FLIR Systems, Inc.
Q2 2015 Earnings Call Transcript

Published: 24 Jul 2015

[Operator:]

Greetings, and welcome to the FLIR Systems Second Quarter 2015 Results Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. It is now my pleasure to introduce, Todd DuChene, Senior Vice President, General Counsel and Secretary of FLIR Systems. Thank you. You may begin.

[Todd DuChene:]

Good morning, everyone. Please note that our earnings press release and presentation slides referred to on this call are available under the Events and Presentation section of www.flir.com/investor. Before we begin this conference call, I need to remind you that 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:]

Thanks, Todd, and welcome, everyone to FLIR's second quarter 2015 earnings call. With Todd and me today is our COO, Tom Surran; Interim CFO, Dave Muessle; Chief Marketing Officer, Travis Merrill; Chief of Product Strategy, Jeff Frank; and Senior Vice President of Corporate Development, Shane Harrison. I'll start the presentation today on slide 4. This morning, we reported second quarter revenue of $393 million and earnings per share of $0.36. Compared to the second quarter of 2014, revenue grew 6% while EPS excluding restructuring charges grew 9%. Operating income, excluding restructuring charges was $71 million, up 13% over the prior year. On a constant currency basis, Q2 revenue was up 12% as the strong U.S. dollar resulted in a $20 million reduction in reported revenues. On a year-to-date basis, earnings per diluted share excluding restructuring charges have increased 21% versus the first half of 2014. Our profitability during the first half of the year improved considerably with adjusted operating margins reaching 19% versus 16% in the previous year. We've been successful in improving profitability in our government-related business as we continue to operate in an environment with decreased demand particularly from the U.S. DoD. During the quarter, we launched several new thermal imaging, visible imaging and test-and-measurement products. These include two new firefighting cameras that are positioned at either ends of our product value ladder. First is our new K2 product which is a Lepton-based camera that creates a meaningful new entry point in the fire safety market. The combination of the K2's economical price point, ease of use, and rugged fire service packaging will make thermal imaging available to a much larger group of first responders to include rural volunteer firefighting departments. Meanwhile, at the top of our value ladder, the new K65 firefighting camera is our first product to meet the National Fire Protection Association's NFPA 1801 standard for firefighting cameras, which has historically been required by many large cities and municipalities in the United States. Towards the end of the quarter, we began shipping the second generation of the FLIR ONE smartphone accessory that is compatible with both iOS and Android-based handsets and tablets. This new variant has been selling well initially through our direct flir.com global eCommerce channel. Additional channels will be opened as our supply capacity ramps up. The security segment launched the FLIR FX, HD Wi-Fi home-monitoring camera that features RapidRecap, a technology that consolidates all motion events over several hours into a short video clip easing the burden of reviewing hours of unnecessary footage. In our Test and Measurement line of business, we launched our MR160 moisture meter, which is our eighth product to feature our low-cost Lepton microthermal camera core. This product further demonstrates how this camera core can be integrated into a broad range of industrial instruments to create differentiated and highly valuable capability of infrared-guided measurement for trade professionals. And lastly, we addressed a new market vertical for thermal imaging with the introduction of our FLIR Vue plug-and-play thermal camera line that is designed for the commercial and consumer drone market. Moving to slide 5 in our earnings release today, we reaffirmed our outlook for 2015. We continue to expect revenues of between $1.55 billion and $1.6 billion for the full year, and earnings per diluted share in the range of $1.60 to $1.70. This range incorporates our current views of currency rates for the year. We also announced today our regularly quarterly dividend of $0.11 per share, which will be payable on September 4 to shareholders of record as of August 21. I'll now pass the call over to Dave to review the second quarter financial results. Dave?

[David A. Muessle:]

Thank you, Andy. The following discussion on pre-tax operating results for the second quarter and year-to-date excludes net restructuring charges totaling $0.5 million in 2015 and $3.5 million in 2014. On slide 7, you will see a summarized income statement. Second quarter consolidated revenue was $393.0 million, an increase of 6% compared to the second quarter of 2014. Our Security, Instruments, and Detection segments reported increases of 34%, 7%, and 77% in revenue year-over-year respectively. Our other three segments reported year-over-year declines. However, the Maritime segment, which is heavily impacted by currency fluctuations due to its sales volumes in Europe would have shown an increase of 6%. Likewise, our Instrument segment would have shown an increase of 16% on a constant currency basis. Sales to the U.S. government represented 19% of total revenue in Q2, compared to 21% of revenue in the second quarter of last year. International revenue was 47% of total revenue in Q2 compared to 48% in 2014. For the first half of 2015, revenue was $737.5 million, a 2% increase over last year. On a constant currency basis, first half revenue would have been up approximately 7% year-over-year. Consolidated Q2 gross margin was 48%, a single percentage point decrease compared to last year, driven largely by the currency exchange impact on our Maritime segment. Our consolidated operating margin was 18% compared with 17% in the second quarter of last year. Segment-level operating expenses declined year-over-year by 2% due to currency. Corporate administrative expenses were $1.4 million higher year-over-year. Our tax rate in the quarter remained at 24%, which is very comparable to the 2014 rate when excluding discrete items from last year. Net earnings were $50.8 million, an increase of 7% over last year, and earnings per fully diluted share were $0.36, an increase of 9% over Q2 of 2014. For the first half of 2015, operating income was $137.1 million, representing a 19% operating margin compared to 2014 operating income of $113.8 million or a 16% operating margin. Net earnings for the first half of 2015 were $99.0 million, representing an 18% increase over 2014. Our earnings per diluted share of $0.70 for the first half of 2015 was a 21% increase year-over-year. Turning to slide 8, you will see that we closed the second quarter with cash at $560.2 million, an increase of $12.4 million during the quarter. Our cash flow from operations for the quarter was $48.9 million or 97% of quarterly earnings as we experienced increases in both accounts receivable and inventory during the quarter primarily due to timing of shipments. For the first half of the year, our operating cash flow was $123.9 million or 126% of first half earnings. We had capital expenditures of $17.6 million in the quarter and returned $15.4 million to shareholders through the payment of dividends. We also repurchased 1 million shares of our stock during the quarter under the 15 million share repurchase program that we announced in February, and we expect to continue to repurchase shares through the remainder of 2015 with a level of such activity dependent on relative value and expected capital needs and M&A opportunities. As Andy stated, we are reaffirming our full 2015 outlook for revenue and fully diluted earnings per share, while the stronger dollar particularly against European currencies during the first half of the year was a significant headwind on our revenue. The impact for the six months was largely in line with our expectations. This concludes the summary of our second quarter and first half results. Let me now turn the call over to Tom Surran to cover our operational highlights for Q2. Tom?

[Thomas A. Surran:]

Thank you, Dave. You will see a summary of our segment results on slide 10. Second quarter consolidated segment operating income grew 12% over the second quarter of 2014, and segment operating margin improved 100 basis points to 23% excluding restructuring charges. Total order backlog finished the quarter at $536 million, which is 4% lower than the first quarter of 2015 as a meaningful amount of our DR SKO units were shipped during Q2, thereby, reducing that program sizeable backlog. Moving to slide 11, during the second quarter, the Surveillance segment saw a revenue decline 5% year-over-year to $107.8 million as growth from our manned portable and land-based imaging systems was more than offset by softness in our airborne gimbals and PVS product lines. Surveillance segment operating income of $26.3 million excluding restructuring charges increased 13% versus the prior year, which represents a 400 basis point increase in operating margin, driven by improved product margins and reduced operating expenses. Surveillance backlog increased 6% over Q1 to $286 million on bookings of $133 million, resulting in a book-to-bill ratio of 1.2. Bookings from U.S. customers improved compared to last year driven by $20 million follow-on order we received from the U.S. Customs and Border Protection's MSC program for our integrated surveillance trucks. Our Europe region was particularly soft during the quarter as macro headwinds have negatively impacted order flow. Turning to slide 12, the Instruments segment second quarter revenue increased 7% compared to the prior year, finishing at $90.3 million despite a $7 million headwind from the stronger U.S. dollar. Driving this growth was the new C2 pocket-sized thermal camera, record revenue from our Science camera products, and continuing strength from our Firefighting products. Stronger gross margin and flat operating expense helped drive 22% growth in Instruments' operating income versus last year and resulted in a 32% operating margin for the quarter excluding the impact of restructuring charges. As Andy mentioned, we introduced two new firefighting cameras that significantly improve our ability to offer life-saving thermal imaging technology to every fireman regardless of budget size. The K65 is a ruggedized high-performance camera that meets the NFPA's requirements for certification and features our proprietary FSX scene-enhancement technology, while the new K2 utilizes our Lepton camera core to offer a new entry-level price point in the firefighting market. Additionally, the Instruments segment introduced the MR160 imaging moisture meter as an addition to the FLIR-branded test and measurement product line. While moisture meters are a ubiquitous tool used by building professionals everywhere, we added the Lepton camera core and an LCD screen to create a highly useful and differentiated tool that will help users efficiently and effectively find trouble spots. Slide 14 summarizes the results for the OEM & Emerging segment where second quarter revenue was down 9% versus last year to $46.3 million. This decline was driven by the divestment of the non-infrared portion of our OCG business, which contributed over $3 million of revenue in the prior year, as well as negative impact from foreign exchange. Excluding these two items, segment revenue was up slightly year-over-year. Customer order push-outs for our high-end cooled products limited growth in both the first and second quarters of this year. OEM & Emerging operating margin, excluding the impact of restructuring charges was 23% in Q2, down from 27% in 2014 due to product transition cost and lower utilization rates in production. Page 15 of the presentation shows OEM & Emerging's new Vue camera, a lightweight and compact camera for the small, unmanned aircraft system market. The Vue is the first of its kind in the high-growth unmanned aerial market where applications for the products include critical infrastructure inspection, agriculture and livestock monitoring as well as Security and Surveillance. Turning to slide 16, the Maritime segment, which has significant exposure to currency movements given that over half of its revenue is built in foreign currencies. So, our second quarter revenue declined 6% to $52 million, with a $7 million negative impact from currency. Slightly offsetting the top line weakness was 20% growth in the FLIR-branded thermal camera revenue year-over-year. Currency exchange impact flowed through to profitability with operating income falling 34% to $6.4 million excluding restructuring charges. And operating margin decreasing to 12% due to an increasingly competitive pricing environment. Slide 17 shows an overview of the Security segment, which had year-over-year revenue growth of 34%, reaching $60 million. Thermal security cameras grew 45%. FLIR-branded visible cameras grew 33%. Lorex-branded product grew 29% compared to prior year. New security system bundles, expanding presence at brick and mortar stores, and recent product introductions including the MPX HD over coax line of product, as well as the FX, FLIR's first home monitoring camera, all helped drive the visible camera product line's growth. Security operating profit was $7.9 with operating margins in line with the prior year as product mix led to a slightly lower gross margins, which was offset by slower growth in operating expenses. On slide 18 is a summary of the Detection segment second quarter. Revenue increased 77% over the prior year to reach $36.5 million driven primarily by deliveries of our DR SKO units to the U.S. government. Also contributing to the strong quarter for Detection segment was 42% growth on our explosives detection handhelds. Operating margin increased nearly 1,000 basis points versus Q2 of 2014 to reach an all-time high of 26% that the operating leverage that resulted from the revenue increase proved beneficial. Detection backlog finished the quarter at $83 million, which was down compared to the end of Q1 2014 as we completed the 2014 DR SKO order, while deliveries on the $51 million DR SKO order received in March of this year will begin delivery later this year in Q3. That concludes my summary of the segments' second quarter. I will now pass the call back to Andy.

[Andrew C. Teich:]

Thanks, Tom. We're pleased with the growth we experienced in the second quarter of 2015. Setting aside the foreign exchange impact that we and nearly all U.S. multinational companies have faced, first half 2015 revenue growth is on the high-single digits, while operating profits have grown over 20% when compared to last year. Product innovation, operational execution and company-wide collaboration are the heart of this performance, and we expect to continue to grow in both the near and long-term. With the launch of the MR160, we have introduced eight new products that are based on our Lepton camera core, and each have either created new opening price points in our markets or established new categories and customer bases for our technology. We intend to continue innovating across all of our markets as well as enter new ones with the ultimate goal of generating excess shareholder return through top-line growth, healthy and consistent profit margins, and strong cash generation. On the organizational front, our search for a new CFO is progressing very well, and we anticipate having this role filled in Q3. That concludes our comments on the second quarter. We'll now ask the operator to open up the call for your questions. Operator?

[Operator:]

Thank you. We will now be conducting a question-and-answer session. Our first question comes from Tim Quillin from Stephens, Inc. Please proceed.

[Timothy J. Quillin:]

Hey, good morning. Nice results, nice growth. You talked about the comparisons on gross margin year-over-year, but could you talk about the comparisons on gross margin quarter-over-quarter? I know there can be fluctuations based on mix, but gross margin was down a fair amount versus where it was in 1Q. And then, second question would be kind of big picture. Which of the new products that you've introduced over the past couple of years, the Lepton-based products, do you think will be the biggest revenue contributor as we look forward? Thank you.

[Andrew C. Teich:]

Thanks, Tim. This is Andy. I'll go ahead and handle the second question first and then I'll pass it over to Tom to talk about the gross margin comparison quarter-over-quarter. At this point, Tim, we're really still at the tip of the iceberg relative to the Lepton opportunity in terms of products that we develop within the company. I can speak a little bit to what's out there on the market today, and certainly, the most successful of those today and the one that will generate the most revenue has been the C2. It's done really well, for two reasons, I would say. Number one is that it's a new form factor that we found has really been embraced quite strongly by the building-user community, the super-slim format, the ease of use of touchscreen, the image quality and so forth have all really been warmly embraced by that market. And at this point, the volumes that we're seeing from that are well in excess of what we had initially planned for the product. And thankfully, we've been able to ramp up manufacturing very quickly on that product to meet that demand. But there are a number of other opportunities out there. I'm particularly excited about the K2, for example. So, coming out with a firefighting product that has enough resolution to do the job properly, that is really well packaged for that extremely aggressive environment but at a price point that opens up thermal imaging to a very large universe of first responders that typically have not been able to afford this type of equipment. There's a really large base of firefighters and the volunteer firefighters in the rural sector that don't have the benefit of thermal imaging technology. And there, I think the Lepton-based K2 is going to open up a new market segment for us there. Tom, why don't you comment on the gross margin quarter-over-quarter issue?

[Thomas A. Surran:]

Sure. So, Tim, the first thing is you're right. Year-over-year, the biggest piece – and I know your question was sequential, not year-over-year, but I do want to point out that the big impact for us year-over-year was the FX impact. In sequential, we had a very strong gross margin quarter in Q1. And if you look through two things that are kind of the big pieces, too and impact on the sequential, one is the product mix is always going to have a large impact on our gross margins. And second, there were some specific things that occurred in the various segments that all brought it down just a little bit. None of those, I believe, are long secular trends, but they did impact us, such as there was a bit of product transition costs in the OEM. We had some aggressive price promotions as we introduced some leading products into the maritime market and there are few other things in the – but in things in the market such as the surveillance market, that was more about product mix than any kind of long-term trend.

[Timothy J. Quillin:]

Great. Thank you.

[Operator:]

Our next question comes from Peter Arment with Sterne Agee.

[Peter J. Arment:]

Yes. Thanks. Again, morning, Andy. Andy, can you talk about what you're seeing on the – kind of the defense side of things in terms of potential as we're going to see another sequestration in the fall, and how you're looking in terms of the backlog and timing of shipments going forward?

[Andrew C. Teich:]

Sure, Peter. Well, we had – in Q2, we actually saw an uptick in U.S. DoD orders and we're also seeing some increased demand as a result of some urgent needs requirement requests that we're seeing coming through from the U.S. DoD side. I would say that that added together with continued unrest that we see, particularly in the Middle East, are driving potential demand for us going forward. The latter piece of that is a little bit harder to predict from a timing perspective. But I would say both of those increases in demand are very much co-linear with our CDMQ model and one of the strengths that we have at FLIR is the ability to respond quickly to requirements that emerge and get equipment fielded very quickly on a global basis. It's still hard to predict in terms of what we're going to see relative to – from a sequestration standpoint. I think that's something that we're looking at and being relatively conservative in our forecasting model. And at this point, we feel pretty good about the backlog that we've got at this point and what the second half looks like. But into 2016, we'll have to see how the second half executes. We'll look at what we think the 2016 opportunity looks like.

[Peter J. Arment:]

Okay. That's good color. If I can just follow up on just a question on overall opportunity, still within kind of reducing your inventory levels. You've talked about I think some of the initiatives in the past on trying to improve your inventory turns, maybe you could update us that because of the – I guess the opportunities there when you benchmark it against other consumer-oriented companies. Thanks.

[Thomas A. Surran:]

So, Peter, this is Tom. The inventory, yeah, we would have liked to have seen more progress at the end of Q2. The reality is we had some inventory queued up for some shipments because, as Andy was talking about these urgent needs, we want to make sure we are prepared to respond to the demands of our customer. And so, we had quite a bit product ready to go to satisfy that. We expect that product to ship here in this quarter. We also do have a move of one of our major production facilities that produces our detectors. That will be occurring later in this year, and we'll be building some inventory to make sure that we can continue to meet our customers' needs during that transition period.

[Peter J. Arment:]

Okay. Thanks.

[Operator:]

Our next question comes from Jim Ricchiuti with Needham and Company.

[Jim A. Ricchiuti:]

Hi. Thank you and good morning. You seem to be getting traction with the newer products, and I'm just wondering if it's meaningful enough now to perhaps if you would be able to even aggregate it for us and give us a sense as to how much this is contributing now to growth. Are you at that point or would you be willing to share that with us if you could?

[Andrew C. Teich:]

So, Jim, this is Andy. We don't talk about specific contribution of each product in reporting our results. But I can say a couple of things related to that. Across many of our business, we've seen unit volumes increase significantly, and that's been in the face of ASP declines, but it has been driving overall growth. If you look at the growth in the Instruments business, if you look at the growth in the Security business that we've been obtaining, those are driven by very significant unit volume growth. And in both of those markets, the total available market opportunity is quite significant, and I think that we're still very thinly penetrated into those markets. In the case of where we've got markets that are quite price elastic, the developments that we've been doing in terms of developing lower cost products that open up this technology to a new class of buyers is really where we think the growth is going to come from in these markets. That said, we're also focused on the upper corner of our markets. And we've got several product introductions that are going to occur later this year in the upper end of our product value ladder. And we believe that that will drive a refreshed cycle in those areas.

[Jim A. Ricchiuti:]

Okay. And maybe just to follow-up on just the last comment about new products and presumably some of these will, if they're at the higher end of market, carry some better margins. So I'm wondering, is there anything we should be thinking about in terms of the mix of revenues in the second half of the year as it relates to gross margins?

[Andrew C. Teich:]

Well, I think that the – as we look at the mix right now for the second half of the year, we think that there'll be a small improvement in gross margin relative to what we've seen in the first half of the year. At this point, though, the new products that we've introduced into the channel support our current gross margin levels. As you've mentioned, some of the products that will get launched at the upper end of our product value ladders tend to have higher gross margin levels associated with them. But I don't expect that to move the needle significantly in the second half.

[Jim A. Ricchiuti:]

Got it. Thanks very much.

[Operator:]

Our next question comes from Peter Skibitski with Drexel Hamilton.

[Peter J. Skibitski:]

Good morning, guys.

[Andrew C. Teich:]

Good morning.

[Peter J. Skibitski:]

Hey, guys. You have had some big receivables outstanding from the Middle East. Have you collected on all of them yet? Because I'm just wondering because it looks like working capital was a use of cash this quarter and I'm just trying to kind of get at what your free cash flow expectations are for the full year.

[David A. Muessle:]

Yeah. Peter, this is Dave. We did have some large receivables from the end of the year we're actively working that. Unfortunately, some of those did not come in, in the first half of the year like we had hoped. We do expect them to come in, a good portion of them come in, in the second half of the year. And right now, based upon our expectations, we would expect to see receivables come down a bit in the third quarter.

[Peter J. Skibitski:]

Okay. And just to follow up, it looks like rest-of-world volumes were down pretty significantly in the quarter. Can you tell us, are you seeing a lot of headwind out of China or maybe the Middle East or both?

[Thomas A. Surran:]

Yeah. Peter, this is Tom. No, not really at all. So, when we look at it, there's – I can talk to one headwind. But in total, our revenue in APAC actually showed nice growth. And there's a couple of places where that occurred. In particular, substantially in our Instruments business, we had very nice growth. And portion of that was related to the application of thermal imaging for screening related to the MERS crisis that occurred in Korea, but we also beyond that had substantial growth. We had nice growth in our security market as well. We had reasonable overall growth. So China, do we have headwinds? The one thing that does kind of hold us back perhaps a little headwind that we need to fight is that there are certain trade restrictions on our products that we have to face, and that always is something we have to deal with, but nothing in particular. No.

[Peter J. Skibitski:]

Okay. I just asked because your chart on slide 7 shows rest-of-the world going from $92.5 million last year to $77 million this year, so I just raised the question in my mind. But thank you.

[Thomas A. Surran:]

Yeah. Okay.

[Operator:]

Our next question comes from Jeff Kessler with Imperial Capital.

[Jeffrey T. Kessler:]

Thank you. At the last two or three trade shows in the Security area that you've been at, there's been a state of new introductions from other companies touting either, obviously, LED-based or infrared-based cameras, but also being able to say that they also have visible light combinations with those infrared cameras. Given that you have a leadership position in this area, what are you doing to offset that – the competition for those who are claiming that they can produce a visible light infrared camera at a cheaper price than you? What's your value proposition to offset that?

[Andrew C. Teich:]

Hey, Jeff. This is Andy.

[Jeffrey T. Kessler:]

Hi, Andy.

[Andrew C. Teich:]

Well, there – in that particular case, they're using a standard CMOS visible camera and just opening it up to the short-wave IR wavelengths that enable through LED illumination. And at the end of the day, it's really completely different technology than what we're dealing with thermal imaging. That's still an active illumination technology that relies on light emitted from the LED illuminators reflecting off of the target back to the sensor. And the problem with that is twofold. Number one, it's very short ranged so you can't get near the kind of range that you can get from a thermal sensor. And number two is that you have a significant issue relative to any kinds of obscurants that are between the camera and the object, and that can be anything from a spider web that forms in front of the camera because those LED illuminators give off heat and attracts spiders, all the way through to any kind of dust, fog, rain, smoke that is in the environment significantly inhibits the effectiveness. The last thing and a real strength for thermal imaging – and we talked about this a bunch during our Investor Day – is the fact that the kinds of things that you're looking for with a security camera tend to be living objects, people or animals, and those stand out very strongly from the background in the thermal spectrum, and they do that in a passive way. So, there's no illumination that is required. As a result of that, video analytics work very reliably. You tend not to be affected by obscurants that are in the scene. And because it's a passive technology, it can't be detected. It's low power and it doesn't attract things like spiders that cause problem with the IR illuminated solutions.

[Jeffrey T. Kessler:]

Okay. As a follow-up in the OEM area, we've just seen a introduction of – some of that could be very interesting in the unpiloted plane area or drone area. Without obviously giving away any company names or anything like that, what areas of OEM – now that you've had Lepton out in the field for a while, what areas do you think are the ones that have the greatest prospects for the next couple of years for us to see new product being adopted by new companies.

[Jeffrey D. Frank:]

Hi, Jeff. This is Jeff Frank.

[Jeffrey T. Kessler:]

Hi.

[Jeffrey D. Frank:]

So, the – on the UAS side, first of all, the product we just introduced, the Vue product, it has turned out it's not a Lepton-based product, it's Tau-based product.

[Jeffrey T. Kessler:]

Okay.

[Jeffrey D. Frank:]

So, it tends to be a higher-performance system. And it turns out that in the past we've been selling kind of Tau cameras into the community. And when I say that community, in the U.S. community, I'm talking about more of the professional virtual side of that community. But our – from a price point standpoint and also from an interface standpoint, the products we had were probably not as desirable as they could have been. And that's what we did with Vue, is we created a price point and modified the products such that the interconnect was much easier. So it's just makes it very simple for somebody who isn't generally a professional user, these are people who are using it for things like agriculture, crop inspections, wildlife detection, that sort of thing. And the response from that has been pretty positive. We've had it out for two months now. We're very encouraged by the response we've gotten from it. And we're going to start pushing some more chips into that – onto that table now. We see it as a growth opportunity for the future.

[Jeffrey T. Kessler:]

Right. And then actually the other part of that question was if you could, in a general sense, talk about what other OEM areas do you think are, in a sense, most pregnant with possibility given the fact that you do have a success or an introduction in one area, what areas are we going to be seeing over the next year or so that you can talk about?

[Andrew C. Teich:]

Yeah. Sure, Jeff. This Andy again. A couple of areas that show opportunity there, the first covers the current verticals that we satisfy with our end solutions. There will be other players that will be in those areas, in Maritime, in Security, in Test and Measurement equipment. And we supply OEM components into those markets. Jeff talked about the UAS market. That's an area where we're getting traction with Lepton, for example, with other micro UAS manufacturers due to its low size, power and weight. The other thing that presents a very significant opportunity for us is the Internet of Things space. Fundamentally, Internet of Things devices are sensors that are connected to users in an intelligent way through the internet. And a thermal imaging module, something like Lepton, provides a very rich set of data that can't come from other types of sensors. But it's a set of data that many Internet of Things devices would benefit from. And we're seeing a lot of inquiries there. We recently conducted a maker event where we invited a bunch of developers to a public event where they developed solutions around Lepton. And that was a very popular event for us and one – a model that we intend to replicate elsewhere in the world later in the second half of the year.

[Jeffrey T. Kessler:]

Okay. Great. Thank you very much.

[Operator:]

Our next question comes from Michael Ciarmoli with KeyBanc Capital Markets.

[Michael F. Ciarmoli:]

Hey. Good morning, guys. Thanks for taking my questions. Maybe if we could just go back to Pete's question on the international revenues. If Europe was up 27%, APAC was up, what was down that drove that 16% contraction in the other foreign (38

[Thomas A. Surran:]

Yeah.

[Michael F. Ciarmoli:]

But you got the rest of world down significantly.

[Thomas A. Surran:]

I think we're kind of slicing U.S. versus – so, we typically define Americas as one region. And that includes Latin America, and certainly the Brazilian market has been a major softness, down significantly. Also has the Canadian market. So, we've also kind of – it's a matter of how we are slicing between the regions. And when I earlier referred to, in that case, APAC, I was referring to a division that had Americas, Europe, Middle East, APAC. This is slicing it with U.S. government, U.S. other, Europe, and the rest of world which is picking up Canada and Latin America. So, I think that's the difference between those two, it was the way the slicing occurred. And in rest of world, I would go to those countries, Latin America, Central America, Middle East that would all have different results.

[Michael F. Ciarmoli:]

Okay. And then just on the guidance, I mean, the second half really assumes a pretty big jump in revenues over first half. Same thing with EPS. I think you mentioned some pushouts from customers in your OEM. We're certainly seeing the broader industrial market look pretty choppy out there with China slowing. I mean, how much line of sight do you guys have into the remainder of the year and even tying in some government risks? I mean, do you guys have enough line of sight to sort of handicap for some weakening global economics out there?

[Andrew C. Teich:]

Well, we do. We had some business that was slated to deliver in Q2 that we were not able to execute during the quarter that was staged for delivery, but we didn't have the orders complete at the point that we're able to deliver them in Q2 and those have come in now. So, that helps to firm up our view of the Q3 revenue situation. There's – of course, there's book and bill that still needs to happen for Q4 deliveries, but that's something that's not atypical for us at this point. We feel pretty good about the revenue forecast for the second half at this point and the revenue increase H1 to H2 is fairly typical to what we've seen in prior years.

[Michael F. Ciarmoli:]

Got it. All right. Thanks, guys.

[Operator:]

Our next question comes from Jonathan Ho with William Blair.

[Jonathan F. Ho:]

Good morning, guys. Just wanted to start out with the DR SKO program and just understand maybe how you guys are thinking about order patterns this year? I mean, it seems like we got a lot of it in the second quarter. It was a little bit light in the first quarter, and you guys gave some commentary. But just wanted to get a sense of how we should be maybe modeling detection or thinking about the detection linearity as we go through the course of the year?

[Thomas A. Surran:]

Sure, Jonathan. This is Tom. So, there are two pieces to the question. There is the order and then there is the shipment. And on the DR SKO program, we had a $25 million order last year. That was delivered and we just completed in Q2, the final delivery on that order. In March of this year, we had a $50 million order. And the magnitude between those two are kind of where we would expect annual bookings on that program. $25 million to $50 million would be the orders. But they will come in typically in those large lumps in one particular quarter. The revenue is distributed more evenly. Now that said, this year in Q3 we're only beginning to deliver on the March order at the end of Q3. The ramp will occur through Q4 and continue for deliveries over the next 12 months. We would expect then subsequently an order sometime into this year, early next year to replace that order, so that we could have a continuing relatively smoother shipment level.

[Jonathan F. Ho:]

Got it. And then just in terms of the acquisition of Sikorsky by Lockheed, I mean, you guys have – historically had a pretty big presence in terms of the Blackhawk side of things. So, I'm just trying to understand, probably not for the near-term, but just longer term, is there potentially a competitive impact on your business there?

[Thomas A. Surran:]

I think it's fairly remote, Jonathan. We have a very rich history, a very long lineage on the UH-60 Black Hawk platform. I would add to that that Lockheed really doesn't have a competitive product in that space. As a customer that has continually been looking for a better value proposition in terms of a sensor, they've been very focused on size, weight, and performance reduction, which the current generation of product that we're shipping into that platform progressed along that path in terms of being smaller, lighter, higher performance product. So, I think we're pretty solid on that front. Qualification process also for the customers on those platforms are fairly lengthy in time. It's not something we're going rest on our laurels. We continue to develop that product platform, listen to the customer in terms of their emerging needs and develop the product consistent with the needs of the customer in that space.

[Jonathan F. Ho:]

Got it. It's a good thing that – yeah, I wouldn't anticipate any change either. Thank you.

[Thomas A. Surran:]

Thanks.

[Operator:]

And our next question is from Noah Poponak with Goldman Sachs.

[Noah Poponak:]

Hi. Good morning, everyone.

[Andrew C. Teich:]

Good morning.

[David A. Muessle:]

Good morning.

[Noah Poponak:]

I remember you all saying a few quarters ago that the acquisition target bucket was something along the lines of larger than it had ever been, but we haven't seen a ton of activity. Could you maybe just walk us through what you're seeing there? Across all industrials, we hear asking prices is a challenge. But maybe just update us on the latest there.

[Shane Harrison:]

Sure, Noah. This is Shane. The pipeline continues to be very, very rich and full. You kind of hit on it. Some of the processes are moving slower than we'd like to, whether it be because of negotiating contracts or mainly in pricing. So, yeah, the valuations are pretty high especially in some of the spaces that we're looking at. That pipeline is pretty broad. We have six segments. There are opportunities across all those segments. We are focused on a few of them. A little heavier than the others, but it's particularly – like security, for example, it's a very hot space valuation wise. So, while the pipeline is pretty deep and rich, the valuation landscape has made it challenging. But it doesn't mean we're not going to be still doing things. I think there are pockets and gems of opportunity that we should be able to act on in the near term.

[Noah Poponak:]

Okay. And what's kind of the range of size of asset you're looking at in a more serious way?

[Shane Harrison:]

Well, if we tiered that pipeline, the top tiers that were active and talking to people on range anywhere from $25 million up to almost $300-ish million. And that $200 million to $300 million is kind of the sweet spot. There are some, let's say, Tier 2 opportunities that might be quite a bit bigger than that. But active things that we're looking at are in that range.

[Noah Poponak:]

Okay. Could you guys give us a little more color on what drove Europe to be better in the quarter? For a while, it had sounded like you guys were still pretty concerned with Europe, so I'm just wondering what's potentially changing there or if it was more just a comparison or something like that.

[Andrew C. Teich:]

A little bit of comparison, yeah. The prior-year comparison on Europe was a bit soft particularly in Surveillance. We had some deliveries of some orders of the revenue side versus the order side. So, earlier comments about headwinds on the bookings that we've made related to what we're seeing going forward, in particular Western Europe, an area we have usually – typically have been very strongly and very good relationships with OEMs and customers there, that's where we're seeing some softness. The deliveries that we saw, the revenue that we saw, we saw a nice growth in this particular quarter. A, it was an easier comp; B, it was just some orders that we took at the end of last year, earlier this year.

[Noah Poponak:]

Okay. So, from a revenue perspective, we shouldn't expect that rate to sustain in the back half necessarily, the rate of growth?

[Andrew C. Teich:]

No, no, no.

[Noah Poponak:]

And then in the Surveillance margin, anything you can tell us about what's in the outlook for how that Surveillance margin will compare to the back half of last year? I'm just – I'm still trying to gauge what the right mid-cycle normalized when things are normal Surveillance margin is on a go-forward basis given how much it's changed over time.

[Andrew C. Teich:]

So, for Surveillance going forward, it will be in line, I wouldn't say dramatically different. There's two things I assume. Gross margin or operating margin?

[Noah Poponak:]

Well, operating margin, but if you could – whichever input matter most.

[Andrew C. Teich:]

Operating margin. Yeah. So I would say the Q2 represents a bit of a low quarter because of just the size of the revenue in the operating leverage. And as we increase that revenue through the balance of the year based on our forecast, you should see our operating margin return mid to the high 20s.

[Noah Poponak:]

Okay. Okay. Thanks very much.

[Andrew C. Teich:]

Thanks.

[Operator:]

Our next question is from Tim Quillin with Stephens, Inc.

[Timothy J. Quillin:]

Hey. Thank you, for taking my follow-up. I just had a couple of questions about your consumer products that I think drive good brand awareness for you. But on FLIR One next gen, can you compare maybe the early response to that versus what you saw on the FLIR One first generation product and what your expectations are relative to what you saw on the first FLIR One?

[Travis D. Merrill:]

Sure. Hi, Tim. This is Travis. Obviously, we won't disclose any specific product volumes related to either first gen or second gen, but I can give you some sort of more qualitative points relative to the FLIR One, both gen one and gen two. First of all, just kind of on the overall media coverage and acceptance, we've actually seen increased coverage across a number of different metrics on the PR front for the second generation versus the first generation, which I think is a pretty good accomplishment given the newness of the technology last year when we first introduced FLIR One. Secondly, we took a slightly different approach this time with the launch. And rather than staging it geographically, we launched it globally on a single day. And by doing so, we obviously opened up a much bigger market from the start that combined with the much broader device compatibility has led to us servicing a natural pent-up demand that we weren't necessarily able to meet with the first generation given the constraints of the iPhone 5 platform. So, I think looking at it from those two perspectives, we've been positive in our viewpoints and how it's doing but it is still very early and we're still, as Andy mentioned on the opening comments, ramping up manufacturing capacity. So, we'll have a better view really as time goes on throughout this quarter.

[Timothy J. Quillin:]

Okay. And then on FLIR FX, I think that had some pretty good reviews, but how is that selling through your retail channels and what's the thought about potentially adding infrared into that product at some point? Thank you.

[Travis D. Merrill:]

Sure. This space of consumer IT, home monitoring, obviously, is a very active one with a number of new entrants and a lot of different players trying to find their footing. We've been very encouraged by the progress that we've made in a couple of months that we've had it in market. Again, on the media front, and you sort of alluded to this, we've had some very, very good coverage, very good reviews that not only goes to drive demand for that particular product but it also helps us build our overall brand in that relatively new consumer market for us. Secondly, user feedback has been quite positive as well if you look at reviews online. And people are really valuing the differentiation that we've put for the RapidRecap and some of the other features. And the third thing I would mention – and I think you might have alluded to this as well – is this product has – really had the strongest retail coverage of any FLIR branded product that we've launched to-date. We've obviously got placement in Best Buy and Target, many regional retailers, and a whole host of e-tail partners. So, I think that also not only serves to open up the market for us from a pure consumer demand standpoint but, again, also helps us build the awareness for our brand, introducing our brand to those folks who may have not heard of us previously. On your second question regarding the injection of thermal imaging technology into this, we obviously have nothing new to announce at this time. But, clearly, there's a very strong value proposition there, thermal in security cameras. And it certainly helps to solve common pain points in this space. So, it will be something that we continue to explore and look at.

[Andrew C. Teich:]

Tim, this is Andy. I'll just add other thing to Travis' comments that has merit relative to FLIR FX is that from a technology standpoint, it's also a platform for us to develop things like cloud connectivity, which the FLIR FX has, mobile apps – it's got a broad suite of mobile apps to go with it and also a recurring revenue model. So, those are all platforms that are important for us as we go forward and broaden that product line to include thermal and other capabilities that will spread across the total security business.

[Operator:]

Our next question – our final question, I should say, comes from Jeff Kessler with Imperial Capital.

[Jeffrey T. Kessler:]

Thanks. Just a quick follow-up on Detection. It took a little while for you to get your – say get your sea legs with regard to Detection and the acquisition of the company that comprised a lot of it. Now, are you set with the – do you believe that you were set with number one, lines of product that are going to sell best for you and also the connections or the actual connections with those parts of the government that are going to – or states that are going to buy these products? Are you set with them so that you have an infrastructure both in terms of the people as well as the products in line with what you think the demand will be?

[Andrew C. Teich:]

Yeah, Jeff. This is Andy. We've made really good progress in this business. The segment required some work, I think, to get it aligned with the FLIR model. But a couple of things specific to the questions in terms of customer base, I mean, we saw quite a good response in Q2 if you take out the program and CRAD (56

[Thomas A. Surran:]

No. That's a very good summary. I think we've restructured the business to be efficient. We are working on new products. It's been well-adopted by the customers. We're seeing the results. And, yeah, we're going to have – through the balance of this year, we think a nice overall year for the Detection.

[Jeffrey T. Kessler:]

Okay. Thank you.

[Andrew C. Teich:]

Well, thank you, everyone, for joining us on the call today and for your continued interest in FLIR's growth as a company. I'd also like to thank the nearly 3,000 FLIR employees around the globe for their continued focus, dedication and execution against our vision of making FLIR the World's Sixth Sense. We're very excited about the opportunity ahead of us, and we look forward to updating you relative to our progress on that front at the end of Q3. Thank you, everyone.

[Operator:]

Thank you. Ladies and gentlemen, this concludes today's conference. You may disconnect your lines at this time. Thank you all for your participation.