalma:]

Good morning, Jim, Carol, Jay and the rest of the team. This quarter's U.S. government sales increased by $27 million year-over-year and I was wondering, if you can provide a breakdown of where that increase came from. I think you mentioned the EO/IR-FP and I was wondering if that was the majority or if there were other contributors?

[James J. Cannon:]

There's a wide range of contributors. Certainly, we deliver a bulk of the EO/IR-FP program. Also in our Industrial Business Unit, a lot of the components that we supply to other defense contractors saw a very strong quarter as well. Shipments out of Santa Barbara for different cooled components, et cetera. Unmanned applications, the CBRNE applications, really across a whole spectrum of products we saw growth. I don't know if I could point to – I guess the two strongest would be the EO/IR-FP and components out of Santa Barbara for other defense contractors.

[Louie DiPalma:]

Okay. And secondly on this quarter and last quarter's calls, auto was cited as a source of strength for your Industrial's OEM division. And traditionally, your partner Veoneer has priced the night vision sensor or servers for luxury auto customers at over $2000 per vehicle. And I was wondering if anything has changed with your go-to-market strategy there that maybe stimulating demand?

[James J. Cannon:]

Yeah. Frank, why don't you take that question. There's a lot that's happened in the past couple of quarters as we focused on that market.

[Frank Pennisi:]

Sure. Just to let you know, a combination of – we're still working with Veoneer. They're one of the folks who are most familiar with thermal or the benefits of thermal, the fact that they can see it at night and rain and fog. And actually even if you read the owner's manuals, you crack open an owners manual for an automatic emergency breaking system, you'll see – you can't see crouched pedestrians and you can't see people up against metal. And there are a lot of things that thermal does that allows you to see more things. We are not exclusive of Veoneer. We're actually going to market with a number of different partners and working on that. And Veoneer has been breaking into more and more standard – I don't want to say standard platforms, but lower or higher volume – lower-priced higher volume platforms. So as a consequence, we're seeing a lot of growth there. We're seeing platforms from Volkswagen, General Motors and Peugeot coming into play that are actually driving a lot of that growth that give us more scale and more ability to continue to get into more and more platforms as we go and eventually getting into autonomous vehicles.

[James J. Cannon:]

And I'll add, when I think about what we can do with ADAS applications, we really look at it from two perspectives. One, certainly with thermal sensors on the vehicle and I think Frank did a good job describing those benefits. And the other is, with the infrastructure and the acquisition of Acyclica is a part of our intelligent transportation business. It's in the Commercial Business Unit. The V2X technology, so intersections can be smarter, run real-time analytics, communicate with the vehicle. All the sensors on the world can't identify pedestrian coming from the other side of a building into an intersection, for example. So when we, again, think about the opportunities with ADAS we think about both on-vehicle applications as well as connected infrastructure.

[Louie DiPalma:]

Thanks, Jim and Travis. One last one perhaps for David Ray. During the quarter a competitor notably won a large infrared award for Textron's Shadow drone. And I think, Jim, during an answer you mentioned potential opportunities with next generation vertical lift. For future aircraft electrical, optical sensor awards such as the Boeing Huey replacement and the future Boeing's Stingray tanker drone, do you guys feel that FLIR has the sensor to compete against the established primes for those future contract awards?

[David Ray:]

So I'll take that question in two parts. So the answer is, yes, both today, and the investments we're making to really push what we're trying to do in size, weight and power from a sensors perspective. The competence you mentioned for Textron's UAS require smaller sensor. Our investments that we're making moving forward to really lay out our EO/IR strategy involves really not only the gimbal size activity we have today, but really looking at smaller opportunities there as well as the delivery mechanisms, i.e., UAVs for ISR become smaller. When you think about programs such as next generation combat vehicle, future vertical lift, I think we're well-positioned from a technology perspective on what we have today as well as the investments we're making over the next year to really go, become a major player there. But in its totality, I think, it's a combination of the systems we have today, but more importantly how we're equipping those both from a SWaP perspective and the technology insertion through the investments that Jim talked about earlier that are really going to position us. This is part of our strategy we've deliberately started to execute within the last year, since Jim came onboard a year-and-a-half. And it's going to take time for us to mature that and we have targeted opportunities where we expect to realize those investments.

[Operator:]

Our next question is coming from the line of Pete Skibitski with Alembic Global Advisors. Please proceed with your question.

[Peter John Skibitski:]

Yeah. Good morning, guys. I apologize I missed part of Noah's initial question. I think I got the flavor for it and hopefully I'm not repeating anything. But Jim on the status of G-BOSS(NYSE

[James J. Cannon:]

With the G-BOSS(E), again we integrate all the technology and such on the platform. Right now G-BOSS(E) when it'll get awarded we're not real certain of. Are they going to continue with the current program, the EO/IR-FP program or make a decision on G-BOSS(E), I think that's one of the things that's up in the air right now. With a two-year DOD budget set and with all the modernization priorities that are underway, there's a lot of effort to figure out how DOD prioritizes, makes decisions in the near-term with the uncertainty past 2020, right. In 2021, 2022 what's going to happen to the DOD budget. But that product started as the RAID program, evolved into the EO/IR-FP program ultimately may become the G-BOSS(E) program. Could be of the scale that we've seen in the past. It's a battle proven solution that really helps with force protection. We're working now to bring even additional technologies through other minority investments and innovations we're doing to that capability.

[Peter John Skibitski:]

I understand. One quick follow-up on Soldier Borne Sensors, are you guys expecting a final award announcement before the calendar year ends or we're pushing into 2019?

[David Ray:]

So the next follow-on SBS, so we won phase one as you know. Tranche 1 which is the next competition is expected to be awarded around the end of Q1 timeframe next year. We expect to get RFP on that probably before the end of the year here. Again, we're continuing to ensure that we're properly positioned to go drive execution of that. We're delivering on phase one to expectations today. So I don't see any of that changing in the near-term.

[Peter John Skibitski:]

Thanks so much, guys.

[James J. Cannon:]

Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Peter Arment with Baird. Please proceed with your question.

[Peter J. Arment:]

Yeah. Thanks. Good morning, Jim, Carol. Jim, a question I guess on Industrial. You've had nice growth year-to-date but there was a sort of a deceleration here. I wonder if you could just give us some of the details around that. Whether it's just more timing, tougher comps, what's driving all that? Are you seeing any impacts from different parts of the regions, any weakness in Asia? And then just as a follow-up to all this is just how you're doing in your newer pricing strategy that you talked about at your Investor Day? Thanks, Jim.

[James J. Cannon:]

Right. Yeah. Our Industrial Business Unit has had a strong year certainly year-to-date. We always knew the back half would be a tougher comp than the first step and have signaled that. We haven't seen any, I'll say, marked deceleration in any part of the business. The instruments business slowed a bit in Q3 compared to prior quarters, the past four or five quarters run rate and that principally was in our European market there. But in other markets for instruments, for example, our OGI, our optical gas finders, have seen tremendous growth. And that's a very strong product for us as regulation and sensitivities around environmental health and safety have increased. And we've got additional features and product capability that's going to come out around that solution. If you talk about geographic trends, our business can be lumpy right across all of our businesses as we win various projects or programs. We've seen certainly in the Middle East in this past quarter, a couple large security orders slip out a bit that we were expecting. Latin America and Canada was driven principally by the delivery to the Mexican Navy that we referenced early when we talk about year-on-year movement that way. With regard to the pricing actions, I'm really pleased with how that effort is coming along and pricing like productivity is an effort that takes time to get going, right. I mean, it takes at least a year to kind of prime the opportunity, to get the resources on board, collect the data, understand the data, pick the opportunities, and begin to go after it. We mentioned several times in the prepared remarks we are beginning to see some of the productivity effects of The FLIR Method. Now, with regard to pricing, most of that effort is focused not so much on current product offering, but future products that we're bringing to market. So, as we're going through the tollgate process to launch new products, pricing – and our pricing leader in tools that are being put in place now are getting exercised. So, I don't think we're really going to see a marked result there really until we're exiting this year going into 2019 as some of these newer products come to market.

[Peter J. Arment:]

Appreciate the color. Thanks, Jim.

[James J. Cannon:]

Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Josh Sullivan with Seaport Global. Please proceed with your question.

[Josh Ward Sullivan:]

Hey, good morning.

[James J. Cannon:]

Morning.

[Carol P. Lowe:]

Morning.

[Josh Ward Sullivan:]

Just on the investments, you mentioned necessary to position for long-term growth and I know you're going to give us more detail in February, but are the investments organic, inorganic, SG&A, or even CapEx, is there any way to frame the context of the conversation at this point?

[James J. Cannon:]

Sure. Again in the fourth quarter, we want to provide much more commentary, but not to be coy, but it's kind of all the above, less so on the CapEx though. I think the investments we need to make certainly are organic in that we've got to attract some different skillsets into our business of scale, technical capabilities that we haven't had the kind of depth we need as we go forward. There also are inorganic investments and those come in two pieces. Certainly, we have an active pipeline of acquisitions that we've been working on for some time, but you've seen us make several minority investments now. And those minority investments are investments that we're making principally to advance our technology roadmap. They're companies that perhaps aren't for sale nor would we want to own them, but we need exclusivity for a capability that they have to integrate into our solutions. Acyclica, the acquisition we made there, certainly is one that we can point to in the past quarter and CVEDIA, the minority investment we made that we can point to in this past quarter, helps across a whole host of our business applications because it creates the engine that can help our machines learn much more quickly and more economically. So, certainly, some organic investments in terms of talent, and in NRE, inorganic as well. I don't see a lot of really large CapEx that's required though. I don't see it being too tremendously capital-intensive what we need to do.

[Josh Ward Sullivan:]

Okay. Thanks. And then I guess just a follow-up on your comments about the M&A pipeline there. Is the market volatility influencing you or pushing towards joint ventures or acquisitions one way or the other at this point?

[James J. Cannon:]

No. I don't think the volatility certainly that we've seen pushes us one way or the other. We've put together a very deliberate acquisition campaign, if you will. We want to be, again, measured about how we do it. The minority investments really have been driven by our desire to rapidly advance our technology roadmap.

[Josh Ward Sullivan:]

Okay. Thank you.

[Operator:]

Thank you. Our next question is coming from the line of Jeff Kessler with Imperial Capital. Please proceed with your question.

[Jeffrey Ted Kessler:]

Thank you. Hi Jim, hi Carol.

[James J. Cannon:]

Hi, Jeff.

[Jeffrey Ted Kessler:]

Good to talk with you again. I just came from a Safe Cities Conference and the talk about the increasing amount of public-private partnership money that's being made available for the first time really. And what I'm thinking of is looking at other companies that have benefited from this like let's just say TASER or Axon and ShotSpotter. What are you seeing in the types of programs that are out there or being mentioned out there for safe cities that you see affecting your business. And I know that this would across a couple of your divisions?

[James J. Cannon:]

Right. Travis, you want to address that?

[Travis D. Merrill:]

Sure. Hey, Jeff.

[Jeffrey Ted Kessler:]

Hi.

[Travis D. Merrill:]

We continue to see a lot of enthusiasm in the smart and safe city domain whether it be security orientation, really securing the entire metropolitan area and in some cases even expanding beyond that into the suburbs, seamlessly networks across a single VMS. Largely, we are seeing public funding around, sometimes coming at the federal level both within Europe as well as within the U.S. Likewise we are seeing, on the smart side much more momentum on the Intelligent Transportation Systems. We're also starting to see a little bit of a joining of these two areas into more of a single type platform across municipalities. So yeah, I mean the momentum there is good. That's where we really focused our enterprise security business. We've had some nice wins there in the past couple of quarters. So it's going to be a continued focus for us.

[Jeffrey Ted Kessler:]

Okay. A follow-up question would be, can you update us on any new product advancements in the sensor area that maybe affecting the company in 2019, 2020 with regard to what you may be doing with Boson or Lepton, or something new that would take it – that would take characteristics of those small sensors that you have out there a little bit further. I know you're not give out anything specific but I'm just wondering what you're looking for in terms of your infrared sensors to take it to the next step or the next year? And who's going to be requiring something like that?

[James J. Cannon:]

Well, that's a great question. I mean, at the core, no pun intended of our business, we're always seeking to push size, weight, power SWaP-C performance. The Lepton was obviously a breakthrough for us and you're seeing the Lepton now integrated into a different security sensors, for example the Lepton integrated with a EO camera and LEDs that can light up with onboard analytics to know if it's a dog or a humanoid moving to trigger the alarm. I'll go back though to what we're doing around unmanned applications, the more that we can do by pushing SWaP-C with sensors gives our unmanned applications more endurance and more capability. So that intersects our company in a lot of places. Unmanned solutions that we're delivering, security solutions, I could go on and on, ADAS for example as well. But absolutely the Boson we're real proud of, it's maturing nicely in production, et cetera getting into a host of different solutions but we're certainly not satisfied with it. We always seek to constantly sort of disrupt ourselves with regard to our cores.

[Jeffrey Ted Kessler:]

Yes. Thank you. Appreciate it.

[James J. Cannon:]

Thank you.

[Operator:]

Thank you. We do have a follow-up question from the line of Noah Poponak with Goldman Sachs. Please proceed with your question.

[Noah Poponak:]

Thanks. Carol, the cash flow statement in the release cites $26 million of other activity impacting operating cash flows. What is in there?

[Carol P. Lowe:]

So there are within pensions and other liabilities is part of that. So that includes amounts relative to the consent agreement, penalty and then just changes relative to a combination of the pension and just other assortment liabilities, but the concern agreement is probably the biggest piece of it.

[Noah Poponak:]

Is your change in working capital in that number? Or can you tell us what that was in the quarter?

[Carol P. Lowe:]

So the total working capital number the improvement for that, the net working capital we've been down for three quarters in a row now and we're down 8% on a year-over-year basis and that's primarily driven by accounts receivable and accounts payable improvements.

[Operator:]

Thank you. We have reached the end of the question-and-answer session. So I'd like to turn the floor back over to management for any additional or concluding comments.

[James J. Cannon:]

Again, I want to thank all of you for joining our call today. As always, I especially want to thank our over 3,500 FLIR employees across the globe for their continued passion and dedication to our customers. We look forward to updating you on our fiscal year end results after the New Year. Thank you everyone.

[Operator:]

Ladies and gentlemen, this does conclude today's teleconference. Again, we thank you for your participation. And you may disconnect your lines at this time.