FLIR Systems, Inc.
Q1 2016 Earnings Call Transcript

Published: 26 Apr 2016

[Operator:]

Greetings and welcome to the FLIR Systems First Quarter 2016 Results Summary. 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. I would now like to turn the conference over to our first speaker, Todd DuChene, Senior Vice President, General Counsel and Secretary for FLIR Systems. Please go ahead.

[Todd DuChene:]

Good morning. 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 forecasts. 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. Let me now turn the call over to Andy Teich, President and CEO of FLIR Systems. Andy?

[Andrew Teich:]

Thanks, Todd. And I want to welcome, everyone, to FLIR's first quarter 2016 earnings call. With Todd and me today is our CFO, Amit Singhi; COO, Tom Surran; Chief Marketing Officer, Travis Merrill; and Senior Vice President of Corporate Development, Shane Harrison. I'll start with a review of the quarter with slide three of the presentation. This morning, we reported first quarter revenue of $379 million, up 10% from the prior year and up 12% on a constant currency basis. Commercial product revenues grew 4% over the first quarter of 2015, while government product revenues grew 20%. Earnings per share were $0.01, which were negatively affected by a $40-million charge to establish reserves booked in the quarter, primarily related to an excess profit ruling dispute between Belgium and the European Commission, which Amit will discuss in more detail. Excluding these charges, earnings were $0.30 per share, which compares with $0.34 per share in the prior year. First quarter operating income was $57 million compared to $66 million in the prior year. As we mentioned in our outlook commentary last quarter, the first quarter of 2015 proved to be a difficult comparable, as it was a quarter that had lower than normal corporate costs as well as our strongest gross margins in the past three years due to foreign exchange and a strong Surveillance product mix. Bookings of $379 million were the highest first quarter order intake we've seen in over five years. Backlog continues to grow, reaching $613 million, which is the highest level since 2008. Surveillance segment bookings grew 50% over the prior year, driven by strong international orders. We introduced several new products since our last call, including the new Boson thermal camera core. This innovative new core is priced and has performance above our Lepton micro camera core and it features powerful onboard processing capabilities enabled by a programmable Movidius Vision Processing Unit. Boson features our latest 12-micron pixel design and is offered in VGA and QVGA resolutions with 15 different field of view options to choose from, each of which use internally produced optical components. Boson's revolutionary size, weight, and onboard processing power will open up new applications and uses for our technology given its versatility and low-power consumption. On the Lepton front, we've been successfully integrated into two new OEM product platforms during the quarter. First was the announcement of the ruggedized Cat branded smartphone that will feature thermal imaging and a FLIR app that will provide building professional, electricians, and first responders the ability to measure surface temperature from a distance, identify mechanical and electrical problems, spot moisture and missing insulation, see in total darkness or see through smoke. Second was the Scott Sight, hands-free thermal imaging system from Scott Safety, which is the first head-mounted thermal imaging system to have a micro display integrated inside the SCBA mask. Both of these products take full advantage of Lepton's industry-leading size, weight, power and cost capabilities. Also, on the firefighting front, we introduced five new FLIR branded firefighting solutions at the FDIC show last week. We continue to see strong market share gains in the fire market. On slide four, you'll see our updated outlook for 2016. We continue to expect revenue to come in between $1.6 billion and $1.65 billion and EPS to be in the range of $1.60 to $1.70 for the full year, excluding the impact of the tax reserve booked in Q1. This represents a revenue growth rate of between 3% and 6% and an EPS growth rate of 3% to 9% when compared to 2015 results after adjusting to exclude the 2015 restructuring charges, investment gain and discrete tax items. Given product margin expectations for specific programs in Surveillance, consolidated gross margins in the second quarter are expected to remain near Q1 levels. These programs are winding down. And thus Surveillance segment as well as consolidated margins should improve in the second half of the year. We intend to be diligent in absorbing gross margin softness through operating cost management. We also announced today a quarterly dividend of $0.12 per share which will be payable on June 3 to shareholders of record as of May 20. I'll now hand the call over to Amit to review the first quarter financial results. Amit?

[Amit Singhi:]

Thanks, Andy. On slide five, you'll see our first quarter financial results. First quarter consolidated revenue was $379.5 million, an increase of 10% compared to the first quarter of 2015. Currency continued to negatively impact the top-line and particularly for the Instruments and Maritime segments, but to a lesser degree than we have experienced in prior quarters. Excluding the impact of currency changes, revenue would have been up about 12% compared to prior year. The largest drivers of the revenue growth came from the Detection, Security, OEM & Emerging, and Surveillance segments increasing 61%, 21%, 20% and 10%, respectively. Maritime revenues improved 1%, while Instruments experienced a 5% decline, driven primarily by softness in the mid-range of the Building & Predictive Maintenance product lines. On a currency adjusted basis, Maritime revenues would be up 5% and Instruments down 3%. Recently, revenue increased in all geographies, except Europe, led by 78% growth in Canada/Latin America and 17% growth in the U.S. Sales to the U.S. government increased $32 million or 61% and represented 23% of total revenue compared to 15% in the first quarter of 2015. Consolidated first quarter gross margin was 47%, a 4-percentage-point decline compared to last year, primarily driven by product and segment mix changes, manufacturing cost absorption, some inventory adjustments, competitive pressures in security retail channels, and non-recurrence of favorable exchange related gain from last year. Operating expenses increased by $10 million or 9% year-over-year, primarily due to the addition of expenses related to the DVTEL business that we acquired in the fourth quarter of 2015 and some corporate expense credits that were recognized in 2015 and did not repeat in 2016. Our operating margin fell from 19.1% in the first quarter of 2015 to 15.1% this year, primarily due to the decline in our gross margin. Our tax expense in the first quarter was $54.5 million, which is based on an estimated annual effective tax rate of 26%, plus reserves for discrete tax items totaling $40 million. These reserves are primarily associated with the previously disclosed European Commission decision against the Belgian tax authority. The Belgian government is currently appealing the decision. The final exposure to FLIR, if any, is subject to the result of the appeal, other related litigation and the determination of any additional deductions that we may be able to claim. The impact of these items have not been factored into our reserve. The company continues to comply with all tax laws. And we expect our 2016 effective tax rate to remain at approximately 26%, excluding any discrete tax items. Net earnings for the first quarter of 2016 totaled $1.1 million or $0.01 per fully diluted share. Excluding the discrete tax items, adjusted net income in the first quarter was $41.2 million, down 14% from last year. And adjusted EPS was $0.30 compared to $0.34 in the first quarter of 2015. We closed the first quarter with cash of $510.6 million, an increase of $37.8 million during the quarter, primarily driven by operating cash flow. Our cash flow from operations for the quarter was $44.9 million or 109% of net income, excluding the discrete tax items. We had capital expenditures of $10 million in the first quarter and returned $16.5 million to shareholders through the payment of dividends. We did not repurchase any shares of our common stock during the quarter but we will continue to evaluate our opportunities to do so in subsequent quarters. This concludes the summary of our first-quarter financial results. Let me now turn the call over to Tom Surran to cover our operational highlights. Tom?

[Thomas Surran:]

Thank you, Amit. You will see a summary of our segment results on slide six. While revenue grew 10% during the quarter, first quarter consolidated segment operating income declined 5% as a result of higher operating expenses, primarily from the DVTEL acquisition, and lower product margins. Moving to slide seven, during the first quarter, Surveillance segment revenue increased 10% year-over-year to $124.2 million. This growth was driven primarily by the Man Portable and Maritime product lines. Surveillance segment operating income of $35.2 million increased 17% versus the prior year, driven largely by reductions in operating expenses. We expect Surveillance second quarter operating margins to be several points softer than the 28% seen in Q1 due to the mix of product deliveries we see in backlog. We do not expect this mix impact to continue throughout the balance of the year. Surveillance backlog increased from the end of 2015 to $314 million. As Andy stated, bookings of $137 million were the highest level seen for the first quarter since the RAID and G-BOSS programs were active in the late 2000s. The first quarter book-to-bill ratio was 1.1x and the 50% year-over-year bookings growth were driven by demand from customers in the Middle East and Asia. Turning to slide eight, Instruments segment revenue declined 5% or 3% on a constant currency basis compared to the first quarter of 2015. Revenue of $79.4 million was negatively impacted by increased backlog during the quarter in comparison to a backlog reduction in Q1 of the prior year. In addition, we have not yet seen the recovery in the high-end Building & Preventive Maintenance offerings, which come from the recently introduced premium T1K product. We're currently developing new products to bolster our mid-range Building & Preventive Maintenance offerings, which were also softer in the quarter. The volume products in our BPM and Building lines that were introduced over the last few years continue to do well during the quarter, as did our OGI fire automation and science product lines. Instruments operating margin was 25%, a decline compared to the first quarter of 2015 as a result of increased operating expenses and higher production costs. Actions are being taken to return the segment's operating margin to its historic levels in the upper 20%s range. Last week at the FDIC tradeshow, Instruments introduced five new products for the firefighting industry. The FLIR K33 and K53 are handheld TICs which offer the firefighter the simplicity of a single button operation, but also provide four-inch displays and FLIR's FSX technology. The KF6 is the first thermal camera designed for mounting on fire engine ladders to provide better tactical awareness in directing firefighter activities. FLIR also introduced two versions of its Aerial Responder Kit which provides firefighters and first responders a ready-to-fly drone-based system, with powerful thermal imaging capabilities, enabling users to be able to assess a scene from an aerial perspective. On slide nine is our Security segment results. Revenue of $47.1 million was up 21% year-over-year. Visible spectrum products grew nearly 40%, but were partially offset by a year-over-year decline in our high-end, high-margin thermal product deliveries. Thermal products are often sold into large installation projects that do not occur on a regular cadence which can cause lumpy thermal product revenue. Security operating profitability fell to a loss in the quarter due to gross margins pressure associated with price reductions for certain slower moving Lorex product inventory, product mix shift to lower margin consumer offerings, and higher operating expenses, primarily from the acquisition of DVTEL. The DVTEL integration is ramping at a measured pace, but we intend to realize meaningful synergies in the coming quarters. The results for the OEM & Emerging segment are shown on slide 10. OEM & Emerging first quarter revenue was up 20% over last year to $47.8 million. Growth was broad across the product line with particular strength in Uncooled Cores, FLIR ONE and the new FLIR Vue drone compatible camera product line. OEM & Emerging operating profit was $10 million in the quarter with margins largely in line with the prior year. In April, OEM & Emerging announced Boson, an important addition to its Uncooled Core family of products. The powerful yet tiny Boson will provide a smaller, less power consuming and highly advanced thermal camera core to both our OEM customers as well as our internal teams. Boson's use of an advanced system-on-a-chip vector processor enables the FLIR XIR video processing algorithms for highly enhanced image quality with low-power consumption. The Boson's internal processing capabilities are expendable. So customers can add software and algorithms suitable for their specific needs. Since the end of last year, OEM & Emerging has added two significant new customers for its Lepton core, each with a particularly interesting thermal-enabled value proposition to their end-users. The Bullitt Group announced the CAT S60 ruggedized smartphone for the industrial and trade professionals that features thermal imaging capability to empower these customers with the ability to preemptively identify jobsite issues before they become significant problems. And in April, Scott Safety announced the integration of Lepton into an SCBA face mask for firefighters enabling firefighters to see through smoke and find hotspots in a fully integrated and hands-free way. Also, during the first quarter, OEM & Emerging Intelligent Traffic (sic) [Transportation] (17

[Andrew Teich:]

Thanks, Tom. We're pleased with the strong bookings growth and resulting year-over-year backlog growth of 10%. While revenues met our expectation for 10% growth, profit margins did not. Gross margins were impacted by a number of factors that we feel are temporary. Operating expense controls were not fully effective in making up the gross margin softness. We expect gross margins to return to the 48% to 50% range in the second half of the year. And we intend to focus on operating costs as we navigate through the year. As demonstrated by the product launches discussed this morning, the innovation engine within the company is strong. This is driving a continued progression in the expansion of military, commercial, and consumer markets. We're now fully integrated into our first smartphone, which has been a long-term objective to increase overall volume, build awareness and increase adoption. We continue to innovate across all sensor performance tiers as shown with the evolving versions of Lepton and now the introduction of the revolutionary new Boson camera core. We've already begun developing next-generation FLIR branded products based on this advanced sensor. That concludes our comments on the first quarter. We'll now ask the operator to open up the call for any of your questions. Operator?

[Operator:]

Thank you. At this time, we will be conducting a question-and-answer session [Operator Instructions] our first question comes from Noah Poponak with Goldman Sachs. Please state your question.

[Noah Poponak:]

Hi. Good morning, everyone.

[Andrew Teich:]

Good morning.

[Thomas Surran:]

Good morning.

[Noah Poponak:]

I think you said – correct me if I'm wrong – Surveillance and consolidated gross margin both about flat sequentially in the second quarter. And then I think you said Surveillance segment EBIT margin down a few hundred basis point sequentially in the second quarter. Could you kind of, I guess, fill in the blank and tell us where you see the consolidated segment EBIT margin heading directionally sequentially in the second quarter?

[Amit Singhi:]

Yes. So, the overall – this is Amit Singhi. The overall softness, as we said, given the overall Surveillance business and the mix that we see in the second quarter, the margins are going to be a bit softer in Surveillance. Overall, as a company, we believe that we would be about in line with where we are on the gross margins in the second quarter. But the operating margin we will see an uptick from where we were in the first quarter.

[Noah Poponak:]

Okay. I guess if I remember correctly last quarter, you were pointing to roughly flattish full year 2016 versus 2015 consolidated segment margins. Is that still in play or are margins trending too much below what you originally thought to get to that?

[Amit Singhi:]

Right now we're still bullish on the second half, Noah. So we think it's generally in that range. As you know, some of this can skew a bit by shipments and product mix in a specific quarter. But, right now, we're still consistent with where we expected it to be. As you may recall, we had guided to a softer first quarter. Some of that is going to continue in the second quarter but the second half we believe would be stronger. So, overall, for the full year, we'll be still in line with where we thought we would be.

[Noah Poponak:]

Okay. And then, lastly, on margins, just – if I didn't know anything about the details of the quarter and I just saw the volume number, it's one of the better volume growth numbers you've had in a while. Typically, FLIR is a company with pretty good operating leverage on positive volume growth surprises. It sort of begs the question, are you pricing down mix-wise? And do investors need to be concerned that a lot of the new product introductions, especially things that are smaller core, are moving down the pricing spectrum? Are we facing this sort of margin dilution impact several more quarters going forward?

[Andrew Teich:]

Yeah. Noah, this is Andy. A couple of things on that. The first, at the top level, at the pricing level, there really haven't been pricing effects here. So what you're seeing here is not an effect of aggressive discounting to get sales to happen. There are some price effects in the Security segment where we're facing stronger competition there, but it's a small piece of the puzzle. To your point about what's happening with new products, as we introduce new products, those products fully support the long-term gross margin objectives of the company. And I don't have a concern around that. The area where we see margin challenges are primarily in the Surveillance segment where we have some larger programs that were booked some time ago that are nearing their conclusion. And these are programs like the MSC program for the U.S. Border Patrol and the PB-EOS program for the Coast Guard. And these are programs that were bid pretty aggressively early in the product development cycle and, as a result, have lower than corporate average margins and they pull down the overall margins particularly of that segment. The good news about that strategy though is it establishes credibility for those products and allows us to sell those products much more effectively in international markets, having the backing of major U.S. users behind them. And in those specific situations where we're selling them internationally, they fully support the corporate overall gross margin objectives.

[Noah Poponak:]

Okay. Thanks very much.

[Operator:]

Thank you. Our next question comes from Ben Hearnsberger with Stephens. Please state your question.

[Ben Hearnsberger:]

Hey. Thanks for taking my question. I wanted to start in Instruments. Specifically why you think you're seeing some softness in your mid-range products? I guess how would you attribute the softness here? Is it more Lepton cannibalization or is it just generally kind of a softer industrial environment?

[Andrew Teich:]

Yeah. Ben, this is Andy again. A couple of things on that. The first issue is, is that mid-range of our product value ladder; those are actually some of the oldest products that we have in our product value ladder. So, from a product development standpoint, we've been very focused on the low-end. We had tremendous success there. The C2 has been the hugely successful product for us following on the heels of our Ex product range. And also the IGM test & measurement products that we have introduced – and those are the traditional test & measurement products that have Lepton injected into them – have been doing extremely well in the market. So, we've got a very solid lower end as part of our Control the Corners strategy. On the other end of the spectrum – and again to our Control the Corners strategy – we launched our T1K product. That's a product that's just getting traction now. When you have a premium product like that that is typically a product that's involved in a replacement cycle of capital equipment, the adoption rate of products like that tends to take longer than one would expect because it is capital allocation type of budgeting process that's required to purchase that product given its price point. But we're seeing that start to get traction. The mid-range of the segment, which is our Exx Series and our Txxx Series, those are products that are the oldest of the product portfolio. They are due for a refresh at this point. They are still quite competitive in the market. But I think you look at the feature set that are coming in advanced new products like the C2 and then the T1K at the other end of the spectrum, it's quite attractive to customers and we'll blend those feature sets and capabilities into that mid-range product. Those products are under development now and are expected to be out within the next six months to 12 months and they will re-bolster that midsection. We also expect that to go somewhat hand-in-hand with the large number of systems and users that we brought into the fold. That those lower end products are likely to be candidates for people who are going to want to upgrade to higher performance units after they've been using a product like the C2 or an IGM product for a year. So we've had a very good track record of moving people up the value ladder after they see the value proposition that comes from thermal imaging.

[Ben Hearnsberger:]

Okay. And is it too early to tell on kind of that upgrade cycle and how long it will take to play out?

[Andrew Teich:]

Well, we've had a lot of experience with it. I think it's a little bit difficult to predict from a timing perspective. But I would say, from an efficacy perspective, we have had a very strong track record of moving existing customers into new product platforms through a combination of marketing and communication and, of course, offering a better value proposition in the subsequent product to make their jobs easier, the data more easy to interpret, imaging performance better and so forth.

[Ben Hearnsberger:]

Okay. That's helpful. And I've got a couple of modeling questions here for Amit. Can you call out the amount of the inventory adjustment in Instruments and how much that impacted margins in the segment?

[Amit Singhi:]

That is a level of detail we don't get into specifically.

[Ben Hearnsberger:]

Okay. Maybe one on Security on integration expenses. I doubt you'll call them out, but can you give us a sense for when those start to flow?

[Amit Singhi:]

What we talked about was primarily around just the inclusion of those expenses that were not in the comparable quarter last year, right. There are integration expenses, but the big piece of this was just the inclusion of the absolutes that were not in the comparison quarter last year.

[Ben Hearnsberger:]

Understood. Understood. So there is nothing really one-time that you would call out?

[Amit Singhi:]

No.

[Ben Hearnsberger:]

Understood.

[Amit Singhi:]

There are some, but they are not significant.

[Ben Hearnsberger:]

Right.

[Andrew Teich:]

Ben, I think – this is Andy again. I think the more important thing to think about in the integration effort on DVTEL is that – and I've seen this happen with a lot of companies that we've acquired. When you acquire a business like that, you bring in different sales leadership. There tends to be a big focus on what am I doing, what are my job descriptions and so forth, people getting aligned on their functions and territorial assignments. And then we also spend a fair amount of time in training, cross-training between the two sales teams, so they can get out there and sell that full suite of products. And, obviously, that takes time and is a distraction from day-to-day business. So, we saw a little bit of headwind effect associated with that. That said, that effort is going well. The products from a brand standpoint have been well integrated at this point and are represented on the website as such. And from a technical standpoint, the compatibility links that were necessary between the FLIR professional and thermal visible products and the DVTEL Video Management Systems have all been put in place and tested at this point. So, we're ready to hit the street running at this point with an integrated solution which is part of the vision on the integration of that business.

[Operator:]

Thank you. [Operator Instructions] Our next question comes from Jim Ricchiuti with Needham & Company. Please state your question.

[Jim Ricchiuti:]

Thank you. Yes. I guess a follow-up to the prior question. If we think about the margins and impact in the Security business, was integration expense that the biggest factor? I mean there were clearly a couple of other moving parts. I mean was Lorex a major drag on gross margins overall? And I assume it was also a function of the lower thermal. I'm just trying to get a sense as to what the bigger impacts were and how we should think about that going forward? Thanks.

[Thomas Surran:]

Yes, Jim, you're right pretty much where you were saying and speculating. And that's true is that we had some pretty good success with the Lorex offerings in terms of the overall volume. And it was at the time when, as Andy mentioned, a bit of distraction in the integration of the thermal team with the DVTEL team and we had a bit lower on the thermal side. So we saw a mix shift to the consumer offering. So that was one impact. We also did have some one-time events related to moving some of the slower moving inventory that we saw in the channel in the Lorex and we wanted to deal with it early in the product lifecycle rather than waiting till later when it could become a much larger issue. So we dealt with it. It's been done. And so that was kind of a one-time piece. So, those two were the major pieces that impacted the gross margin in Security.

[Jim Ricchiuti:]

So, going forward, you would assume that we're going to see – it sounds like we're going to see some improvement just on the two factors that you cited going forward?

[Thomas Surran:]

Yes. That would be a fair statement.

[Andrew Teich:]

Yes. That's correct. Jim, the other issue that's a pretty big factor in the Security margins is what the percentage of thermal is. And, here, we also had kind of a tough comp relative to last year. The number of cooled cameras that we sold in the Security segment in Q1 was down rather significantly versus Q1 of 2015. And that's a business that tends to be kind of lumpy because you're going after either large infrastructure or enterprise class customers. And they can be a bit lumpy. And when those projects do have a high concentration of cooled thermal cameras, there's a lot of margin in those. We did see growth in our uncooled thermal cameras during the quarter. But it was not enough to offset the fairly significant decline as a result of the lumpiness of the cooled camera business. We think that the prospect though over the rest of the year for the thermal business is quite good. The value proposition there is still quite strong. And we continue to introduce new products in that space. And it really is a key thesis of the success of that business, is to be successful in thermal and continue to drive thermal. And that's bolstered now by having the integration of a full Video Management System in our 360 C2 Surveillance platform. The integration of those three things offers a much more turnkey solution for customers that are doing large scale perimeter security applications.

[Jim Ricchiuti:]

Got it. Thank you.

[Operator:]

Our next question comes from Peter Arment with Sterne Agee. Please state your question.

[Asher Carey:]

Hey. Good morning, guys. This is Asher Carey on the line for Peter.

[Andrew Teich:]

Morning.

[Asher Carey:]

I have a question on Detection actually. The DR SKO program – I know it contracts out through May 2017 with the DoD. Because that's a meaningful part of the revenues for Detection, how should we think about the future opportunities? Like is there any runway beyond the first quarter of 2017 or is that revenue that will have to be made up?

[Thomas Surran:]

Yes. Asher, is it?

[Asher Carey:]

Yeah.

[Thomas Surran:]

Yeah. So, yeah, the DR SKO program – obviously, they have what's currently led in terms of the contracts and what's in the budget. Then all of a sudden there is the expected program life, which we see going up to 2019. And then there's the replacement. The need of the DR SKO offering solutions doesn't go away in 2019. And so we would expect derivatives or next-generation offerings to continue to be developed and supplied to the customers.

[Asher Carey:]

Okay. Thank you.

[Operator:]

Thank you. Our next question comes from Michael Ciarmoli with KeyBanc Capital Markets. Please state your question.

[Michael Ciarmoli:]

Hey. Good morning, guys. Thanks for taking the questions.

[Andrew Teich:]

Good morning.

[Michael Ciarmoli:]

Andy, maybe back to the margin question. I know I think you said you have no real concern about gross margins and the fact that they've trended down. But the reality is we continue to see these margins trend down. I mean as you guys think about it, you've made a decidedly, I guess, more aggressive effort to put out lower cost products, tap in the consumer market with Lorex. I mean should we be thinking about structurally lower margins going forward? I mean I know it sounds like you guys are designing products with these 48% to 50% gross margins in mind. But if we're going to have to start dealing with standard maybe retail issues, inventory in the channel, discounting, I mean, is this something we should just get used to?

[Andrew Teich:]

Well, I think, it's a function of the mix of the business, Michael. We see the gross margins manifest themselves lower when we have a segment like Surveillance which is normally pulling the overall margins up, margins that are below our target average. And, again, that happens when we have strong deliveries into a program, typically a US program, a record type program where we have lower than normal gross margin. So that's something that we're watching very closely. We continue to have the ability to bring in new business. The book-and-bill business, the international business that we bring into the Surveillance has margins that are well above the average margin for the quarter, so these things offset each other. You're correct that when we integrate businesses like Security or Raymarine that have inherently lower gross margins and those businesses represent the larger percentage of total for FLIR that it can pull down the overall gross and operating margins for the business. And I think that's something though that we can see coming from a fair way off. And in each of those businesses, we continue to make sure that we have products within those businesses, the thermal content products within those businesses that generate higher gross margins that help to bring up the overall gross margins of that business and offset the lower margins associated with the consumer and retail aspects of those business. I'd say a prime example is, is in the security space where we acquired DVTEL. We've integrated our 360 Surveillance business. Those are two software-oriented businesses that can support much higher gross margins that will help to bring up the overall gross margin levels for the Security business.

[Michael Ciarmoli:]

Okay. And even on your – you had a good bookings quarter, Surveillance. Is there anything in those bookings? I mean, are those – you talk about mix of deliveries next quarter bringing Surveillance margins down. Is there anything in the business you've been looking lately that has lower margin or something that we should anticipate that going forward in the Surveillance segment?

[Andrew Teich:]

No. We've actually done an analysis of the margin and backlog in Surveillance. And it looks solid. It's in line with our expectations. I think probably more what the wildcard is in Surveillance is what does the book-and-bill margin look like. And typically the book-and-bill margin looks good. And, again, we've said Q2 Surveillance margins will be down again as a result of us wrapping up a couple of programs that we've got in there. There are still three programs that are ongoing that have lower than average gross margins. And these are programs that have been around for quite some time that are just in the high cadence delivery phase right now. And we've got to run those through the system and they're going to pull over our gross margins down. I do want to underscore though the strong benefit that comes from programs like that because of the credibility that comes from being on these rather significant U.S. platforms. It really drives very strong credibility for those same products in international markets.

[Michael Ciarmoli:]

Got it. Thanks a lot, guys.

[Operator:]

Thank you. Our next question comes from Jonathan Ho with William Blair. Please state your question.

[Jonathan Ho:]

Good morning. I just wanted to start out – particularly given the outperformance in the full year and the fact that you guys left the revenue guidance range roughly the same, is there any sort of seasonality shift we should be aware of in terms of the revenue pattern or anything that was potentially pulled forward into 1Q?

[Andrew Teich:]

So, yes, Jonathan. We saw strong bookings in Q1 in both Surveillance business and in the Detection business. And it's possible that there may be some pull forward from Q2 in those bookings that we have. The business is still a bit challenging to forecast in that space. And we've now seen a couple of back-to-back very strong quarters in terms of overall bookings growth. I think Q4 was up 26% in Surveillance and Q1 was up to 50% in bookings. And we're very pleased to see that but the visibility is still a bit challenging on that front. The overall feel from the market is good. It seems like more frequently than not we've got new requirements that are coming in that weren't identified clearly in our forecast. And I've been in that space before in my career and it's a good indication that demand is increasing. And, of course, it's very much in line with how we operate as a company. Our CDMQ model affords us the ability to be very responsive in a short period of time to urgent needs. And we're seeing more of that urgent need requirement. So, as a result of that, I think, we're being conservative in terms of how we're looking at what the bookings look like for Q2 for Surveillance if there was a significant pull forward from Q2 into Q1, but I would also say that there's potentially upside in that regard.

[Jonathan Ho:]

Got it. That's helpful. And then just as a follow-up. As we look at some of the new products that you've talked about on the firefighting side with Cadillac, how should we think about, I guess, the expected revenue that's going to come from these products? Is there a meaningful ramp that we should be looking for or some type of acceleration and maybe what quarters those could fall into?

[Andrew Teich:]

Sure. Well, starting with the firefighting space, I mean this is an area where I mentioned in the prepared comments that we feel that we're doing quite well from a market share gain standpoint. And we're building on that success through the launch of five new products that were launched at FDIC, so those two new handheld products, one new dedicated product that mounts off the top of a ladder – truck ladder for aerial surveillance and two DJI drone-based products for drone-based aerial surveillance for firefighters which is becoming increasingly popular tool to have at a fire scene. I think this is part of our strategy. It's one of our key six strategic pillars to identify and attack new viable markets. And firefighting is one that – the market has been around for a while. The value proposition of thermal is incredibly strong there. We have a strong capability to create products and to innovate new products. And what we're doing here is not only building the value ladder of handheld products to have not only the most attractive opening price point all the way through the upper corner to a very attractive and well-priced NFPA system with our A65, but also to inject a couple of easy to use products in that and expand the overall product category by solving other problems that we're learning from firefighters which really come around we need to get an aerial view of what's going on at a fire scene. And that can be done from a ladder and from a UAV. So we feel that we should see that fire segment's growth bolstered by the expansion of new applications within that segment. And that's been a key strategy for us as we work to offset some of the softness that we're seeing in the mid-range of the product line in Instruments.

[Jonathan Ho:]

Great. Thank you.

[Operator:]

Thank you. Our next question comes from Jeff Kessler with Imperial Capital. Please state your question.

[Jeffrey Kessler:]

Thank you. One of the – can you hear me?

[Andrew Teich:]

Yes, we can. Go ahead, Jeff.

[Jeffrey Kessler:]

Thank you. One of the wildcards that's still sitting out there that has not produced big revenue yet is the OEM area. And I'm wondering, without going into specifics, which I am sure you won't, can you give us some broad-based areas in which OEM is being at least tested or beta tested or proof-of-concepted at this point in time, areas that may be of interest to us in a year or two years.

[Andrew Teich:]

Sure, Jeff. I'll talk about three things there. First, we talked about in the prepared comments the two new OEMs that we've established with Lepton, one being the CAT phone and the second being the Scott Sight. Both of those are completely new applications. I don't see those as being cannibalizing. They offer completely new capabilities to those two OEMs. And I think that they will generate significant interest with other players in that market. So, clearly, the launch of the CAT S60 phone has got a number of other smartphone manufacturers looking at that. And when that product gets launched and starts getting traction later this summer, we think that there will be other parties that are going to be serious about looking at that capability for inclusion into their devices as well. And similarly, when you look at firefighting and SCBA is one of the most common pieces of the turnout gear. And integrating a thermal imager directly into an SCBA offers a hands-free capability that a lot of firefighters have been looking for. So we think that that product concept is going to do well. Two other areas that I'll mention, one is the introduction of Boson. So we've got a completely new core here, a core that has a very powerful system-on-a-chip vector processor embedded in it that can host a number of different image improvement algorithms, automatic detection, artificial intelligence algorithms. And it's a system-on-a-chip that also supports all the typical peripherals that you have in a handheld system display, battery control, USB, memory, those user interface, those kinds of things. So that will make it easier for people to create products around that core and I think should drive future business for the OEM group. Also, the fact that that core is available with 15 different fields of views and two different resolutions gives a lot of flexibility to system developers. And then the last thing that I'll mention is we continue to get traction in the OEM space with automotive. We've got – Cadillac has just begun shipping units with CT6. And it seems like it's getting good response. And we continue to have other auto manufacturers in the hopper there. So it's been a slow go, getting traction with night vision, but it's one that is gaining steam in terms of its adoption rates.

[Jeffrey Kessler:]

Is this with the same VaR or with a different one?

[Andrew Teich:]

This is still with Autoliv. So -

[Jeffrey Kessler:]

Okay. My follow-up question is given that you've had some very good growth in revenue and in product sales in areas like Security, areas like Detection where the margins may be a little bit lower in spots, nevertheless, those products that you've been selling, particularly when it comes to Security, how much bleed over do you think those products are going to have as a beneficiary to other segments in the business given that there is a lot of R&D and a lot of obviously – and a lot of development that has to go into integrating DVTEL Video Management System, analytics and other types of the storage with the types of products that you have in Security? Some of that is applicable to the other areas and the other divisions that you have.

[Andrew Teich:]

Yeah. That's absolutely correct, Jeff, and it's really a big part of the strategy within the company, is to leverage developments across the segments. And, frankly, things like the Security segment with its cloud services that are being developed with the video analytics capability, with the mapping capability that's coming out of 360 Surveillance, those capabilities are applicable into other businesses, into Maritime, into Instruments, into Surveillance and we're actively doing that. Also, the development of the Boson core with its embedded vector processor, vision processor that is inside that unit, we can develop algorithms for that for video analytics and artificial intelligence that can be applied across multiple segments within FLIR. And that is something that we've got a team that is solely focused on that. It's been a long-term vision here at FLIR. It was part of the reason that we bought Traficon. We also got additional video analytics capability with the acquisition of DVTEL with the former ioi image assets there. And it's still early days in terms of what we will be showing from a video analytics standpoint, but we believe that the broad spectrum of products being offered in Surveillance, Instruments, Maritime, Security, and even Detection can benefit from those enhanced capabilities that will run on board this low-power core.

[Jeffrey Kessler:]

So, at some point in the future, we may be seeing a Traficon/ioi booth or adjunct to one of your tradeshows?

[Andrew Teich:]

Yeah, exactly. In fact, part of the integration efforts that are going on with DVTEL are integrating the video analytics teams between those two groups.

[Jeffrey Kessler:]

Okay. Great. Thank you very much.

[Andrew Teich:]

Pleasure.

[Operator:]

Thank you. Our final question comes from Noah Poponak with Goldman Sachs. Please state your question.

[Noah Poponak:]

Hey. Just had a few follow-ups. The 20% government products growth, was that entirely organic or not?

[Andrew Teich:]

It was entirely organic. Yes.

[Noah Poponak:]

And can you talk about that by, I guess, anything that stood out by geography or by government agency?

[Andrew Teich:]

Yes, just a moment, Noah. As we looked at, the skew was much stronger towards U.S. DoD. If you looked at the revenue for the quarter, there was a much stronger skew towards DoD versus federal and state law enforcement. So from a revenue standpoint, during the quarter, the DoD total was up a little over 50%. And this is – I'm talking about total. If I look just within Surveillance, the DoD business grew faster than the other business in the quarter. We find that there is some shift typically back and forth between DoD customers and typical three letter agency customers. And we had a particularly strong quarter for total DoD business from a revenue perspective during Q1. And that can move around a little bit.

[Noah Poponak:]

And, sorry, is the 20% a U.S. number or a global number?

[Andrew Teich:]

I think what you're talking about there is the difference between the total U.S. government bookings year-over-year. Is that what you're referring to, the 20%?

[Noah Poponak:]

I'm just trying to get an understanding for – in addition to the numbers you just gave me on U.S. and on DoD, what happened internationally in the government business or if it's specific to Surveillance?

[Andrew Teich:]

Yeah. So the government products revenue of plus 20%, I think, is U.S.

[Thomas Surran:]

Yeah. That's 22% for total business.

[Andrew Teich:]

Yeah.

[Noah Poponak:]

Middle East specifically, there has just been a lot of concern there given the oil price. Can you -

[Andrew Teich:]

Hey. Noah, I want to go back to that. The government products revenue increase of 20% is the total government products. It's not U.S. only.

[Noah Poponak:]

Okay.

[Andrew Teich:]

So we have – those first two bullet points on slide number three have shown historical growth rate averages of our commercial versus government businesses. And that 20% growth that you see shown in the government business was largely driven by DR SKO.

[Noah Poponak:]

Okay. Any ability to talk about -

[Andrew Teich:]

I thought you were talking about the U.S. content.

[Noah Poponak:]

And then any ability to talk about what international government did in the quarter and, specifically, if there was any – specifically here is what you saw in your Middle East revenues?

[Andrew Teich:]

Hang on just a moment, take a look at that. The Middle East – I mean primarily when you're talking about the government for the most part, that would be in our Surveillance business. And that business had relatively small growth, but fairly strong business. So, although the growth wasn't large, it was still a healthy quarter. Even if you deal with it overall, we had about 4% Middle East growth.

[Noah Poponak:]

Okay. And then if I could just ask about the balance sheet and the cash flow statement a little bit. You guys have, I think, talked about the M&A pipeline being pretty full, but you haven't done a ton. The net cash position increased sequentially again. So, I guess, what's next from here with the balance sheet?

[Amit Singhi:]

So, Noah, as you know, we continue to look at M&A opportunities. And there are several in the pipeline. We're not at a point where we're ready to announce anything at this point. The other piece, as you probably are aware, we have debt that is coming due this summer. So, in terms of the balance sheet, we will be looking to refinance our notes that are coming due. And when we do that, we would be looking at overall our complete debt profile, including the credit lines and the revolver that we have, just given the overall conditions in the market and being opportunistic in terms of what's available out there with relatively low interest rates. But, again, we're not ready to announce specifically what we're going to do, but that's something that's going to come in the second quarter.

[Noah Poponak:]

Is there anything specific that's holding up acquisitions from getting across the finish line? Just kind of scrolling through my notes here I wrote down a couple quarters ago you guys saying that the pipeline was potentially more full than ever. What's holding things up from getting done?

[Shane Harrison:]

Noah, it's Shane. The thing that's really been holding up lately is sellers' expectations of what they think their company is worth really. And we've seen some slowdown in some of those targets as far as getting to close to the finish line in a couple of examples where we got an update as far as performance. And it just wasn't making the model work anymore. So we did walk away from a deal or two here recently. And it's largely because of exactly that slowdown in the business itself that we're looking at. But the pipeline still is quite rich. We're still looking at a lot of things but that's the specifics to closing the last couple of things that we've been looking at.

[Amit Singhi:]

And, Noah, this is Amit, just one more follow-up to the cash build-up. The other thing, as we pointed out, right, we did not do any share buybacks in the quarter. Again, because we look at all our investments to make sure that they are the right business decision and just given the share price and where we were at, it was just not the right time to buy. So that was the other reason why that use of cash was not there in the quarter.

[Noah Poponak:]

Okay. Thank you.

[Operator:]

Thank you. There are no further questions at this time. I'll now turn the conference over back to Andy Teich for closing remarks. Thank you.

[Andrew Teich:]

Thank you all for joining us on the call today. Before we close, I'd like to note that Dave Muessle will be retiring from his role as Corporate Controller and Chief Accounting Officer early next month. I'd like to thank Dave for his more than 16 years of outstanding support and dedicated service to the company. Dave will be replaced by Brian Harding, who is currently our Vice President of Corporate Finance and Accounting. Brian will formally start in his new role on May 6. Dave, we wish you all the best as you transition into retirement. And, Brian, we welcome you to your new role. I'd also like to thank the more than 3,000 FLIR employees around the world for their continued dedication and innovative spirit, as we pursue our goal of becoming the world's success. Thank you all and we look forward to talking to you next quarter.

[Operator:]

This concludes today's webcast. All parties may disconnect. Thank you.