FLIR Systems, Inc.
Q4 2017 Earnings Call Transcript

Published: 14 Feb 2018

[Operator:]

Greetings. And welcome to the FLIR Systems' Fourth Quarter and Full Year 2017 Results Conference Call. At this time, all participants are in a listen-only mode. A 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, Shane Harrison. Please go ahead.

[Shane Harrison:]

Thank you. Good morning, everybody. 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 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 expectation. 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 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 over time. 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?

[Jim Cannon:]

Thank you, Shane. And thank you everyone for joining FLIR's fourth quarter 2017 earnings call. With Shane and me today; Carol Lowe, our CFO; Travis Merrill, the President of Commercial Business Unit; Frank Pennisi, the President of Industrial Business Unit. And I'd like to welcome David Ray. The new President of Government and Defense Business Unit. The fourth quarter was another sound quarter from a growth and profitability standpoint. We grew the top line at 4% year-over-year, improved our adjusted gross margin; reached the highest quarterly adjusted operating margin since 2012; and improved our working capital metrics. The quarter kept off the year that saw a record level of revenue and adjusted earnings per share. We feel we are set up well for 2018 with a strong backlog. Our reposition security business and a lower than expected tax rate. We are very encouraged to see our law makers agree on a multiyear US Department of Defense budget. And while we are well into our 2018 operating plan, this will help us focus on US DoD priorities for 2019 and beyond. I'll start the review of the fourth quarter on Slide 3 of the presentation. This morning we reported fourth quarter revenue of $495 million, which was an increase of 4% over the fourth quarter of 2016 and 2% on an organic basis. Our commercial products revenue grew 7% over the prior year and our government products were flat with the prior year. As a reminder and is discussed on our last call, our customers accelerated the delivery of couple of key programs into the third quarter that affected this fourth quarter of 2017. Adjusted gross profit and adjusted operating income grew 10% and 8% over the prior year respectively. With operating margin expanding approximately 80 basis points over the fourth quarter of 2016. We demonstrated solid leverage by growing operating income, double the rate of revenue growth. Adjusted earnings per share for the fourth quarter were $0.58, which represents 12% growth versus last year's adjusted earnings per share of $0.52. Total company 12 months backlog finished the quarter at $652 million, that's up $60 million or 10% over the end of 2016. Indeed the highest year end backlog level in nearly a decade. For the full year, shown on Slide 4, revenue of $1.8 billion was 8% higher than 2016. Organically, 2017 revenue growth was 2% over 2016. Commercial products grew 13% and government products grew 2% compared to the prior year. Adjusted gross profit grew 12% with margin improving 180 basis points. Adjusted operating income also grew 12% while adjusted EPS grew 11% from a $1.69 to $1.88. As mentioned on our earlier calls and shown on Slide 5, we intend to fuel parts of our business, feed other parts of our business and focus our operating portfolio. As announced last week, we sold our Canada based non thermal security operation that included Lorex branded retail security products, as well as small and medium business security products in the first quarter of 2018. We made the decision to divest this business in order to better focus our security division, differentiated technology on the more attractive critical infrastructure and enterprise markets for security solutions. We want to thank the employees of Lorex our SMB business for their hard work over these last five years. On Slide 6, looking ahead to 2018, today we announced our initial expectations for full year revenue to be in the range of $1.73 billion to $1.76 billion. And full year adjusted EPS to be in the range of $2.05 to $2.10. We exclude the results of the divested businesses from 2017. These ranges represent expected revenue growth of 4% to 6% of organic growth and adjusted EPS growth of 9% to 12%. This outlook represents our highest organic growth rate in nearly a decade, and implies solid operating leverage in the business. Carol will provide more color around this guidance. We also today announced the 7% increase to our quarterly dividend to $0.16 per share. As we discussed in the past, and as we were begin to reporting in three business units rather than six segments beginning in the first quarter of 2018, for your reference in the appendix of slide deck, you'll find quarterly revenue and operating income history by our new business units. This realignment of businesses and resources will reduce our complexity, improve our agility, unlock synergies, increase team collaboration and enhance management focus. It is our goal that this lead to improved ability to grow and create sustained shareholder value. With the addition of David as our Government and Defense Business Unit President in January, our executive staff transition is complete. And we are ready to execute on our strategy and accomplish our task of exceeding our commitments with integrity, while we innovate the world's sixth sense to enhance perception awareness in order to improve decision making to save lives and livelihood. We intent to discuss our strategy in detail at our upcoming Investor Day on May 16 in New York City. We will be sending out invitation in the coming weeks but please hold this day on your calendar. On Slide 7, you'll find an update and overview of the FLIR method or TFM. Our continuous business improvement initiative that we feel will accelerate organic growth, improve profitability and generate excess cash to maximize value creation. During the fourth quarter, we began aligning internal resources as well as recruited new talent to execute on our TFM strategies. For 2018, one of our priorities is the creation of a pricing analysis function to apply pricing strategy across all of our businesses. So we ensure we are making informed pricing decisions. Additionally, we are implementing several productivity enhancement projects which are intended to improve manufacturing efficiencies and increase our sensor production yields, which is as important as those savings trickle through all of our vertically integrated businesses. The longer term mission of TFM includes focusing our sights on pricing and productivity. It also drives innovation and product development, standardize this core business processes, improve cross business communication, enhances our talent development programs and boost our acquisition and integration processes. Ultimately, all these benefits will better enable us to grow organically, drive strong profit margins and generate cash. On the topic of product innovation, you'll see on Slide 8 a summary of the products we've introduced since our last earnings call. Many of these products are built around Boson, our highly differentiated thermal camera core that offers industry leading size, weight and power consumption capabilities. First, our Security segment introduced a new thermal bullet camera called the FLIR FB Series ID, which combines the thermal sensor with high performance video analytics to offer high reliability and alarming solutions. In December, the security segment also introduced the Quasar Panoramic visible light camera that effectively reduces the number of cameras required for wide area surveillance. At the consumer electronic show in Las Vegas, we rolled our second -generation thermal vision Automotive Development Kit or ADK. The ADK is designed to introduce autonomous automobile system designers to the power of thermal sensing, specifically how the technology is ideal for sensing at night through adverse weather conditions, identifying and classifying living being, sensing at long distance which includes seeing up to 4x farther than traditional headlights. In January, at the Shooting, Hunting and Outdoor Trader SHOT Show in Las Vegas, our Outdoor and Tactical Systems business or OTS introduced the FLIR Bridge, advanced thermo monocular. The Boson based bridge incorporate the digital compass and other features into a light weight housing that can be hand held or helmet mounted. Also at the SHOT show OTS' Armasight by FLIR brand launched three new family of night vision scope that offer multiple mounting options, better battery life and more lens options for multiple fields of view. And lastly, our Instrument segment NGS brand launched our latest intelliRock system, which is a sensor system used by construction professional that provide data to ensure the strength and the quality of concrete. The new intelliRock III version now incorporates a Lepton camera to add thermal sensing capability to the solution. Let me now welcome Carol to FLIR's quarterly earnings call and have her review the fourth quarter financial and operational highlights. Carol?

[Carol Lowe:]

Thank you, Jim. On Slide 9, you'll see our fourth 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 appendix. Consolidated revenue for the quarter was $495 million, a 4% increase compared to the fourth quarter of 2016. Geographically, revenue increased 25% in the Middle East, 12% in Europe and 2% in the US. While Asia was down 8% due to a tough comparable in the prior year. The strength in the Middle East region was due to deliveries from the surveillance segment. Revenue to the US government was 24% of total revenue, and increased 2% versus last year. Adjusted gross margin improved 250 basis points year-over-year to 49%, driven by product mix, acquisition and new products. Fourth quarter adjusted operating margin was 23%, about 80 basis points higher than last year, with the gross margin improvement being offset partially by higher R&D and selling spend. Adjusted net income for the fourth quarter of 2017 was up 14% to $82 million and adjusted earnings per share were $0.58, 12% higher than the prior year. Quarterly cash flow from operations grew 2% $99 million, and was 121% of adjusted net income. During the quarter, we returned $21 million to shareholders through the payment of dividend. At the segment level, revenue growth in the Detection, OEM and emerging, Maritime and Instrument segment was partially offset by declines in the Surveillance and Security segments. Improved margins in several segments helped to grow total adjusted operating income faster than revenue. We finished the year with $519 million of cash. On Slide 10, you'll see our full year financial results. Consolidated revenue was $1.8 billion, an 8% increase over prior year and 2% on an organic basis. Geographically, revenue increased in all regions except the Middle East, which was down slightly. Sales to the US government increased approximately $50 million for the year, up 12% and represented approximately 26% of total revenue compared to 25% in 2016. Consolidated full year adjusted gross margin was 49%, a 180 basis points higher than last year due to margin accretive acquisition, product mix and new products. Our adjusted operating margin for the year was 20%, 70 basis points better than the prior year. Adjusted to 2017 net earnings totaled $263 million, or $1.88 per fully diluted share compared with $234 million, or $1.69 for fully diluted share. All segments except security grew to revenue in 2017 versus the prior year. The decline in security was due primarily to the retail product line; a business that as Jim mentioned has since been divested. Total segment operating margin improved 90 basis points for the year. Our guidance for full year revenue is $1.73 billion to $1.76 billion. And full year adjusted EPS of $2.05 to $2.10 representing revenue growth of 4% to 6% and adjusted EPS growth of 9% to 12%, when you exclude the divested security businesses. This outlook assumed a diluted share count of 142 million shares and that our adjusted effected tax rate will go from the 25.4% in 2017 to 21.5% in 2018. The reduction in the effected rate in 2018 is due to the enactment of the US Tax Cuts and Jobs Act of 2017. The new statutory federal rate reduction of 14% impacts our rate by about six points given over 50% of our income is earned outside of the US. This reduction is offset by approximately one point from the elimination of certain tax credit under the new law and by another point on the net change and our expected foreign income tax rate. The US tax reforms resulted in $93 million of discrete tax items in our fourth quarter 2017 GAAP results. This is made up of $81 million of deemed repatriation charges of previously earned foreign income, most of which will be payable over the next eight years. And a $12 million charge due to the revaluation of our net deferred tax asset. Detailing the segments a bit more, you'll see on the left side of Slide 11, a summary of Surveillance's fourth quarter results. Fourth quarter revenue for Surveillance was $151 million, down 5% from the fourth quarter of 2016. Strength in land products was offset by softness in airborne, OTS and integrated systems product lines compared to the prior year. Operating income for the Surveillance segment was $48 million in line with the prior year but we saw an operating margin improvement from 30% to 32%. Surveillance bookings grew 9% year-over-year with growth in all regions except Europe. Notably in the quarter, we booked a $7 million order for Black Hornet Nano UAS system by the Australian army. Surveillance's backlog increased 8% over the prior year to $354 million. On the right side of Slide 11 is a summary of the Detection segment, which saw fourth quarter revenue grow 18% year-over-year to $39 million. Timing of deliveries under the DR-SKO program drove this increase. Operating profit increased 18% with margins maintaining at 30%. Detection finished the fourth quarter with $59 million of backlog, up $2 million from the end of 2016. Moving to Slide 12. Instrument's revenue of $103 million was up 7% over the fourth quarter of 2016. And helped Instrument finished 2017 with an all time high annual revenue level. Broad product line growth drove the Q4 revenue increase with particular strength in volume, handheld, plant predictive maintenance cameras as well as growth in our science camera. Instrument's operating profit in the fourth quarter increased 3% over the fourth quarter of 2016 to $33 million or 32% of revenue. Operating margins declined 110 basis points as investments from the sales organization and R&D were made to accelerate growth as we move forward in 2018. The results for the OEM and Emerging segment are shown on Slide 12 as well. OEM and Emerging's fourth quarter revenue was $88 million, increasing 15% over last year. And represented another all time quarterly high in revenue for the segment. The acquired Integrated Imaging Solutions line of business was the drive of the growth. Organic revenue was up slightly due to strong results from our Lepton cores partially offset by a small decline in other cores and component sales. The Lepton revenue in the quarter was the highest level of Lepton revenue since its introduction in 2014. OEM and Emerging operating profit grew 43% year-over-year to reach $26 million. Operating margin of 29% was up 560 basis points versus the prior year on higher product margins and improved yield. Order backlog in OEM and Emerging segment increased 5% during the quarter to $169 million. Moving to Slide 13, on the left side you'll see the Security segment revenue of $71 million was down 3% compared to last year's fourth quarter. High-end cooled thermal was the primary driver of the decline due to the fact that in the prior year we shipped a number of cool security cameras for specific project that did not repeat in 2017. Security operating income was $5.7 million or 8% of revenue and declined 36% from the prior year. Continued pressure on gross margin in the Lorex retail and the SMB businesses combined with higher investment and Lorex e-commerce marketing drove the decline in margin versus the prior year. As Jim stated, we completed the sale of the retail and SMB portion of the security segment last week. The businesses divested had combined revenue of $140 million in 2017 and were breakeven on an operating income basis. We recorded a $23.6 million non-cash loss in our GAAP results related to the transaction. Maritime segment revenue was $44 million, up 14% versus the prior year, which represented the highest growth rate in this segment since our acquisition of Raymarine in 2010. The market performance of Raymarine Axiom Multi Function Displays led this performance which spurt growth in related sensors and instrumentation including Thermal Cameras, Echosounders and Radars in the quarter. Maritime operating income was $4 million or 9% of revenue. This represents the highest operating margin for fourth quarter since we created the Maritime segment. Improved margins combined with OpEx discipline created significant leverage. With operating income growing 90% over the fourth quarter of 2016. This concludes my summary of the financials and the segment. I'll now turn the call back over to Jim.

[Jim Cannon:]

Thank you, Carol. We are proud but not satisfied with these results and with our performance in 2017. It was a year a lot of change and the team executed very well considering, I commend the very hard work of all of our employees in making 2017 a success. As we look ahead, our focus will be on growing organically, improving margins and deploying cash effectively. We pivoted our security division away from consumer oriented market and towards the markets that can drive the most value out of our differentiators. The FLIR message is underway and we expect to begin the same improvements in cost, processes and innovation during 2018 and beyond. And I now feel that we have the right senior team, organizational rhythms and operating structure in place to take this excellent company to the next level and achieve our vision of enabling the world with a powerful sixth sense. I'll end the prepared remarks by reminding everyone of daily task. To consistently exceed our commitments with integrity and our purpose, which is to innovate the world sixth sense to enhance perception, awareness in order to save lives and livelihood? We are committed to organic growth, margin improvement and executing our plans without compromise to our core values. I'll now open up the call for questions-and-answers. Operator?

[Operator:]

[Operator Instructions] Our first question today is coming from Noah Poponak from Goldman Sachs. Your line is now live

[Noah Poponak:]

Hey, good morning, everyone. Can we talk about balance sheet utilization because with the strong free cash generation of the business, you are back into a net cash position after spending really just a few quarters out of on -- haven't bought back stock in a little while the guidance has the share count going up a decent amount. So what is the thought process around balance sheet, proper balance sheet utilization? Where should net debt to EBITDA and net to debt to cap be and what are you looking to do? I know Jim you've talked about wanting to add more inorganically. What's out there in terms of size and could you not at least offset share count creep while still looking for sizable acquisitions?

[Jim Cannon:]

Sure. Well, as we mentioned in earlier call, we paid down some of our debt in the third quarter as we levered up to prepare for an acquisition in the first half of 2017 which just didn't materialize, right. And then as we -- it went through the second half of this year and as you stated, it's important task to grow inorganically as we think about this business going forward and the capabilities we have. There is a lot that we want to do to augment those capabilities in particular as we talk about moving from sensing solutions and the helping make decisions, the analytics and software required, again to focus on total mission outcomes for our users. And that's going to require inorganic activities like it happen in concert with organic work. Now with regard to the potential targets that are out there, their size et cetera. It's sort of all over the Board, and I think you all know evaluations right now can be incredibly high. Now we have a very active pipeline underway. Of course, there is only so much certainly we can talk about that here. Have not yet certainly been able to execute on the deal in the back half of this year to talk about. But regardless, lots of activity underway and as we mentioned on earlier calls. We want to have a balanced approach of share buyback opportunistically when it makes sense for so deploying our own capital to invest in our technologies. We want to constantly innovate and disrupt of ourselves if you will, do acquisitions as we've talked about. And we are also looking at opportunities to make minority investment in companies that perhaps we don't want to acquire out right, but have a technology or capability that's important to us. So that's an area of interest as well. But Carol any additional thoughts from your perspective.

[Carol Lowe:]

Yes. Thank you, Jim. I would say we will share more information on our capital allocation strategy when we have our Investor Day in May. We do enjoy the benefit of investment grade rating and would intent to maintain that rating. We feel like it's the right decision for the company, it gives us financial flexibility to address acquisitions as they come up under the right strategic acquisitions in addition to rather when they are a broader macro impact from an economic standpoint. So we will continue to focus on maintaining the investment grade. And look for the right opportunities to invest for both organic growth as well as acquisitions as Jim described.

[Jim Cannon:]

And I'll just cap it off, Noah, by saying right now our focus we have and you see it in the guidance of 46% organic growth. We want to consistently demonstrate organic growth. And as we mentioned in the past -- in organic strategy that compliment that as we go forward.

[Noah Poponak:]

Where do you -- where you can take leverage net debt to cap or net debt to EBITDA and maintain your investment grade rating?

[Carol Lowe:]

So we can probably go right now up to about 2.5x but again it's all depending on the quality of the asset. If we are executing an acquisition. So depending on the cash flow generated and the accretive value that gives us room as well, as well as the commitment to bring leverage back down. So as always with acquisitions it depends but we have quite a bit of room to go from our current leverage grade before we would even start pushing that out of bound.

[Noah Poponak:]

And where would you pin the likelihood that, that happen in 2018 that you take leverage 2x -2.5x for inorganic activity.

[Jim Cannon:]

Yes. There is no way really for us to predict that, right. Certainly would be opportunistic as those kind of deals came along. But right now would be difficult for us to predict anyway.

[Noah Poponak:]

So with the guidance having the share count up to decent amount, should we think of that as there is enough in the pipeline to --even though you can't predict that likelihood that there is enough in the pipeline that there is decent chance of that happening or should we think of that as more like a placeholder and if nothing happen to your buyback stock.

[Jim Cannon:]

Yes. We really don't want to speculate what's going to happen with future acquisitions in 2018. Suffice to say we are going to continue to be acquisitive but impossible for us to predict timing or give you any sort of forward looking insight there.

[Operator:]

Thank you. Our next question is coming from Peter Arment from Baird. Your line is now live

[Peter Arment:]

Thank you. Good morning, Jim, Carol, Shane. Jim, on the guidance when you -- the 46% organic maybe can you just may talk about some maybe the puts and takes, how you are maybe thinking about that? And how that looks maybe on if you can from a segment level, maybe if you could just quantify it a little bit? Thanks.

[Jim Cannon:]

Yes, sure, Peter. If we look at past performance, 46% organic growth is a sound improvement as we go into 2018. And we look across the business and you know from following our company for sometime with six segments now three business units, over the past several years it's been a bit choppy the end market. We would have one business that could be significantly ahead but then that could be neutralized by another business that perhaps the market dynamics weren't strong. Right now as we look at our end market across commercial and industrial and government defense business unit, we feel pretty good about all of those markets. We have a multiyear budget now that's been passed by our law makers and while in 2018 that doesn’t mean a lot tailwind to us, certainly going into 2019 with OCO dollar, OCO funding being included in that budget. It gives some confidence for our war fighters to make decision around readiness and modernization et cetera. Our commercial business unit, we took a pretty big step focusing the security business away from retail and into places where we can differentiate. Our Maritime business is growing nicely throughout 2017. And with Axiom and other new products has momentum. The industrial business unit in particular with the acquisition of IIS which anniversaried itself in November is seeing just tremendous organic growth throughout 2017. And that's without the introduction of thermal into their kind of product or technology offering. That's with their core machine vision. So across all of that they use when we think about that 46% organic growth rate, we don't see any real laggard. All the business units we expect to perform and contribute to that kind of guidance. And we want to throughout as we mentioned earlier do that with leverage down to our earnings. So as I mentioned on the earlier question, organic growth maintaining and improving margins, good capital efficiency, those are the three sound metrics that we are going to be really, really focused on. And then as you'll hear in our Investor Day, executing the strategy with inorganic opportunities that lay in accretive to that effort.

[Peter Arment:]

It's helpful. And just about as a follow up just you mentioned kind of create this new or pricing strategy. I was wondering if you could just give us an example maybe how this is different from what is being done today from I guess you mentioned standardization across the platform.

[Jim Cannon:]

Yes. So with the full method and we are really excited about it. It brings an operating discipline into our business that really begins to take us into -- I don't know -- I hate to use the word next level but for lack of better one I'll use it, to the next level. Again, FLIR is a great company but as we brought six segments into three business units, we really tapped into a lot of economy of scale and synergies when it comes to standardizing processes. And when we think about how we want to drive margin improvement, pricing and productivity are two of those key levers. Now with regard to productivity, for a long time we've worked to improve our processes and improve yield and improve again the way that we implement lean on the shop floor but we can always do better. And we've got different site sort of different places on that continuum of lean manufacturing prowess. With regard to prices, pricing the same holds true. So we want to bring in a seasoned pricing leader who has spent a career in that discipline and we are fortunate to get great individual on board, now building out that team and you know with the good pricing analysis, first it start with collection the data right. Really understanding where those opportunities are, pricing to win et cetera. I'll say that the team is formed. Those efforts and operating rhythms are underway. But a pricing effort won't take effect right away. We are going to be working through the first half of 2018. And I expect more into the second half of 2018 really going into 2019 is where we are going to see the real tailwind of that effort. So the 46% organic growth that we are targeting right now is really volume driven to begin with.

[Operator:]

Thank you. Our next question is coming from Drew Lipke from Stephens. Please proceed with your question.

[Drew Lipke:]

Yes, good morning, guys. Just maybe talking about the commercial strategy and thinking about the level of vertical integration that FLIR has historically targeted there and maybe you rolled out your Thermal by FLIR at CES, can you maybe talk about this and talk about some of the changes that you are making in the go-to-market strategy in commercial?

[Jim Cannon:]

Yes. So when we think about -- when you mentioned Thermal by FLIR, I mean that's in our industrial business unit but we'll talk about commercial products in general. I wouldn't say there is any significant shift to how we are going to market per se but we are certainly organizing differently. We are thinking about end markets. For example, first responders, there are a lot of different parts of our business to touch that. How can we come together and have a more coalesced offering? But across our commercial business unit and industrial business unit, there is a lot of product innovation it's underway that's given our sales team a lot of great tools to go out in the market and help solve problems for our customers. We mentioned ADK that we launched at the consumer electronic show which is really helping autonomous automobile designers understand what they can do with thermal. Again, the benefits we could talk about on and on as we mentioned earlier its capability. And Thermal by FLIR, we got a lot of great partners that again have end users that thermal technology is really helped with their jobs day in and day out and accomplishing their mission. So you'll see our partners with Thermal by FLIR, I don't know if it signals a different wholesale go-to-market strategy, but certainly maturing some very strong relationships with partners in the marketplace.

[Drew Lipke:]

Okay. And then it seems there wasn't a viable case for thermal in retail security. And a lot of that seemed to tie to the fact you couldn't really drive the thermal penetration there and realize the pricing. As we think about some of your other markets, I mean are there any others that need portfolio shaping or maybe if there is not a real viable case for thermal in your opinion as you look maybe at the commercial segment.

[Jim Cannon:]

Well, you are right. And again we made the decision with the retail business that long term it wasn't a fit as we want to focus on more of those perimeter security application where thermal really is a differentiator and critical infrastructure et cetera. In our Maritime business which is growing nicely and improving margins, we again got that business out of bankruptcy and have steadily made improvement to, but it was really this year with Axiom, the new MFD and other technologies that it began to grow and accrete at great clip and when we looked at what it was, our thermal offering for the recreational boater there wasn't perhaps the adoption we wanted. Now we are addressing that and have addressed that by introducing price point to the more affordable for the recreational boater to use thermal on the water and also then focusing our business on a lot of commercial maritime application. I'll point to the SINS and SINS 2 order that we secured from the coastguard. When those guys are going out to the sea the recreational boater are trying to get off the water. And there is no doubt that thermal technologies are an important technology to increase awareness and perception on the sea to avoid other objects to operate under tough weather conditions et cetera. So again right now not prepared to announce any kind of wholesale go-to-market difference. But you'll see us continue to focus on in the maritime space. Those commercial opportunities and build our relationships with the folks like the coastguard, maritime law enforcement et cetera.

[Operator:]

Thank you. Our next question today is coming from Jonathan Ho from William Blair. Your line is now live.

[Jonathan Ho:]

Hi, good morning. I just wanted to start out could you maybe quantify for us or just remind us of how much of the revenue was pulled forward from Q3 to Q4 in terms of the Surveillance business unit. And then just given some of the changes in the business how we should we think about any potential shift in the seasonality for 2017 either on the revenue or expense lines?

[Jim Cannon:]

Right. So we had about $15 million that came into the third quarter of 2017 out of the fourth quarter of 2017 for that Surveillance business accelerated delivery that the customers needed. The EO/IR-FP program which was awarded in Q3 was shipped about $7 million of that in the third quarter. Another $4 million in the fourth quarter as we are constituting or reconstituting the supply chain to make delivery. In DR-SKO was another piece again that had that shift. If we think about seasonality going forward, I don't know foresee, we don't predict any huge change in what we think traditionally with our seasonality. If we think about our government and defense business now that there is a multiyear budget in place perhaps that provides more consistency. Whether would it be a bit more volatility and how some of the businesses would come in but at this point no real change I believe in our seasonal. Carol, anything to add from your perspective?

[Carol Lowe:]

So, Jonathan, I would just note that as we look at our 2018 operating plan and the guidance we provided, just a reminder that we did have a very strong Q3 as well as Q4 in 2017. So from a comp basis when we compare 2018 to 2017, the second half of the year will be a little bit more challenge versus both comps compared to the first half of 2018.

[Jonathan Ho:]

Thank you. That's very helpful. And then just as a follow up in terms of your comments around operating leverage. I guess I wanted to get an understanding or better understanding of what you think the magnitude or the impact and the timing for some of the process enhancement you are looking at would be for either 2018, 2019 maybe sort of a medium term. What can you really do from an operating leverage standpoint?

[Jim Cannon:]

That's a great question. So we have expanded margins throughout the course of the year. But I would not attribute that margin expansion in 2017 to FLIR method. We introduced the FLIR method in the third quarter, we established executive sponsorship, and we began to detail how we want to execute it and how it makes it for FLIR, what are the levers that we want to go after? Because it wasn't just productivity but we want to increase velocity. We want to increase velocity in which we innovate. We want to focus on talent development. Lot of components to the FLIR method. Again to mature and become a much more disciplined operator as we move from six segments into three business unit. So, now I am happy to say we do have that dedicated leadership and resources to point of impact. We moved some very talented folks to be dedicated to FLIR method. We recruited some great talent from outside. And probably our biggest event to date is in the fourth quarter we did a big effort in our IIS business that you know is growing significantly over the past year to a point that its backlog really needed to be reduced. We got improved our capacities there. So the team went up there with intent to do just that. Reorganize the manufacturing footprint, shop floor to be able to get more products out, more velocity and capacity through the business. And we are beginning to see that. But like all continuous improvement efforts, there is a bit of long tailwind until we can really realize forecast and has great confidence in predicting when that productivity will come through. So as we think about 2018 right now, while we certainly have internal targets that we are going after, much of the FLIR methods benefit as on the pricing side will come towards the end of 2018 with the intent that we are really trying to build strong conditions with regard to margin improvement as carry over into 2019.

[Operator:]

Thank you. Our next question today is coming from Peter Skibitski from Drexel Hamilton. Please proceed with your question.

[Peter Skibitski:]

Good morning, guys. Jim you alluded earlier to the strong kind of budget allocate at this point within DoD. And in light of that I am just wondering are you guys trying to see any kind of chunkier, larger program opportunity at DoD? Or you think as far as Surveillance goes it's a matter of continue to kind of hit signals and doubles right in the home runs, you got the kind of their large a quarter or two ago. I am just wondering if there is more out there with the budget going up.

[Jim Cannon:]

There are more out there. There are some pretty significant programs probably the largest of which is the soonest is G-BOSS-E which is going to be what the EO/IR-FP or what used to be RAID evolves into. So certainly that's something that's front incentive for us. Others as well, David Ray brings a new perspective to our government defense business unit as well. We are going to compete for programs as well as continue to go out for signals and doubles. But why don't I let David say few words in this regard.

[David Ray:]

Thank you, Jim. Jim mentioned earlier, I think the outlook for 2018 is good for the business. To your question about the budget, as the budget firms up as we talked about, we see more opportunity in kind of your rotary ring platform with respect to modernization budget as they firm up. Jim talked about readiness which we think about the concept of readiness really being able to look at ways to modernize existing systems, other end field. Both land, sea and air, those present opportunities for us from an upgrade perspective to really look at ways to we can grow business with those double and triples as you talk about versus the signals that we kind of seen in the past.

[Jim Cannon:]

And we are not opposed to home runs either. So we are going to swing for the fences where we can for sure.

[Peter Skibitski:]

Thanks guys. Let me ask one for Carol. Hey, Carol, do you have any CapEx expectation for 2018? Maybe a D&A look also.

[Carol Lowe:]

So our CapEx, we are expecting it to be higher than what it has been in the last couple of years; ranging somewhere around that 2.5% to 3% of revenue. So that's where we expect that to be. Our D&A, depreciation and amortization and including our stock comp amortization with $102 million for 2017 and we would expect it to be basically at that level for 2018.

[Peter Skibitski:]

Got it. And Carol does this new revenue recognition standard impact you guys in any meaningful way?

[Carol Lowe:]

No. It doesn’t. The transition impacts that will go directing retain earnings upon implementation. It's less than $5 million and on a go forward basis it's not significant. Obviously, some timing impact especially in the government and defense business but overall not material.

[Peter Skibitski:]

Great. One last one guys maybe for you Jim. I feel like we haven't talked about this yet. And I thought you needed to be broached because it has been in your filings. Does this [I Tower] or kind of language let's call, that's been in your filings. Is there any reason for us to be concerned there? I raised it because I had another company that had an issue when it cost them some money. How are you guys thinking about that? I am sure you have fair language in the K?

[Jim Cannon:]

Sure. What we have consistently disclosed that we are in continuing dialogue with the State of Department with respect to compliance program. And we have detailed the voluntary and other disclosures that we made to the state department with respect these issues. We've also mentioned on previous call the investments that we've made to remedy these issues, these are areas that we've maintained significant focus and we are working hard to make sure we got the best processes, best people in place to ensure we are world class in that regard. Historically, a consent agreement has been tool used by State Department to ensure mediation in situations like ours. But regardless the outcome of our continued discussions with the state of a company, we have both the legal and moral obligation to safeguard our technology. And we are committed to do that. As a veteran myself and to represent the hundreds of veterans we have at FLIR, we know first hand how important it is to protect technology for our country.

[Operator:]

Thank you. Our next question is coming from Jim Ricchiuti from Needham & Co. Your line is now live.

[Jim Ricchiuti:]

Hi. Good morning. Just question on the IIS business and you alluded to this, the strength you saw last year and I am just wondering what's the outlook look like for this business just given the difficult comparison? What do you seeing in some of the core commercial market that they address?

[Jim Cannon:]

Well, again the acquisition of Point Grey or IIS is we call it now fantastic acquisition. And we bought the business again we intended to introduce thermal technologies but their organic growth rate, the backlog then became and all hands on deck to meet that backlog, really we've not even gotten to the step yet which we see as opportunity as we go forward. Now, throughout 2017 they grew tremendously. Do we expect that continue growth rate? No. They had one job in particular, it's drove a lot of organic growth. We are kind of gotten through that. And we are backed down to what we will say is what -- is a more normal rate going forward. There is still a pretty significant cliff. Also mentioned, this is one of the places where we first had made big steps with the FLIR method to drive and improve capacity. But with us here is Frank Pennisi; he leads the Industrial Business Unit. Frank, any additional comments you like to make about IIS.

[Frank Pennisi:]

Yes. I would tell you that IIS sits in two fabulous markets. You got machine video and market at the high single digit market; you got a people count market, its lower double digit market. And the fact that there is a strong player in that arena, there is a lot of tailwinds and lot of ability to continue driving and performing throughout the year.

[Jim Cannon:]

And you know its part of our company. We are going to continue to invest in. We like the technology. There are again great synergies with the rest of FLIR and the customers we serve. So again you'll see us continue to feed that part of our business.

[Jim Ricchiuti:]

And follow up question. You may have addressed this and I may have just missed it. But did you comment at all on the potential gross margin lift that you could see from the divesture of the Lorex business?

[Carol Lowe:]

No. We didn't make the specific comment at the gross margin as the operation margin level. The improvement without the Lorex business for 2017 would have resulted in 170 basis points higher operating margin. The business that was dispose that is basically ran it breakeven at an operating income level for 2017.

[Jim Ricchiuti:]

Got it. But is it fair to say that it has been a drag on gross margins?

[Jim Cannon:]

Yes. $140 million in revenue is breakeven on margin, yes.

[Jim Ricchiuti:]

Yes. And the last question for me and this is more of just with respect to the automotive market, more of a bigger picture question. You had some challenges clearly penetrating the automotive market. And I am just wondering Jim, as you think about that market and the ADK, any sense as to how we might think about FLIR playing in this market longer term?

[Jim Cannon:]

Sure. I don't know if I characterize as challenges. I don't think that marketplace and a technology that they are going to be used for ADK are still very much evolving. Low cost radars, thermal sensors, lidar et cetera, there is still just a lot of technologies been explored and price points being examined to see what make sense. As we talked about ADK and introducing that, that's another way by which we want to drive adoption awareness of the capabilities of thermal technology. And we've had successes in particular with using thermal cameras to identify deer or other animal that could be on the side of the road ahead or outside of the headlight beams to be able to predict any kind of collision there. And I'd say also when we think about ADAS, we think about thermal technology and again we do more than just thermal low cost radar et cetera. We think about unmanned not just automotive. For example, commercial trucking applications that indeed might enter the market and be seen on the roads before you see automobiles an ADAS applications or the same technology is used on the military side of the house, where you will see more and more unmanned vehicles on the battlefield. One of the biggest casualties producing tactics that our enemies have used has been the IED. And so having trucks or convoys moving over open road and in the battlefield exposed to that, it's certainly something that our leaders want to eliminate going forward. And again there you see our technologies that are already widely adopted and widely known. So I think there is certainly market maturity that's got to continue to happen. We are going to continue to educate and collaborate with our partners to inform them about the capabilities of thermal technologies but we want to also provide a whole suite of sensing solutions in that regard not just for the automotive marketplace but I would call it for the unmanned space.

[Operator:]

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

[Jeff Kessler:]

Thank you. And hi Jim, hi Carol, hi Shane. Just two quick questions. Number one as you consolidate and come out with basically three new groupings that speaks towards cross selling. And cross selling obviously not just across all of the visions but particularly within the three new divisions more emphasis on that. Are there going to be some incentive set up to that are not in place right now to improve and incentivize more cross selling of product as these groups begin to -- as the group begin to consolidate from 6 to 3?

[Jim Cannon:]

Jeff. That's a great question. And that's -- it's absolutely one of the opportunities that we wanted to after as we consolidated from six segments to three business units. For example, our OEM business sells through a lot of defense prime contractors that also touch what was our Surveillance business. Or if you look in the commercial business unit, we have security products and technologies that sell well within intelligent traffic solution or other transportation safety application. Or maritime for example, we mentioned maritime working to -- with the coastguard on SINS and SINS2 and obviously we worked with the coastguard on the Surveillance side as well with their airborne gambles and whole host of other technology. So step one is bring the businesses together under common leadership. So you got a leader that's making sure they are making decisions for once FLIR if you will. And then step two just that, how do we organize our team, identify those end customers we are going to and de -conflict any space that we might have there. So we are putting the best space forward. And then lastly, of course, we want our sales team as they go out in the marketplace not to be disincentive or that see other parts of our company indeed as competitors within the market. But operator as one FLIR and as we go into 2018, those things are coming together. We are again about a quarter and half into the integration of the segments into the business unit, but already opportunities are coming forward. That's great question, Jeff.

[Jeff Kessler:]

Okay. And one final question that is I think it was mentioned that Boson sales were down a little bit. Was that for one segment or was it for the company as a whole? And that was for the quarter I am assuming.

[Jim Cannon:]

No. I must have must misspoke or you have heard that wrong. Boson is actually up. And we’ve got some great product launches with it. The Boson for its size, weight, power consumption, processing capability, market leading capability. So when OTS was to breach in other cameras, the Duo Pro, et cetera, Boson now as we are improving more and more just to get the capacity up and yield up as well. Boson is growing product line for us.

[Carol Lowe:]

Yes. I think just to clarify the reference was to some other core and core components that was not relative to Boson.

[Jeff Kessler:]

Okay.

[Jim Cannon:]

Boson has been very well received in the marketplace; it's enabling again a lot of solutions and capability.

[Jeff Kessler:]

I only asked because I must have misunderstood because that surprised me greatly. That's it. Great, thank you very much.

[Operator:]

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

[Michael Ciarmoli:]

Hey, good morning, guys. Thanks for sticking around here and take the questions. Maybe Jim or Carol, I don't know who want to hand this one. But you clearly --you refocused the security segment; you got momentum in all markets. The volume seems to be driving all the growth. I understand the pricing analysis and productivity. Maybe you get a little bit of benefit in late 2018 but that's more 2019. I would have expected to see more leverage and drop through. I mean it seems like the margin expansion next year is really just from losing the low margin Lorex and we've sort of got flat operating margin with the majority of EPS growth coming from tax. Is there more conservatism there? And I could appreciate Jim and Carol; this is your first time issuing full year guidance. But any color why there is not more core margin expansion on the volume growth?

[Carol Lowe:]

So if you are looking at earnings per share, the one thing note so the tax reform is giving us the year-over-year benefits $0.10, so noticed favorability for that. You also have to take into account the dilution that occurred relative to shares in 2017. That creates an overhang for us in 2018. And so it masks good operating leverage performance by about $0.04 per share. So you have to take that into account as well. And I think that's why it's not coming through in terms of the leverage that we are really seeing in operations results for the year.

[Michael Ciarmoli:]

Okay. But it still seems like the margins are going to be fairly flattish, right? So you are just saying that there is some of that overhang was in the margins as well.

[Carol Lowe:]

No. From a margin standpoint we do have -- we have uplift relative to the sale of Lorex business. And right now again we are focused on accretive revenue growth, organic growth that's built into the forecast and as Jim noted, it's predominantly on volume for 2018.

[Jim Cannon:]

And you know as we look back in past years, putting 46 points organic growth, maintaining indeed expanding margins consistently demonstrating leverage. That something that's real important for us to have a consistent say do ratio going forward. And that's why you hear so much focus about the FLIR method, pricing et cetera. Systemic things that we can put in place so that if we have any kind of large make shifts et cetera in the business, we can still again grow organically, maintain or expand margins and impress the business forward. So for us 2018 is a good step forward particularly when you compared to those metrics over the near past.

[Michael Ciarmoli:]

Got it, that's helpful. And then maybe just for David on the government. You came from Raytheon. I have always thought FLIR had the quicker go-to-market strategy more of the commercial off- the- shelf. It seems like the DoD with comment from Ellen Lord; she wants to get technology into the field faster. I mean it would seem like the new strategy is tailored specifically to one FLIR deliver from a manufacturing standpoint to the war fighters. Is there anything you guys have to do differently with the sales strategy? Or is it just more basic blocking and tackling to either win the singles, doubles or even get the home runs?

[David Ray:]

I think it's a combination of both. That's a great question. I think Jim talked about our ability to focus. If you think about what we've traditionally done in the market we play in with respect to our Surveillance and Detection business. I think there is a tremendous opportunity to focus on those customers where we can drive the most amount of value. I agree that one of the reasons this company is positioned as well as I think it is in the government defense space is because of that agility. It's because our size as we continue to grow, allows us to take innovation, implement and execute at a pace that our competitors can't do in the marketplace. And we are going to take advantage of that. And we think it presents opportunity. We just have to take that energy and focus in the right market with the right customers on the right mission. And continue to focus on how we are helping the customers deliver mission outcome and not just selling the product. We feel like we can do both. We feel like that creates an opportunity to capture more of the customer budget, but doing that and focus amount is really what's going to take us to the next level.

[Operator:]

Thank you. Our final question today is coming from Josh Sullivan from Seaport Global. Please proceed with your question.

[Josh Sullivan:]

Hey, good morning. Thanks for -- me in here. Just one question. Are there any updates on the Black Hornet with SBS? I think the industry day was mid January, just any update on what this opportunity could look like or maybe timing at this point.

[Jim Cannon:]

Yes. So there is another industry day or fly off I am not sure what the nomenclature of it is, at Fort A P Hills, that's coming up. No decision yet. Hard for us to predict when that decision will come. But still very much in the competition and again there is going to be another gating exercise or fly-off that's coming up will be participating in. I will note in the fourth quarter and as Carol mentioned we got $7 million Black Hornet from the Australian Army. And we are really proud of that. And programs are going to build upon that. I have had the privilege over the past quarter to talk to various users that actually use Black Hornet in theater on target et cetera and the feedback that we get from them, it really moves us. When we think about our purpose of innovating, to save lives and livelihood. The Black Hornet is just doing that right now around the world. So not sure exactly when SBS will come or how to close but we continue to focus very heavily on that technology and believe very much in its capability in theaters.

[Operator:]

Thank you. We 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.

[Jim Cannon:]

Well, again I want to thank all of you for joining our call today. I want to especially thank all of our employees for their hard work in 2017, and their dedication to our customers. I look forward to talking to all of you again soon and seeing you at our Investor Day on May 16 in New York City. Thank you very much.