FLIR Systems, Inc.
Q3 2016 Earnings Call Transcript

Published: 26 Oct 2016

[Operator:]

Greetings, and welcome to the FLIR Systems Third Quarter 2016 Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Todd DuChene, Senior Vice President and General Counsel for FLIR Systems. Please go ahead, sir.

[Todd M. DuChene:]

Good morning, everyone. Please note that our earnings press release and presentation slides that will be referred to on this call are available under the Events & Presentations section of www.flir.com/investor. Before we begin this conference call, I need to remind you statements made on this call, other than historical facts, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and are based on our current expectations. Words such as anticipates, estimates, expects, intends, and believes and similar words and expressions are intended to identify forward-looking statements. All of these statements are subject to risks and uncertainties that could cause actual results to differ materially. Please refer to the press release we issued earlier today for a description of factors that could cause actual results to differ materially from those forecast. The forward-looking statements we make today speak as of today. And we do not undertake any obligation to update any such statements to reflect events or circumstances occurring after today. Let me now turn the call over to Andy Teich, President and Chief Executive Officer of FLIR Systems. Andy?

[Andrew C. Teich:]

Thank you, Todd, and thank you all for joining us for FLIR's third quarter 2016 earnings call. With Todd and me today is our CFO, Amit Singhi; COO, Tom Surran; Chief Marketing Officer, Travis Merrill; and SVP of Corporate Development and Investor Relations, Shane Harrison. I will start the review of the quarter with slide 3 of the presentation. This morning, we reported third quarter revenue of $405 million, an increase of 6% compared to the prior year. Commercial product revenues grew 10% over the third quarter of 2015 and government product revenues grew 2%. Driving the year-over-year growth in commercial products were the newly-acquired products from DVTEL and Armasight, strengths in fire and PPM/building products, and increased Lepton core sales. On the government products side, increased deliveries of military thermal camera cores, land-based imaging systems, and Man-Portable systems were partially offset by slower activity from our airborne gimbal products. Earnings per share for the quarter were $0.43, which were negatively affected by a $2 million charge we took in the quarter for the expected cost to remedy product quality issues that were identified with certain of our SkyWatch surveillance towers that are in the field. Excluding this charge to cost of goods, earnings were $0.44 per share. This represents 10% growth in EPS versus the third quarter 2015, when you adjust out the discrete tax benefit we saw last year of $0.12 per diluted share. Growth and operating profit margins in the third quarter improved significant on a sequential basis, up 170 basis points and 380 basis points, respectively, compared to Q2 of 2016. Stronger product mix and better absorption of overhead costs helped increase gross margin, while lower OpEx spending drove further improvements in our operating margins. Operating cash flow for the quarter was $89 million, our highest quarterly cash flow from operations since 2013. On a year-to-date basis, operating cash flow has grown 9% over the first nine months of 2015, the result of our focus on improving our accounts receivable collection and controlling inventory levels. Total company 12-month backlog finished the quarter up 13% year-over-year to $644 million, our highest since 2008, and our fifth straight quarter where we've shown sequential growth in backlog. Backlog in the Surveillance segment is up 16% over the balance at the end of Q3 2015. On the new product front, the Instruments segment launched a new and improved A35 and A65 thermal temperature sensors for continuous monitoring and automation systems. The Security segment released the newest version of Latitude enterprise-class VMS software, and our OEM & Emerging segment's traffic business introduced the RSX-F thermal sensor for passenger, train and railcar applications. And just a couple of weeks ago, the Detection segment introduced the new R100 personal radiation detector. On October 3, we announced our agreement to acquire Point Grey Research. You'll see on slide 4 a summary of the transaction and the business. Point Grey, which is based in Vancouver, BC, is a global leader in developing and selling machine vision cameras. These are advanced visible imaging cameras and solutions used in industrial automation systems, people counting systems, medical diagnostic equipment, intelligent traffic systems, military and defense products, and advanced mapping systems. We're enthusiastic about the potential of this transaction, as we feel machine vision and retail people counting are very attractive end-markets and are two largely underpenetrated application spaces for thermal imaging. Point Grey will provide us a scalable platform from which to grow the business and integrate our thermal technology. Thermal imaging provides a differentiated data set for a wide range of machine vision applications to include the ability to remotely measure temperature, accurately analyze thermal patterns and see through factory obscurants, including smoke, dust and steam. Common applications include monitoring welding, drying, sealing, molding, curing and extruding processes, as well as a range of food processing and non-destructive testing applications. Additionally, thermal technology can improve people counting solutions, giving us ability to accurately detect, track and quantify living beings in a wide range of environmental condition. Point Grey's product and selling strategy is very similar to our OEM camera cores business, in that itself camera modules on a B2B basis to makers of imaging and automation system, and as such, the business is expected to be a very strategic fit for our OEM & Emerging segment. We look forward to bringing the Point Grey team aboard and getting started on innovating the next generation of machine vision solutions. We expect to close the transaction during the fourth quarter and the acquisition price of approximately $253 million will be funded by our current foreign cash balances. While we're not discussing the financials at Point Grey specifically, we do expect transaction-related cost to negatively impact FLIR's fourth quarter earnings by approximately $0.01 per share; however, we expect the acquisition to be accretive in 2017 and thereafter. On slide 5, you'll see our outlook for 2016. We continue to expect full-year 2016 revenue to finish in the range of $1.6 billion and $1.65 billion, and an EPS to be in the range of $1.60 to $1.65, excluding the SkyWatch costs, the impact of the potential acquisition of Point Grey, the Q2 investment write-down and certain discrete tax items. This outlook represents a revenue growth rate of between 3% and 6% and an EPS growth rate of 3% to 6%, and compared to the 2015 results after adjusting to exclude the 2015 restructuring charges, investment gain and discrete tax items. We also announced today a quarterly dividend of $0.12 per share, which will be payable on December 2 to shareholders of record as of November 18. I'll now ask Amit to review the third quarter financial results. Amit?

[Amit Singhi:]

Thanks, Andy. On slide 6, you will see our third quarter financial results. Consolidated revenue was $405 million, a 6% increase compared to the third quarter of 2015. The largest drivers of the revenue growth came from the OEM & Emerging and Instruments segments, increasing 22% and 11%, respectively. Security segment revenue declined by 5%. Recently, revenue increased in the U.S., Europe, Middle East and Africa and Asia by 6%, 9%, 12% and 11%, respectively, while it declined in Canada/LatAm by 19%. Sales to the U.S. government increased $33 million or 42% and represented 28% of total revenue compared to 21% in the third quarter of 2015. In this quarter, we recorded a charge of $2 million with certain expected costs to remediate previously-disclosed product quality issues associated with our SkyWatch surveillance towers. We've not yet completed our analysis of all affected units that might require such remediation. As we gather more information and finalize our assessment, this charge will likely increase. Consolidated second quarter gross margin was 47%, 10 basis points lower than last year, primarily due to the charge for SkyWatch repairs, partially offset by favorable segment mix. Gross margin improved 170 basis points sequentially compared to second quarter, primarily driven by improvements in the Surveillance and Instruments segment. Our operating margin for the quarter was 20%, 6 basis points better than last year, despite the $2 million SkyWatch repair charge mentioned earlier. Our third quarter tax expense was $16.6 million. We now expect our 2016 effective tax rate to be 24% excluding certain discrete tax items. Net earnings for the third quarter of 2016 totaled $58.6 million or $0.43 per fully diluted share. Third quarter 2015 net income of $73.1 million was aided by $17.4 million favorable discrete tax item related to the release of a previously recorded tax reserve. Excluding the impact of the SkyWatch repair charge, adjusted EPS for third quarter of 2016 was $0.44 compared to $0.40 in the third quarter of 2015, a 10% year-over-year improvement. Our cash flow from operations for the quarter increased 20% from year-ago levels to $88.6 million, or 151% of net income, driven by continued improvements in working capital as a result of our special initiatives. Our days sales outstanding and days inventory on hand improved year-over-year, driving an improved cash conversion cycle. Our capital expenditures for the quarter were $6.8 million, significantly reduced from the higher levels a year ago when we were in the midst of consolidating our manufacturing facilities in Santa Barbara. During the quarter, we repurchased 1.2 million shares for $36.3 million and returned another $16.5 million to shareholders through the payment of dividends. We repaid the entire $250 million principal amount of maturing notes in early July. With this repayment and the second quarter issuance of the $425 million five-year notes and the upsizing of our credit facility to $500 million, we've completed the implementation of our previously communicated capital strategy. We've increased our gross leverage ratio from 1 turn to about 1.4 turns, while maintaining a strong balance sheet and an investment-grade rating. We've also increased our liquidity, lowered our weighted average cost of capital, lowered our interest rates and increased our borrowing flexibility. We closed the second quarter with cash of $677.7 million. We intend to use our foreign cash balances to fund the potential acquisition of Point Grey in the fourth quarter. This concludes the summary of our third quarter financial results. Let me now turn the call over to Tom Surran to cover our operational highlights. Tom?

[Thomas A. Surran:]

Thank you, Amit. Slide 7 is a summary of the third quarter results by segment. All segments, except Security, showed higher revenue than the prior year. Segment-level operating profit was up 8% as a result of the top line growing 6%, a steady gross margin and improved operating leverage. Moving to slide 8 to cover the Surveillance segment, third quarter revenue for Surveillance was $136.4 million, up 4% over the third quarter 2015. Increased revenues from land and Man-Portable products as well as from the new Outdoor & Tactical Systems line of businesses, each contributed to the growth, while our gimbaled products showed decline on a difficult comparable to the prior year that included significant RAID and MEDEVAC program shipments. Operating profit for the Surveillance segment was $38.4 million, which was down slightly from the prior year. However, if the SkyWatch costs are excluded from the results, then Surveillance's operating profit would have grown slightly. Compared to the second quarter of this year, Surveillance operating margins improved 520 basis points as product mix returned to normal levels. Surveillance backlog increased to $22 million from the end of Q2 to $363 million and is up 16% from one year ago. Strong follow-on orders from U.S. and Middle East programs helped drive the growth in backlog. Surveillance segment book-to-bill ratio was 1.2x in the third quarter, which was the fifth time in last six quarters that book-to-bill has been above 1.0x. On slide 9, you will see a summary of the Instruments segment's results. Revenue increased 11% as compared to the third quarter of 2015 to $82.7 million. The success of our new T1K premium handheld camera helped our Plant Predictive Maintenance & Building product line grow over 20% year-over-year. Instruments firefighting line of products continues to gain traction in the market, growing revenues 77% over the prior year. Additionally, FLIR-branded Test & Measurement products grew 60% over the prior year. Many of the FLIR Test & Measurement products now feature our Infrared Guided Measurement or IGM technology that is uniquely enabled by our Lepton camera core. Instrument operating profit in the third quarter grew 25% over the prior year to $27 million or 33% of revenue. Gross margins were equal to last year and SG&A expenses declined slightly to improve operating margins. On a sequential quarter basis, operating margin improved by over 8 percentage points as a result of improved manufacturing efficiency and cost containment initiatives. During the third quarter, Instruments introduced upgraded versions of the A35 and A65 thermal imaging temperature sensors. The new sensors which are used for advanced process control, quality assurance, condition monitoring, and fire prevention, feature a more robust housing, higher vibration tolerance, new field-of-view options, and extended temperature ranges. The sensors feature leading digital communications standards, including GigE Vision compatibility and GenICam protocols for seamless integration with existing customer systems. On slide 10, you will see the Security segment results. Security's third quarter revenue of $56.4 million was down 5% compared to last year's third quarter. Reduced shipments of consumer-grade Lorex security bundles created a significant headwind to segment performance. Partially offsetting this, retail softness was higher enterprise-class product revenue and 13% growth in thermal security cameras. Security operating margin was 5% in the quarter, well below the prior year. While gross margins were slightly better than last year, increased operating expenses and amortization related to the DVTEL acquisition pushed down profitability. During the third quarter, we reduced Security segment operating expense by 8% and we continue to work to find cost improvement opportunities in the Security segment. In September, the Security segment released the latest version of the enterprise-class Latitude Video Management System. This latest release adds communication protocols with all FLIR thermal security cameras and recorders, support for pan/tilt/zoom tracking and cell-based motion detection support of FLIR's Quasar cameras. This Latitude software solution enables our customers to be able to integrate large sites of up to 10,000 cameras and to control and monitor all of them with one user-friendly software interface. The results for the OEM & Emerging segment are shown on slide 11. Reaching an all-time high, OEM & Emerging third quarter revenue was $62.7 million, increasing 22% over the prior year. Growth was seen in nearly every product line with particularly strong results from military-grade thermal camera cores. Lepton cores also showed significant strength with delivery to OEM customers for products such as the Cat Phone. And the FLIR ONE mobile accessory continues to perform well with revenue growing 131% compared to the prior year. OEM & Emerging operating profit also reached an all-time high for the quarter, increasing 40% over the prior year to $19.9 million. During the third quarter, OEM & Emerging's intelligent traffic system line of business introduced the RSX-F sensor for railcar monitoring. This new product integrates a thermal and visible camera to provide passenger and cargo train operators the ability to pre-emergently detect fires with advanced software algorithms running on the thermal data streams, as well as enable the monitoring of railcar activity. Also during the quarter, one of our OEM customers Snap-on Tools introduced a Lepton-based handheld thermal imager that is specifically designed for automotive diagnostics and utilizes advanced software to help mechanics and technicians easily detect engine, HVAC and electrical issues in a car. As Andy mentioned, we recently announced that we have agreed to acquire Point Grey Research. Once completed, the acquired business will become the integrated imaging solutions line of business within our OEM & Emerging segment. Turning to slide 12, Maritime segment revenues were $40.6 million, representing 4% growth versus the prior year. Higher sales of thermal cameras drove the revenue growth. Maritime operating income was $2.4 million in the quarter, representing a 6% operating margin in the segment seasonally low quarter. Operating income grew 29% over the prior year as lower operating expenses helped operating leverage. The Detection segment results are summarized on slide 13. Detection's third quarter revenue was up 2% year-over-year to $26.4 million as DRSKO shipments were up slightly over the prior year, offset by year-over-year decline in explosives product revenue. During the quarter, Detection's booked its largest-ever order for radiation products, a $9 million order from the U.S. Department of Homeland Security for our R300 personal radiation detector. Consistent gross margins combined with reduced operating expenses resulted in a 26% growth in operating income year-over-year. Detection finished the third quarter with $68 million of backlog, declining $6 million since Q2 due primarily to shipments under previously received large DRSKO orders. Two weeks ago, Detection introduced the R100 personal radiation detector. The R100 is the new entry-level price point for our Detection's radiation product line and is the industry's only IP67-certified and American National Standards Institute drop-test compliant personal radiation detector. It is a belt-worn detector for use by first-responders, law enforcement, military and security personnel, and features an integrated Bluetooth radio for sending reports wirelessly to central command. That concludes my summary of the segment third quarter. I'll now pass the call back over to Andy.

[Andrew C. Teich:]

Thanks, Tom. Overall, the quarter was in line with our expectations. Our guidance for the year is unchanged as we've not seen indications that the fourth quarter will be materially different from previous expectations, including a second-half gross margin that is approximately 2 points ahead of what we saw in the second quarter. We're encouraged by our backlog levels and expect growth and operating margins to improve sequentially and year-over-year as we realize the results of our cost containment activities. We're excited about our product roadmaps and are looking forward to an exciting next 12 months with new products coming from all of our segments and from our recently acquired businesses. In the near term, we're focused on finishing the year with a strong fourth quarter. That concludes our comments on the third quarter. We'll now ask the operator to open the call up for questions. Kevin, can you go ahead and open the call for questions?

[Operator:]

Certainly. We'll now be conducting the question-and-answer session. Our first question today is coming from Jim Ricchiuti from Needham & Company. Please proceed with your question.

[Jim Ricchiuti:]

Hi. Good morning. Just wanted to focus a little bit on the commercial security market, and I wonder if you could talk a little bit about the decline you're seeing there. And you mentioned – you highlight Lorex as being down significantly. Can you give us some sense as to how much that's down and whether that's just market related? Is there some share shift going on? And what are the steps that you're taking in terms of driving some growth back into this business?

[Andrew C. Teich:]

Sure, Jim. This is Andy. In that business, the largest piece of the decline was related to the Lorex consumer retail piece of the business. And there, you can have some rather dramatic shifts based on retail placements. And in this case, we had two SKUs in the Costco stores and we've dropped down to one SKU in the Costco stores, and that's a bit of a cyclical business. So, we expect in the future that there will be a strong probability of us recovering that SKU. But in this particular case, we've been displaced by a lower-priced product offering. We have some new product and technology that is coming in that space, which we feel that can help to regain the position that we had there. Relative to your question about what are we doing longer term, it's really about product development, in that particular case. We're looking for continuing to inject features into the product suite and improving both the support and the backend software capabilities for those products to differentiate them from a rather commoditized space.

[Jim Ricchiuti:]

Andy, are you satisfied with the other pieces of the business? How is DVTEL performing relative to your expectations?

[Andrew C. Teich:]

So, I would say, DVTEL from a technology standpoint is performing well. The integration of thermal camera capabilities into the Latitude VMS that Tom mentioned in his prepared comments has gone very well. We've also taken our Surveillance 360 software capability, which is our mapping capability, and integrated it into the Latitude VMS suite. So, we offer a very good and differentiated capability there, particularly for large outdoor perimeter security applications. That said, I would say the frontend, the integration of the frontend of the DVTEL business has not gone as well as we would have expected. So, we've had a little bit of a delay there in terms of integrating those businesses together. We expect that to come to conclusion here this quarter and we should see the sales growth return in that business as a result.

[Jim Ricchiuti:]

Okay. Thanks a lot.

[Operator:]

Thank you. Our next question today is coming from Ben Hearnsberger from Stephens. Please proceed with your question.

[Ben Hearnsberger:]

Hey. Thanks for taking my question. I'm looking at Surveillance, and we've had three positive revenue growth quarters, backlogs improving. I guess, given what you're seeing in the end-market, do you have confidence that this momentum continues into 2017?

[Andrew C. Teich:]

Sure, Ben. Surveillance has done well and we've seen growth on the revenue side, particularly in the U.S.-based business. From a backlog standpoint, we've seen growth coming from our international customers. So, in subsequent quarters, I think you'll see a higher concentration of international systems shipments. In terms of the long-term outlook, there are a couple of things to consider. I would say that from an international perspective, we can expect to see continued demand there as there is continued political unrest internationally and our systems are very well received for ISR applications and border-control applications. From the U.S. perspective, there's still a question mark about what happens relative to the continuing resolution that's set to expire on the December 9 of this year. So, that's a bit harder for us to predict in terms of what the budget situation is going to look like. We're hopeful that Congress can seek a successful budget resolution and get that situation resolved for us and for the nation. We're also – as we've mentioned on previous calls, our business is more of a short-cycle-oriented business, which makes it a bit more difficult for us to forecast. But we do like what we're seeing in terms of the competitiveness of our products in the marketplace, and we do have some new products in development that will get launched in the early part of 2017 in this market that we expect will help to drive demand as well.

[Ben Hearnsberger:]

Okay. And then, looking at the Security business, within the enterprise piece, when do you expect to release a hybrid product that I know you guys have talked about in the past?

[Andrew C. Teich:]

So, we don't talk specifically about when we're going to launch products, but what I can tell you, Ben, is that we've got a very rich stream of thermal-based products, targeted at the enterprise class that we'll be launching later this year and early next year.

[Ben Hearnsberger:]

Okay. That's helpful. Thank you.

[Operator:]

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

[Peter John Skibitski:]

Hey. Good morning, guys. Nice quarter. I want to give a shot at the Point Grey deal. Maybe you could talk about, in terms of your M&A hurdles, if this deal meets your M&A hurdles? And then if there's anything you can say in terms of – I'm curious if it will be dilutive to OEM margins on an ongoing basis? And when the deal closes, should we get more financial details at that time?

[Andrew C. Teich:]

Sure, Pete. So, first, the deal does meet our M&A hurdles, and we've put quite a bit of diligence into this deal. We're particularly excited about the fit, I would say, both from a product standpoint and from a cultural standpoint. The machine vision space is a space that's been growing quite well and Point Grey is involved in machine vision. They're involved in mapping applications. They're involved in people counting applications. And each of those are growing markets and they're markets where we believe that there will be a bidirectional transfer of technology between Point Grey and FLIR that will benefit both sides of our business. Certainly, the injection of thermal technology, as I mentioned in the prepared comments, is something that brings a significant opportunity to Point Grey. And then we also think that there are elements of Point Grey's business and particularly their knowledge relative to visible sensors that will benefit our OEM business and also some of our other segments businesses, as many of those other businesses use visible cameras within them. To your last question, we will have more details about the acquisition in subsequent calls. We're very much looking forward to getting the team on board and integrated, and moving forward with our plans thereon.

[Peter John Skibitski:]

Okay. If I could, just one follow-up on Instruments. I thought that segment might struggle a little bit until your new mid-level products come out next year. But it had a real solid quarter, clearly. So, I'm wondering if you could just – you touched on it, but could you just give a little more color on what led to such a strong quarter this quarter for Instruments? And so, is the new mid-level products next year just going to be additive to that essentially?

[Andrew C. Teich:]

Sure. It's a combination of things, Pete. One of the things that we talked about previously is that we have spent quite a bit of time focusing on the low-end product offering in the Instruments segment and creating the IGM product line, also creating some other Lepton-based products in the lower spectrum of the Instruments product range. Those products are catching on and doing quite well now, so we saw very strong growth in the FLIR-branded Test & Measurement product line. Most of those products are IGM/Lepton-based products. The second thing that we talked about was that we move from the low end all the way up to the high end of our product range and we refresh that with the product we call the T1K. So, that's in production and shipping nicely during the quarter, and we saw a very good uptick there in our PPM & Building business and that was largely driven by traction that we saw with that T1K product. We've been messaging for the last few quarters that we've been working on the mid-range of our product value ladder. It's a fairly long-term development and it is scheduled to launch in early 2017, and that certainly will help to drive growth in that segment. The one other thing that we've done in that segment is we also are selling FLIR ONE through the Instruments' industrial channels, and that's a separate channel relative to our retail pursuits with that product, and that's been helping to get traction as well. And the combination of both the FLIR ONE and the IGM products are, I think, very helpful in the market as they not only introduce the FLIR brand, but they fundamentally create new thermographers in the market, which we hope over time would be looking to move up the value ladder with higher capability instruments that we coincide with the launch of the new mid-range products.

[Peter John Skibitski:]

Okay. That's interesting. Thanks very much. If I could just sneak one last one and then I'll kind of get out of the way. Amit, did you say – do you have an upper bound on what the SkyWatch, I guess, liability is?

[Amit Singhi:]

Yeah. Right now, we booked to the low-end, which is the $2 million, based on all the units that could be out there, and we've been at this for several months now to trace all the units that are out in the field and what are affected, but the upper bound could be as high as $20 million.

[Peter John Skibitski:]

Okay. Great. Thanks so much, guys.

[Andrew C. Teich:]

You're welcome.

[Operator:]

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

[Peter J. Arment:]

Yes. Good morning, Andy. One clarification. Did you specify what the organic growth for the overall company was in the quarter? And then, if you could also just maybe give us a little bit of how you're viewing the Lepton product, etc., rollout? I mean how many products, I guess, do you kind of – if you can give us that, how many are – where Lepton is now embedded in the overall product base in terms of instruments, and how you see that growth being accepted? Thanks, Andy.

[Andrew C. Teich:]

Sure. So, the organic revenue growth for the company was a little over 2%. And then, moving over to the Lepton-based question, Lepton has been doing quite well. Total growth in Lepton sensors that were shipped were up over 200%. And we've got quite a broad range. I think we're approaching almost 20 products now internally that are using Lepton, and really quite a broad array of products externally that are using Lepton. Tom mentioned in his prepared comments that one of our OEM partners, Snap-on Tools has launched a product that is specifically focused at automotive mechanics, for automotive maintenance applications. We also launched a product last quarter with Scott Fire and Safety and that's a firefighting product, where the camera is embedded in the SCBA, breathing apparatus mask. So, there have been a number of applications out there that we've been serving with Lepton externally. And also, we mentioned a couple on this call. We're quite excited about the products that have been launched in the traffic space. There have actually been two new products that we launched in the traffic space. One is for railcar monitoring and the other is a Lepton-based product that is designed to be used at crosswalks. So, we think the opportunity set there is really quite large, and our manufacturing base for Lepton has been ramping quite rapidly. And of course, we've got a high volume of units that have been shipped and are going into the Cat Phone as well. So, we're quite pleased with the way that business is developing.

[Peter J. Arment:]

Yeah. That's great color. Is the firefighting channel still your biggest channel, or is there another channel that's overtaken that yet?

[Andrew C. Teich:]

No. The Cat Phone is by far the largest user of Lepton at this point. It's quite large.

[Peter J. Arment:]

Got it. Thank you very much.

[Operator:]

Thank you. Our next question today is coming from Jonathan Ho from William Blair. Please proceed with your question.

[Jonathan F. Ho:]

As a follow-up to that last question, could you give us a little bit more color in terms of Cat Phone user volumes as well as initial reception?

[Andrew C. Teich:]

Sure, Jonathan. We don't specify the specific volumes of products that are sold. But I would tell you that the Cat Phone business has been going well. The customer there, that's the manufacturer of the phone has actually come back and reordered a subsequent order ahead of their initial forecast for the year. So, the demands are exceeding their expectations. They're also expanding their channels for the distribution of the product. So, I think, frankly, it's actually still early days to really understand what the total traction is going to be for the phone. We've also seen the introduction of that phone generate interest with other rugged handset and tablet manufacturers. So, we're fairly optimistic that we should be able to see other platforms adopt the technology.

[Jonathan F. Ho:]

Got it. And then with regards to the Security segment, I mean, clearly, there's some challenges at least in the short run. But how should we think about the operating margin performance? Should we think about this as maybe structurally being lower over time? Or can you just give us maybe some thought process to follow in terms of where those operating margins should rebound back to?

[Andrew C. Teich:]

For the time being, the margins are going to be lower there. They're going to be single-digit margins for some time as we develop the platform, integrate DVTEL, and ultimately inject low-cost thermal technology into those products. It's a very competitive space, but it's a very large space with a lot of opportunity. So, we're going to be in an investment phase for at least the next 12 months in that business. And we expect over time, though, as the thermal products get traction and take on a larger portion of the total unit sales in that space that the margin will move up into the double-digit range. The traction for thermal products in the Security space continues to be quite good and the margins, both gross and operating, there are quite good. It's just that the visible piece of that business is very competitive space. The total demand in China has been declining, and as a result of that has forced many of the large Chinese suppliers to look elsewhere for business, and that comes more into the spaces that we compete in.

[Jonathan F. Ho:]

Thank you.

[Operator:]

Thank you. Our final question today is coming from Saliq Khan from Imperial Capital. Please proceed with your question.

[Saliq Jamil Khan:]

Hi. Good morning, Andy.

[Andrew C. Teich:]

Good morning.

[Saliq Jamil Khan:]

A question for you. Two things on our end, the first one being is, as you talked about the reduced operating expenses on the Security side, where exactly is the cost cutting taking place within that segment, and how do you ensure that you can improve the efficiency of the overall business while reducing the costs?

[Andrew C. Teich:]

So, the reduction in expenses there has really been across the board, Saliq. We're quite judicious in making those cuts. Particularly after you do an acquisition, I think there are opportunities to set the business up to run more efficiently and that's fundamentally what we've done. I would say that FLIR has a pretty long and demonstrated history of managing operating expenses through a prescribed model for business segment. And fundamentally, that's what we've done here. We have a specific model that prescribes how much money we spend on R&D and selling, marketing and G&A. And in this particular case, we've looked at this business and what its likely revenue projections are, and brought those expenses in line with that model. Again, in terms of the long-term predictability of the business, I think we've got a pretty good track record of managing expenses to the top line of our individual segments. And we're comfortable at this point that the expenses have been right-sized in this business. And particularly looking at the product pipeline that we've got in place right now, we are much more confident that we can deliver the results in the coming quarters.

[Saliq Jamil Khan:]

And there has also been a lot of conversation surrounding drones and what that could mean for the camera manufacturers as well as the thermal camera manufacturers. Could you give us an update on what you're doing right now to be able to better capture this market and how your relationship with DJI is evolving?

[Andrew C. Teich:]

Yeah. We're very excited about the drone market. We talked about it a little bit during the last call as well. At the end of the day, there are an awful lot of applications for thermal cameras where the application is better served as the camera's in the air, and a drone, of course, is an ideal platform to make that happen. Our partnership with DJI has been going quite well. So, that's one of the vectors that we have to the market. So, we're doing customized product for DJI, and the first of which of those that's on the market right now is the Zenmuse XT, and that's been selling quite well. We also have our own line of products. The FLIR Vue and Vue Pro and Vue Pro R products are direct products that can be connected to a wide variety of drones that are on the market. And we also have a vector into that market through our OEM channels. So, there are people that are integrating both our Tau cameras and our Lepton cameras directly into those drones and there are some that are actually under development right now that will get launched in the next quarter or two. So, overall, it's a market that we're very excited about we think it presents quite a large opportunity and it's one that is very, very thinly penetrated. I will remind you, though, that the concept of putting thermal cameras on drones is something that we've been involved in for quite some time. I think today, unquestionably, we are the world's leading supplier of uncooled cameras that are flying on drones through our partnership with AeroVironment, who has been using our camera payloads for many years now, primarily in the military space. But we do see consumer and industrial applications as a very nice opportunity going forward.

[Saliq Jamil Khan:]

Andy, just one last one on my end, if I could squeeze that in?

[Andrew C. Teich:]

Sure.

[Saliq Jamil Khan:]

You talked about the lower expended products, and I may have missed this earlier. However, to me it sounds like you're still committed to that product line. However, with the increased competition that we're seeing within this product line, particularly within the retail space, you're seeing the thinning of the overall margins, not just for Lorex-branded products, but across the board from some of the other DIY solution providers that we follow. What could the future look like for Lorex? And does it still make sense the way that it sits right now with overall FLIR?

[Andrew C. Teich:]

Yes, we're continuing to – we constantly do portfolio analysis on the assets that we have within the business, and Lorex is one that we're looking at, at this time. That said, though, this is a business that's still growing. Lorex has a good presence and a good brand in the space, and I think it's really about two things. It's about maintaining the retail channels that we have in place and creating products that are differentiated and easy to use. There's also continues to be an opportunity for thermal in that market in that the primary application of these products is to alert people when there are activities going on in the camera field-of-view and it's very difficult to do that reliably using only a visible sensor as the input source. And we know from our experiences in this business that thermal provides a much more accurate and valid data stream. And it really ties to the acquisition of Point Grey, where Point Grey has a business of – in the people counting space, primarily oriented at retail analytics, where we believe that we can utilize technology and processing capabilities that Point Grey has developed, augment that with thermal and create a solution for specific verticals within the consumer security market that we feel will be differentiated and defensible.

[Saliq Jamil Khan:]

Thank you.

[Operator:]

Thank you. We've a follow-up from Ben Hearnsberger from Stephens. Please proceed with your question.

[Ben Hearnsberger:]

Hey. Thanks for taking my follow-up. I think you guys mentioned something on unit volume growth in Instruments. I'm sorry if I missed that number. Would you mind providing that?

[Thomas A. Surran:]

I don't have it at my fingertips. I do – did we disclose that?

[Todd M. DuChene:]

I don't think you mentioned that, I believe.

[Ben Hearnsberger:]

I know in the past, you guys have, at times, provided it. I guess, the point I'm getting to is, it seems like unit volumes have been growing significantly within Instruments, primarily driven by Lepton. And the idea is we've got more product in more people's hands, and as the mid-range comes out next year, I guess, I kind of hypothesize that we may have a larger-than-normal upgrade cycle. I guess, can you just speak to that? It seems like next year sets up well for Instruments based on this.

[Thomas A. Surran:]

Yeah. I mean, I think – so you're referring to the fact that we decided and are pushing the low-end to create that awareness for the value proposition of thermal imaging into the Instruments market, and that's absolutely what we did. Just to give a specific number, year-over-year, we saw the increase in the unit volume. And I'm doing kind of a calculation in my head, so forgive me if I'm off a little bit, but I believe it's 75% increase, plus or minus a couple of points there. And the reality is we do expect that those users who are exposed to it at some of the low end will understand how the higher-end solutions we provide can do things for their work, for their businesses for efficiency, for accuracy, so that they can provide higher-level services. And we would absolutely expect them to migrate up into our midline products. And we hope that with the new midline products that we'll be introducing, there's a number of new features that will be coming there that we would see a nice upgrade cycle with that, not only for our existing customers that are in the mid-range, but also these new customers that we've exposed with the entry-level price point products.

[Ben Hearnsberger:]

Okay. And so, we have 75% unit volume growth. Can you give us the percentage of volume growth that was Lepton-based?

[Andrew C. Teich:]

Yeah, Ben, I don't think I want to go into that level of fidelity. But, certainly, one can assume that there's significant growth at the low-end, when you look at the combination of the volume growth relative to the revenue growth. But that said, I do want to underscore what Tom said. The strategy here in terms of creating IGM products, for example, is not only to provide thermal imaging into the hands of a much broader audience and, I would say, a different type of demographic than we have historically been selling to in the Plants (47

[Ben Hearnsberger:]

That's great. Thank you very much.

[Andrew C. Teich:]

My pleasure.

[Operator:]

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

[Andrew C. Teich:]

Thank you, Kevin. I'd like to thank everyone for joining us on the call today. We continue to be enthusiastic about the traction we're getting in our core markets and are encouraged by the successes we're seeing with a wide range of new products that incorporate our Lepton micro camera core. We remain focused on broadening our footprint from our high-end surveillance and targeting systems, down to our consumer-oriented instruments and situational awareness products. We look forward to addressing the growing machine vision and people counting business with the addition of Point Grey. I want to thank our employees around the world for continuing to enable our mission of becoming the World's Sixth Sense. And we look forward to seeing you on the call next quarter. Kevin, you can now conclude the call.

[Operator:]

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