FLIR Systems, Inc.
Q1 2017 Earnings Call Transcript

Published: 26 Apr 2017

[Operator:]

Ladies and gentlemen, greetings, and welcome to the FLIR Systems First Quarter 2017 Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Todd DuChene, General Cousel and Secretary of FLIR Systems. Thank you, sir, you may begin.

[Todd DuChene:]

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. All of 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 forecast. The forward-looking statements we make today speak as of today and we do not undertake any obligation to update any such statements 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 Andy Teich, President and CEO of FLIR Systems. Andy?

[Andrew Teich:]

Thanks, Todd, and thank you for joining us for FLIR's first quarter 2017 earnings call. With Todd and me today is our CFO, Amit Singhi; COO, Tom Surran; Chief Marketing Officer, Travis Merrill; SVP of Global Product Strategy, Jeff Frank; and SVP of Corporate Development and Investor Relations, Shane Harrison. I'll start to review the first quarter with Slide 3 of the presentation. This morning, we reported first quarter revenue of $407 million, an increase of 7% over the prior year. Commercial products revenue grew 12% over the first quarter of 2016 and government products grew 2%. The addition of our recently acquired businesses drove this growth. On an organic basis, first quarter revenue declined 2% as we saw softness in Surveillance and in the retail channel of the Security segment. The Instruments and Maritime segment had single-digit revenue declines as backlog increased due to new product introductions in the quarter. Partially offsetting these declines was 29% organic growth in our OEM and Emerging segment. Adjusted gross profit and adjusted operating income grew 9% and 12% respectively, in comparison to the prior year. Adjusted earnings per share for the quarter were $0.36, which represents 13% growth versus last year's adjusted EPS of $0.32. Operating cash flow for the quarter was $75 million or 176% of our GAAP net income in the quarter and was 64% higher than the prior year, driven primarily by continued improvement in our working capital levels, particularly accounts receivable in the current quarter. Total company 12-month backlog finished the quarter at $608 million, up 3% since the end of 2016. This month, we produced our 1 millionth Lepton camera core. The revolutionarily small and significantly lower-cost sensor has enabled a significant expansion in the use of our technology. Since its launch in 2014, we've seen a 58% compound annual growth rate in our total unit volumes, as we've developed more than 20 FLIR-branded products utilizing Lepton and delivered tens of thousands to other companies who have successfully integrated it into their own products. 2017 is going to be a strong year for new product introductions for many of our businesses. Since our last earnings call in February, our Instruments segment introduced the new EXX line of mid-price point planned predictive maintenance and building handheld thermal cameras. Instruments also brought to market two new high-speed thermal imaging cameras for science and research applications and the new ETS320 benchtop thermal camera for electronics product development and testing applications. The Security segment announced several new products as well, our new patent [ph] product, a 4K box camera and corner mount security cameras. In the OEM segment, we launched a new variant of our Lepton with 4x more pixels than the previous Lepton. And our Maritime segment launched a breakthrough line of thermal cameras for boaters as well as the new Axiom family of Raymarine-branded multifunction displays that feature revolutionary new 3D sonar technology. On Slide 4, you'll see our outlook for 2017. We continue to expect full year 2017 revenue to be in the range of $1.78 billion and $1.83 billion and adjusted EPS to be in the range of $1.81 to $1.91. This assumes organic revenue growth in addition to the growth associated with our recently acquired businesses. We also announced today a quarterly dividend of $0.15 per share which will be payable on June 9 to shareholders of record as of May 26. I'll now ask Amit to review the first quarter financial results. Amit?

[Amit Singhi:]

Thanks, Andy. Good morning. On Slide 5, you'll see our first quarter financial results. Please note, all of these financials are on a non-GAAP basis. Reconciliation to GAAP data is included in the slide appendix. Consolidated revenue for the quarter was $407 million, a 7% increase compared to the first quarter of 2016. Exchange rate changes negatively affected revenue growth by about 100 basis points. Excluding the results of acquisitions made in the last 12 months, year-over-year revenue decreased $9 million or about 2%, more than explained by a decline in the Surveillance segment. OEM & Emerging and Detection segments grew 77% and 9%, respectively. Instruments, Security, Surveillance and Maritime declined 2%, 4%, 4% and 6%, respectively. Geographically, revenue increased in the U.S. and Asia by 14% and 23%, respectively, while it declined in Canada, Latam, Europe and Middle East and Africa by 23%, 1% and 12%, respectively. Sales to the U.S. government increased versus last year by 36% to about $106 million, representing about 29% of total revenue. Consolidated first quarter adjusted gross margin was 48%, about 90 basis points higher than last year. At constant currency, gross margin improved by about 130 basis points year-over-year, driven primarily by improvements in all standard variances. Our adjusted operating margin for the quarter was 17%, about 70 basis points higher than last year. At constant currency, operating margin improved by about 90 basis points year-over-year, driven by the increase in gross margin. Adjusted net income for the first quarter of 2017 totaled $49.6 million, 10% higher than prior year, and adjusted EPS was $0.36, 13% higher than prior year. Our cash flow from operations for the quarter increased 64% from year-ago levels to $75 million or 152% of adjusted net income. Our quarterly cash conversion cycle reduced by over 10 day's year-over-year as a result of our working capital improvement initiatives. We did not have any acquisition-related outflows in the quarter nor did we repurchase any shares. Our capital expenditures for the quarter were $13.6 million, slightly higher than last year. During the quarter, we returned $20.5 million to shareholders through the payment of dividends, $4 million higher than prior year as a result of our 25% year-over-year dividend per share increase announced earlier this year. We closed the fourth quarter with cash of $397 million. This concludes the summary of our financial results. Let me now turn the call over to Tom Surran to cover our operational highlights. Tom?

[Thomas Surran:]

Thank you, Amit. Slide 6 is a summary of the first quarter results by segment. The OEM & Emerging segment drove the overall revenue growth of 7%, with 77% revenue growth for this segment. Organic growth for the OEM segment was 29%. Growth in segment level operating income was 10%, again, driven by the OEM segment growth of 128%. Operating margin improvement outpaced revenue growth due to improved gross margins. Moving to Slide 7 to cover the Surveillance segment. First quarter revenue for Surveillance was $118.7 million, down 4% from the first quarter of 2016. The additions of Prox Dynamics and Armasight businesses were not enough to offset slower international shipments and the delay of a $6 million delivery to a specific U.S. customer. Operating profit for the Surveillance segment was $26.4 million, down 26% versus the prior year due to product mix and higher operating expenses as a percentage of the soft revenue. Surveillance backlog declined $8 million from the end of 2016 to $320 million but is up 2% from one year ago. Surveillance segment book-to-bill ratio was 1.0 in the first quarter. On Slide 8 is a summary of our Instruments segment. Revenue declined 2% as compared to the first quarter of 2016 to $77.9 million. Revenue growth from firefighting products was overshadowed by declines in the planned predictive maintenance and building product line, as customers awaited deliveries of the recently introduced products. Backlog for Instruments increased 15% during the quarter, mainly due to bookings for new products launched during the quarter, including new offerings in the plant, predictive, maintenance and building line. Instruments operating profit in the first quarter increased 6% from the first quarter of 2016 to $21.1 million or 27% of revenue. Better gross margins, combined with reduced operating expenses helped to improve operating margin 200 basis points. During the quarter, Instruments introduced several new products, as shown on Slide 9. First with the launch of the new EXX Series product line into the mid-range plant, predictive, maintenance and building market. This replaces the existing EXX Series of products which were originally launched in 2011. These new FLIR EXX Series cameras were redesigned from the handle up and improved on the previous version with Wi-Fi connectivity, interchangeable lenses with autocalibration, laser-assisted autofocus, a larger and brighter touchscreen and improved image processing capabilities such as UltraMax and MSX. A couple of weeks ago, Instruments Science business launched two new high-speed thermal cameras at the SPEI Show in Anaheim. For use by scientific technicians and researchers, the X6900sc SLS and the X8500sc SLS cameras can capture thermal images at up to 1,004 frames per second and measure temperatures up to 3,000 degrees Celsius. In this week, Instruments introduced the ETS320, a hands-free benchtop thermal imaging system for using testing and analyzing circuit boards and electronic components. The ETS320 is a new factor -- form factor for thermal sensing that we expect to be extremely valuable for evaluating the performance of electronic systems that are continuously shrinking in size yet growing in power and processing. On Slide 10, you will see the Security segment's results. Security's first quarter revenue of $45.1 million was down 4% compared to last year's first quarter. This decline was due largely to continued softness in the retail channel for visible security systems, which offset good results from lower [ph] e-commerce business and FLIR-branded enterprise-class security solutions. Security operating income was $300,000 for the seasonally weak first quarter, but operating margins increased 530 basis points, with improved gross margins and lower operating expenses compared to the first quarter 2016. Moving to Slide 11; at the ISC West Security Conference in Las Vegas, the Security segment launched Version 8.0 of FLIR's enterprise-class united video management solution with global administration across multiple sites, enhanced online security credentials, simplified system installation and streamlined camera discovery. Also introduced at ISC West were three new FLIR-branded security cameras; the PT Series dual-sensor camera that features a cool or uncool thermal camera and then the HD visible cameras; the Quasar 4K visible spectrum box camera that is uniquely compact and designed to enable a multitude of integration options; and the Aerial 3 Visible Spectrum Megapixel Corner Camera that provides ceiling-to-floor and wall-to-wall views and a Vandal-proof flush mount housing. The results for the OEM and Emerging segment are shown on Slide 12. OEM and Emerging first quarter revenue was $84.8 million, increasing 77% over last year and reaching another all-time high for the segment. The creation of OEM's intelligent imaging solutions line of business from the acquisition of Point Grey helped drive growth in the quarter, as did continued strength in military-grade thermal camera cores and Lepton cores. OEM and Emerging operating profit reached an all-time quarterly high of $24.4 million, more than double the prior year. Product mix, improved manufacturing variance, and better factory absorption helped drive higher gross margins versus the prior year. As Andy noted, we reached an important milestone this April when we produced our 1 millionth Lepton. Additionally, we introduced a new variant of the Lepton to our OEM customers, this one with 160 by 120 resolution, which is 4x the number of pixels as the existing Lepton on the market. Turning to Slide 13, Maritime segment revenues were $48.6 million, a decline of 6% versus the prior year. Like what was seen in the instruments around the anticipation of the new product rollouts, revenue was soft in thermal cameras and multifunction displays, with new offerings introduced in both lines during the quarter. Backlog from the Maritime segment grew 27% during the quarter. Maritime operating income was $5.2 million in the quarter, with operating margins declining 50 basis points, due primarily to the soft top line despite improved gross margins. At the Miami Boat Show in February, the Maritime segment introduced the latest variance of the FLIR M-series thermal cameras and the new Axiom generation of Raymarine multifunction displays. The new M132 is a highly compact, adjustable tilt thermal imaging system that utilizes our [indiscernible] camera core to create a new entry-level price point for fixed-mount thermal maritime cameras at $2,500. The M232 adds full pan-tilt capability and a 2x digital zoom. When either of these new M-series cameras are added to a Raymarine multifunction display with a lighthouse 3 operating system, the boater can utilize our new FLIR crew's intelligent thermal analytics technology that detects and alerts on objects or obstacles that are in the water. The M300 and 600 series of thermal cameras were also updated with an improved visible imager, and stabilization was added to all models. The new Raymarine Axiom generation of high-performance MFDs are all-glass touchscreens that featured the new Intuitive Lighthouse 3 Operating System, a Quad core processor for powerful and fast operation and a real vision 3D sonar built in to create lifelike views of beneath the boat. Our Detection segment results are summarized on Slide 14. Detection's first quarter revenue was up 9% year-over-year to $31.8 million. This growth was broad, but particular strength came from radiation product deliveries to the U.S. Domestic Nuclear Detection Office and other U.S. federal agencies. Operating margin was down slightly from 28% last year to 27% in the first quarter as a result of slightly higher R&D spend. Detection finished the first quarter with $74 million of backlog, increasing $17 million due to the receipt of another order from the U.S. Department of Defense for DRSKO units; this one for $54 million of deliveries through Q2 of 2018. That concludes my summary of the segment's first quarter. I'll now pass the call back over to Andy.

[Andrew Teich:]

Thanks, Tom. The first quarter was a success on many fronts. Top line growth of 7% with improved gross margins helped drive a 13% increase in adjusted EPS. We were efficient in converting that income into cash, with quarterly operating cash flow growing 64% year-over-year. Our recent acquisitions are integrating well and are adding value strategically and financially. Organic growth was below expectations, particularly in the Surveillance segment, but we see this as a temporary timing-related issue and expect to see Surveillance return to growth in the second quarter. We're happy with the investments that we've been making in products and processes. Recent products introductions are providing to be a success, and more innovations we have coming are expected to add to our momentum. And the investments we've been making in improving our manufacturing yields are beginning to show success through higher profit margins. To update you on the CEO transition, our Board of Directors has been working with our search firm to identify high-quality candidates, and that process continues. We hope to bring someone into the role in the near term. We do not have any updates at this time. I continue to lead the business, and we intend to run uninterrupted as we continue to focus on serving our customers and executing our strategic plans to deliver shareholder value. I'd like to now open the call for Q&A. Adam?

[Operator:]

Thank you, sir. Ladies and gentlemen, we will now be conducted a Question-and-Answer Session. [Operator Instructions] Our first question comes from the line of Jim Ricchiuti from Needham & Company.

[Jim Ricchiuti:]

Thank you. Good morning. I just wanted to go back to the Surveillance segment. The pickup you're expecting in Q2, is that the delivery of the shipment that was delayed in Q1, that $6 million? Just trying to get a sense as to what's going to drive that.

[Andrew Teich:]

That will be part of it, Jim. We did have that one $6 million order that was delayed. That order has now been received and is skewed for delivery. We have the equipment actually produced and sitting on the shelf, ready to go. So that's part of what will be an uptick in Q2. We also had some international revenue that was delayed due to either customer issues or licensing issues. So we feel that some of that revenue will flow through as well. And we're also expecting stronger bookings in Q2 -- Q2 or Q1, the bookings were a little bit lower than we had expected. The $6 million order was part of that, but there were others as well. The Middle East was kind of slow in Q1, and we expect that to return to growth in Q2.

[Jim Ricchiuti:]

Okay. And just turning to the commercial OEM & Emerging. It looks like you guys had a real strong quarter. And I wanted to maybe understand a little bit more of the drivers on the organic side and it does appear, it sounds -- it appears that Point Grey is off to a good start. And maybe if you could just elaborate a little bit on what you're seeing in that part of the business?

[Thomas Surran:]

Sure, Jim. I'm going to hit the organic piece first, then I'll come back to Point Grey. But on the organic side, I think that there are three drivers in the OEM business that have been driving the organic growth. So one of those is the launch of Boson, so we're starting to get traction with that product. The second is continued traction coming from Lepton. So Lepton's doing well, and obviously we talked about the million unit milestone there. And the third one is continued strength in the defense side of that business, with [indiscernible] being one of the larger customers there. The both bookings and revenue have been quite strong, and we expect that to continue through the rest of the year. Moving over to the inorganic side and the OEM; Point Grey or Integrated Imaging System, IIS, as we call them, had an excellent quarter, very strong bookings and backlog build, significantly ahead of our investment case. And we think that will continue in Q2. So demand has been strong there, team's been executing really well, very good integration as well. So we're feeling good about that business, and demand has been strong.

[Jim Ricchiuti:]

And the markets where that's been strong, Andy?

[Andrew Teich:]

So there are two primary markets that have been strong in IIS. One is the machine vision market, so there they're selling cameras that are doing inspection of new product developments. We can't talk specifically about customers there but this has just been very high demand related to some new product development that are coming in the market in the consumer space. And the second area is in the people counting business. So there we have stereo vision cameras that are utilized in primarily retail environments for counting customers as they enter and exit the store and we've seen a pretty strong uptick in orders there as well.

[Jim Ricchiuti:]

Okay, thanks a lot.

[Operator:]

Thank you. Our next question comes from the line of Jonathan Ho from William Blair.

[Jonathan Ho:]

I just wanted to start with some of the weakness in the Surveillance business. And are you anticipating any potential impact from the situation in Washington, particularly around the potential for a continuing resolution?

[Andrew Teich:]

Yes, Jonathan, it's always difficult to predict what the impact of a CR is. In the past those have had mixed effects on our results. Much of the products that we supply into the U.S. though are supplied under an urgent needs basis. And as we've spoken in the past, we don't have a high level of program of record business in our backlog. But that said, it is a little bit difficult to predict. I would say that on the demand side, we've seen a fairly high level of activity in the RFI, RFQ space in the last 90 days. And I think the general theme of the rebuild of the U.S. Military and retrofit of older equipment is a positive sign for our sector in general. But at this point, I think it's a little bit difficult to predict. I'm feeling pretty good about how I see it factoring. Our U.S. business was up, our DOD business bookings were up slightly in Q1 from a Surveillance standpoint. Overall, they were up significantly, but that was largely bolstered by the DRSKO order and detection.

[Jonathan Ho:]

Great. And then just in terms of the initial reception for the new products. It looks like you guys have some backlog orders there but just wanted to kind of see what you're hearing from customers. And how much elasticity do you think you can drive with sort of the new product categories on the commercial side?

[Andrew Teich:]

The initial reception so the new product has been quite good, and the primary areas that saw new product launches during the quarter were in Instruments and Maritime. And in both of those cases, we built backlog rather significantly; it was about a $4 million backlog building each of those two segments. And the majority of the backlog built in both of those cases was related to the new products that were launched but we weren't able to ship as we ramp up production in those products. That will flush through in the current quarter. The overall reaction of the products has been quite good. In the Instruments space, the EXX products, the new products in the science business will help to drive a refreshed cycle. The EXX product was initially launched in 2011, and we have a pretty large installed base, it was a very high-selling product for us from a volume standpoint. And as a result, I expect to see a product refresh cycle, given the age of many of those cameras that are out there and the feature set that is offered by the new products. And similarly, in the Maritime space, the lower-priced thermal cameras that we've launched, I think, can really flex the price elasticity that's in that market, getting down to a cost that is close to the cost of a radar. It's something that we've had as a vision for that business for a long time. And the new Axiom product line is very powerful, has very innovative features and is really the first major platform change that we've had in that business since the launch of the Adam product a year after we acquired the business in 2010.

[Jonathan Ho:]

Great, thank you.

[Operator:]

Thank you. Our next question comes from the line of Pete Skibitski from Drexel Hamilton. Please go ahead.

[Peter Skibitski:]

Good morning. So on the first quarter revenues being a bit light, you're saying it was primarily -- you think, due to the timing and new product instructions, not necessarily due to kind of a macro weakness or any weakness from the DOD continuing resolution?

[Andrew Teich:]

There were two things, Pete. The majority of the revenue shortfall was actually in Surveillance, and in that case, it was a combination of timing of orders and issues related to orders and backlog that prevented us from shipping them in the current quarter, many of which we expect to get resolved in the current quarter. The second issue was the aforementioned point that I was mentioning to Jonathan about the backlog build related to the new products that were launched, fairly light in the quarter in Instruments and Maritime.

[Peter Skibitski:]

Okay, okay. And the 29% organic growth in OEM, was that largely the timing of lightning part [ph] deliveries, mainly, and also maybe if Lepton for FLIR-1?

[Andrew Teich:]

It's not a timing issue, actually. That business has had steady growth. There was not a backlog build in that business. So it's just strong orders across the board in those three categories that I mentioned; lightning, of course is part of our military-oriented cores and components but we saw strong demand in the Lepton, we saw strong demand in Boson. And then of course, as we've mentioned earlier, the IIS segment, the former Point Grey business had very strong demand, there was a backlog build in that particular area, and the industry in general has had strong demand in both machine vision and people counting.

[Peter Skibitski:]

Okay. So I mean, OEM organic growth, I mean, my takeaway is it seems like you're taking OEM for the full year to be a double-digit organic grower. Is that a fair takeaway?

[Andrew Teich:]

It will be double-digit -- well, now looking at it from an organic standpoint, I think it will be high single digits for OEM. But the inorganic growth in OEM coming from IIS will drive overall revenue well in the double digits.

[Peter Skibitski:]

Okay, okay. My last one, I'll get to the end of the queue; do you guys have any visibility on the opportunity for the new Southern border wall technology?

[Thomas Surran:]

Well, that one is hard to predict but I can tell you two things. Obviously, that we're seeing some political rhetoric suggesting that there might be a little bit more of an emphasis on technology versus physical walls. If that does happen, and again, I think it's hard to predict right now, but if that does happen, we're well positioned. We have a very strong position on the border. As a technology provider, we've been very successful for decades providing very useful technology, both in thermal imaging and, on an increasing level in radar. And the platforms that we have out there today, whether it be handheld, UAS, airborne, vehicle-mounted or pole-mounted, we've got systems across every one of those platforms and they're very well-liked and well-respected by CPP and border patrol. Pete, I just want to go back on one other thing on an OEM organic; the other program that's been doing well from the [indiscernible] standpoint are the what's reefed to as the layer cum [ph], these are the anti-missile defense systems that are mounted on aircraft. So that's a program that's been doing pretty well.

[Peter Skibitski:]

Got it. Very helpful, thank you.

[Thomas Surran:]

My pleasure.

[Operator:]

Thank you. Our next question comes from the line of Michael Ciarmoli from SunTrust. Please go ahead.

[Unidentified Analyst:]

Hi, good afternoon guys, this is actually Les [ph] in for Mike. One question for you on the margin side, specifically when it comes to Surveillance and Security, just year-over-year and sequentially in Surveillance was down. So maybe comment a little bit on that. I understand that was a product mix issue and then also on the Security side as well, if you could.

[Andrew Teich:]

Sure, Les. On the Surveillance side, it is largely product mix. That's a business that margins can move around, depending on the mix of sales between airborne, maritime, land-based units. So that drove the margins down a little bit in that business. Generally, though, we've been seeing the mix in the backlog improve. In Security, margins were up overall, and largely, that was coming from better margins in our e-commerce business. And we have better margins associated with the thermal products and the software products that are coming from the former DVTEL [ph]. In that business, the traditional retail margins are the weakest in that space, and we had growth in those other areas and declines in the retail space, which drove, I think, it's around 530 basis points of total operating margin improvement in the Security space year-over-year.

[Unidentified Analyst:]

And would you say looking into the second half for the year, maybe even 2Q, margin should improve slightly? Or...

[Andrew Teich:]

Yes, margins will improve sequentially in both of the as the year progresses.

[Unidentified Analyst:]

Got it, okay. And then just one last one for me; any issues in a product cannibalization on introduction? And I understand there's some hold-off period because of the new introductions, but any comment on that?

[Andrew Teich:]

There are some normal ramp-up that's associated with the production of new products that are introduced in the quarter. All of the products that have been launched in Q1 are in production at this point and shipping, so I don't anticipate any problems.

[Unidentified Analyst:]

Okay, thank you.

[Andrew Teich:]

My pleasure.

[Operator:]

Our next question comes from the line of Jeffrey Kessler from Imperial Capital.

[Jeffrey Kessler:]

I have a couple of questions. First, it appears that what you've done this year is to invest very heavily over the course of -- after your R&D has come out of the woodwork. And you've launched, at the end of last year and into this year, a lot of new products, which have, I'm going to say, frozen the market. But given pauses, looking at replacing products in about three -- at least three of your categories; I know you can't sequence this to make it easier because each division is different, but the question really -- the question really involves, what are we going to see in terms of sequential margin improvement as these new products begin to replace the older products? And what is the, essentially, the sequence of revenue replacement that we're going to see? Because, again, we haven't seen as big a replacement cycle over several divisions of yours as we have this year.

[Andrew Teich:]

Sure, Jeff. So your point is correct. We've been investing over the course of the last couple of years in these new product platforms. And many of these platforms run on about a two-year cycle. And we foreshadowed this in previous calls that we were expecting those cycles to come to fruition in the early part of 2017. And we've seen some of those product launches already. There are still some that are yet to come. The new products that we have launched support company-wide gross margin targets. And in many cases, the margin profile of those products are better than the gross margins of the products that they are replacing. The fact that we had three segments, launched new products all in the same quarter is largely related to timing and meant that our industry. Many times, we tried to align product launches with major trade shows in the industry. But we have other new products that are yet to launch in Q2 and in H2 of this year. So to answer your ultimate question as to how this is going to affect margins overall, we expect margins improve sequentially as the year progresses, and that's a function of the new product launches and the other efficiencies that we've been driving in the business. Some of those manifested themselves in Q1.

[Jeffrey Kessler:]

And the segments that will be most affected by new product launches that haven't been announced yet are going to be where? Or you don't want to give that out yet?

[Andrew Teich:]

Yes, I don't really want to talk about which specific segments will have new products that are coming, but we've got a fair bit yet to go for 2017 on the new product front.

[Jeffrey Kessler:]

Let me focus on just one area, and that's Security. Clearly, obviously, at the retail level, there's a race to the bottom in -- it's a race to the bottom in retail pricing. On that -- looking -- in that your new products that you've introduced before them should clearly show where your focus is going to be at from the new major VMS area to the high visible spectrum IP box camera. Are these the types of introductions in Security that we are likely to see going forward? This is a fairly large amount of new products that you introduced, at least the ISE tradeshow and other trade shows as well. I'm wondering how you expect this to effect the revenues in the business, which have been volatile over in that segment over the last couple of years, as you've gone from small product, which has gone way up. Now it's come down. And they're going back to enterprise-level products, some of which are quite high-end, but some of which are mid-market products.

[Andrew Teich:]

Yes, Jeff. There's a couple of things there. One of the things is that the new products that we have announced that we'll continue to announce are going to hit on three majors themes; integrated products, differentiate products and intelligent products. So those will help to set these products apart from the commoditized, low-end retail businesses that you started your question with. The other two areas that we're going to focus on are enterprise and perimeter Security. And the reason for that is not only do they benefit from those three aforementioned points, but they're also areas that pull on strengths that we have at FLIR. Thermal imaging and radar, for example, are both technologies that are highly beneficial for perimeter applications. Enterprise locations, in general, have both perimeter and interior applications that exist, and we see the perimeter side of that equation presenting an opportunity for FLIR that we can take advantage of, utilizing the core technologies that we have in the company. So you'll see more to come there in terms of technology and product launches, but I feel confident that we'll be well positioned to enter those spaces that will be able to drive higher margins from those segments than we have historically from the retail segment of the business. It's...

[Jeffrey Kessler:]

And how far -- with these new products, how far down the line in terms of, what we call, pipeline discussions are you in towards getting these toward? Maybe there is a backlog that's really built here, but the pipeline and the nature of the pipeline may be important.

[Andrew Teich:]

Well, if you look at pipeline, it starts with demand, and we believe that the demand exists for these kinds of applications. The next step down in the pipeline is what distribution looks like, and distribution is largely established through our existing businesses in that space. And then the next phase is really product execution, and that's the part that is under development, in some cases. Some products have already been launched, but we have more to come later in the year that will hit these themes that I've spoken about earlier.

[Operator:]

[Operator Instructions] Our next question is a follow-up question from Pete Skibitski from Drexel Hamilton.

[Peter Skibitski:]

Not to belabor the point, but I want to talk more about Security on the revenue side. So Andy, you guys are going to stay in the retail side. I know lauric some had some headwinds and the foreign competition. But you want to stay in the real retail space, I think, it sounds like. And I guess, my question is what are your return to growth in retail? And can your move to sort of enterprise, outpace, if you will, the headwinds in retail?

[Andrew Teich:]

Yes, thanks, Pete. It's a good question to ask here because the commoditized, undifferentiated part of retail is something that is not a focus for us. We want to move to a space that pulls on those themes of integration, differentiation and intelligent-enabled products. And there will be a retail component of that, but it's going to be at the higher end of the retail market and more into the small and medium business integrated portion of the market. I think it'll take some time to create that evolution, but generally, that's where we won a vector of the business. And that'll be a higher-margin business and a less commoditized business that'll pull on the strengths that we have inherent in the technology base that we have at FLIR.

[Peter Skibitski:]

Is it going to take a while to make that shift? In other words, should organic growth in Security be down this year? And hopefully, by next year, you're going to get that enterprise side going?

[Andrew Teich:]

Yes, I think that, that's -- it will take some time because some of the strategy relies on products that we have not yet launched, and those products are going to be required to drive organic growth back into that business in a meaningful way.

[Peter Skibitski:]

Okay, got it. And one last one for Amit. So Amit, so free cash conversion was good this quarter. I think it was 1.4x. Are you expecting -- could it be more than 1 on a full year basis also in the free cash conversion? And then just wondering if you could talk about you been here for probably long enough time now to see if there's any real inventory reduction opportunity at FLIR or if there is just kind of the nature of the business in terms of these levels of inventory.

[Amit Singhi:]

Yes. So the free cash flow conversion will be more than 1 projected for the full year. The operating cash flow as a percentage of income will be more than one as well. So that is the plan. It won't be as high as it was in this quarter. At 52% [ph] on operating cash flow as a percent of net income, it won't be that high, but it will be above one. On inventory, also, while this quarter, we were higher when you look at the DIO year-over-year, that went in the right direction, depending on the revenue and the sales. But we do expect to continue our inventory reduction initiatives, including the monthly reviews that Tom's been having with the segment, and that will provide production year-over-year.

[Operator:]

Our final question comes from the line of Asher Carey from Baird. Please go ahead.

[Asher Carey:]

This is Asher on the call for Peter Arment. I have a question, a follow-up to a previous question on the adoption of current products and how you're seeing the road map for additional products. I know you have 20 out there right now or more than that. And how we expect the product mix to grow, how OEM conversations are developing, but more specifically, if you could touch on the that zone and its reception to date. How are you seeing that growth being accepted? Is it still ramping? Or has it leveled off? And how has that put the Lepton on the map for other parties to become more serious about considering the inclusion and other devise to drive volumes?

[Andrew Teich:]

Thanks, Asher. Those are all great questions. We're all very happy with the traction that Lepton is getting. We have a personal goal for hitting the 1 million unit mark for Lepton number, pleased that we have hit that now. And having launched more than 20 products under the FLIR brand with Lepton, those products are all doing very well. Our total unit volumes nearly doubled year-over-year this quarter for thermal products. So we're getting very good traction with those products, and I like the fact that every one of those sale creates a new demographer out there, and that's a person that has the potential to move up the product line into product like the EXX that we just launched late in Q1. Relative to CAT phone, continues to do very well. We're in undersupply situation, so we're still supplying-constraint on [indiscernible]. We could actually sell more of those if we could supply more Leptons into that. And that's really a yield issue. And we made very good progress on yield improvements during the quarter, and I expect that to continue into the first half of the year. So I'm pleased with the way the CAT phone has been doing, and there are several other manufacturers of similar products in the market that have been looking at and experimenting with the integration of Lepton into other mobile platforms. So we will see more products on that front in the coming months and throughout the year.

[Operator:]

Thank you. Ladies and gentlemen, we have no further questions in queue at this time. I would like to turn the floor back over to management for closing comments.

[Andrew Teich:]

Thanks, Adam. Overall, we're pleased with the results from the quarter. We saw good revenue growth, good growth in our backlog and launched several great new products with more to follow. I'm particularly pleased with the gross margin improvement we saw and the smoothness and efficacy of the integration of our recent acquisitions. I want to think the nearly 3,500 FLIR employees for executing our strategic initiatives in Q1 and for continuing to support me and the rest of the executive team as we prepare for leadership transition. Thank you all for joining us on the call today.

[Operator:]

Thank you, ladies and gentlemen. This does conclude the teleconference for today. You may now disconnect your lines at this time. Thank you for your participation, and have a wonderful day.