FLIR Systems, Inc.
Q3 2015 Earnings Call Transcript

Published: 28 Oct 2015

[Operator:]

Greetings, and welcome to the FLIR Third Quarter 2015 Results 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. I'd now like to turn the conference over to your host Mr. Todd DuChene. Thank you. You may begin.

[Todd DuChene:]

Good morning, everyone. Please note that our earnings press release and presentation slides that will be referred to you 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:]

Thank you Todd, and thank you everyone for joining us on FLIR's third quarter 2015 earnings call. With Todd and me today is our COO, Tom Surran; Chief Marketing Officer, Travis Merrill; Chief of Product Strategy, Jeff Frank; and SVP of Corporate Development, Shane Harrison. Additionally, I would like to introduce our new CFO, Amit Singhi who joined FLIR in August after spending 21 years at Ford where he most recently was the Head of Finance of their global aftermarket parts and service business. We're thrilled to add Amit to the team, and look forward to leveraging his experience in financial reporting, operations, planning and strategy. I'll start the review this morning of the quarter with Slide 4 of the presentation. We reported third quarter revenue of $382 million and earnings per share of $0.52 which includes a $0.12 per share resulting from a GAAP required reversal of a tax reserve that was determined no longer necessary. Compared to the third quarter of 2014, revenue grew 2% while EPS grew 41%. Excluding restructuring charges and the discrete tax item, third quarter EPS grew 3%. Foreign exchange continued to be a headwind on revenue in the third quarter. On a constant currency basis, Q3 revenue was up 6% as a strong U.S. dollar resulted in a $14 million reduction in reported revenue. Third quarter operating income excluding restructuring charges was $76 million up 3% over the prior year. Net income in the quarter was aided by the $17.4 million discrete tax item previously mentioned. Our restructuring efforts that began at the end of the 2013 have led to improved profitability, with year-to-date earnings per diluted share excluding restructuring charges and the Q3 2015 discrete tax item increasing 13% versus the first nine months of 2014, and adjusted operating income growing 14% versus the first nine months of 2014. Since last quarter, we've introduced several new products in many of our markets. To highlight a few, first, in our Instruments segment, we introduced the T1K series of uncooled high-definition thermal cameras, which effectively created a new upper corner for our Instruments segment value ladder. Also introduced in the Instruments segment were two new additions to the FLIR branded Test & Measurement product line. The CM174 clamp meter and the MR176 moisture meter each featuring Lepton thermal imaging sensors to deliver our highly differentiated infrared guided measurement on two tools that are main stays for electricians and building professionals. And in our detection segment, two new ground breaking products were launched, the Fido X2 explosives trace detector brings our advanced chemical detection technology down to a new more accessible price point, and demonstrates a new DNA for our detection product lines which feature modern ergonomic industrial design, a simple intuitive user interface, and lower cost to manufacture. Detection also introduced the Griffin 410, our newest portable mass spectrometer used for detecting explosives, drugs, chemical warfare agents and environmental pollutants actively in the field rather than waiting for samples to reach the lab. Moving to Slide 5. In our earnings release today, we updated our outlook for 2015. As a result of soft demand in Europe and in some of our Instruments and maritime end markets, as well as currency impact on profitability, we now expect revenues to come in between $1.52 billion and $1.57 billion for the full-year and earnings per diluted share excluding restructuring to be in the range of $1.76 to $1.81, which includes both the previously mentioned $17.4 million discrete tax benefit in Q3 and an estimated $12 million after tax gain on an investment expected in Q4. Excluding the restructuring costs, the one-time tax item and the investment gain, we expect fully diluted EPS to be in the range of $1.55 to $1.60. We also announced today a quarterly dividend of $0.11 per share, which will be payable on December 4 to shareholders of record as of November 20. I'll now pass the call over to Amit to review the third quarter financial results. Amit?

[Amit Singhi:]

Thanks, Andy. Good morning. First of all, I wanted to mention that I'm very excited to join the FLIR team. It's a great company with fantastic technology, products, and people positioned at an inflection point with significant long-term growth potential, very happy to be here. The following discussion on pre-tax operating results for the third quarter and year-to-date excludes restructuring expenses, which totaled $0.3 million and $1.1 million in 2015 and $4.1 million and $16 million in 2014 respectively. On Slide seven, you'll see a summarized income statement. Despite currency headwinds, our revenue, operating income, operating margin, and EPS improved year-over-year. Third quarter consolidated revenue was $382 million, an increase of 2% compared to the third quarter of 2014. Our surveillance, OEM and emerging markets, security and detection segments reported increases of 5%, 3%, 22%, and 7% respectively in year-over-year revenue. Our other two segments reported year-over-year decline with Instruments down 9% and Maritime downs 13%. As we've noted earlier in the year, these two segments are most heavily impacted by currency fluctuations. Adjusting for currency impacts, Instruments and Maritime would have shown year-over-year revenue declines of 3% and 4% respectively, driven by competitive pressures in Maritime and market softness in Europe and Latin America. On a unit volumes basis, Instruments and Maritime grew 62% and 40% respectively. Overall revenue would have shown a year-over-year increase of 6% on a constant currency basis. Regionally, U.S. revenue grew 12% year-over-year. Sales to the U.S. government increased by about $2 million or 2% and represented 21% of total revenue in Q3 for both 2015 and 2014. International revenue was 43% of total revenue in Q3 2015, compared to 49% last year. For the first nine months of 2015, revenue was $1.119 billion, a 2% increase over last year. On a constant currency basis, nine months revenue would have been up approximately 7% year-over-year. Consolidated Q3 gross margin was 47%, a 2 percentage point decrease compared to last year, primarily driven by gross margin deterioration in the Security segment due to product mix, as well as overall changes in segment mix and the negative impact of changes in exchange rates. Operating income and margin improved slightly year-over-year despite adverse currency effect. We reported a tax benefit of $1.9 million in the third quarter, primarily due to a $17.4 million favorable discrete tax item related to the release of a previously recorded tax reserve. We continue to expect our 2015 effective tax rate to be approximately 24%, comparable to 2014 excluding discrete tax items from both years. Excluding restructuring charges, net income was $73.7 million, an increase of 31% over last year. And earnings per fully diluted share were $0.52 in this year's quarter, an increase of 33% over Q3 of 2014. Excluding restructuring charges and the favorable discrete tax items mentioned before, net income was $55.9 million, flat compared with the prior year and earnings per fully diluted share were $0.40, an increase of 3% over last year. For the first nine month of 2015, operating income was $213.4 million, representing a 19% margin compared to 2014 operating income of $187.8 million or 17% margin. Net income for the first nine months of 2015 were $172.3 million, representing a 23% increase over 2014. Earnings per diluted share of $1.22 for the first nine months of 2014 was a 26% increase year-over-year. On Slide eight, you will see that we closed the third quarter with cash of about $525 million, a decrease of about $35 million during the quarter as strong operating cash flow was more than offset by investing and financing activities to improve overall shareholder value. In the quarter, we improved our accounts receivables and payables. Inventories increased due to new product introductions in Instrument and Maritime segments, as well as seasonality in the Security segment. We've begun implementing detailed plans with each of our segments to accelerate our progress on inventories and expect to improve our metrics over the next year. Our cash flow from operations for the quarter was $73.6 million or 101% of quarterly net income as reported. For the first nine months of the year, our operating cash flow was $197.5 million or 115% of nine-month net income as reported. Our cash flow from operations improved year-over-year due to improved net income and better working capital management. We had capital expenditures of $19.4 million in the third quarter and returned $15.4 million to shareholders through the payment of dividends. We also spent $62 million to repurchase approximately 2.2 million shares of stock during the quarter under the two-year 15 million share repurchase program that we announced in February. We will continue to assess the repurchase of our shares in the future with the level of activity dependent on relative value and other uses of cash, including M&A opportunities. This concludes the summary of our third quarter and first nine-month results. Let me now turn it over to Tom Surran to cover our operational highlights for Q3. Tom?

[Thomas A. Surran:]

Thank you, Amit. You will see a summary of our segment operating results on Slide 10. The third quarter consolidated segment operating income grew 1% over the third quarter of 2014, while segment operating margin remained level with the prior year 24%, excluding restructuring charges. The negative operating leverage that resulted from softness and the Instruments and Maritime segments revenue was offset by improved profitability in our government businesses. Total order backlog increased by $31 million to $568 million, which is a 6% increase over the second quarter of 2015. Moving to Slide 11, during the third quarter, Surveillance segment revenue increased 5% year-over-year to $131.6 million, as growth from our land and Maritime product offerings more than offsets smaller declines in airborne and integrated system product offerings. Surveillance segment operating income of $40.1 million excluding restructuring charges increased 19% versus the prior year, which represents a 350 basis point increase in the operating margin, driven by a combination of increased revenue and reduced operating expenses. Surveillance backlog increased 10% over Q2 to $340 million and bookings of $166 million, resulting in a book-to-bill ratio of 1.3. Bookings improved compared to last year as demand from customers in the Middle East and slight growth in the U.S. offset a weak European region. During the quarter, the Surveillance team won a $50 million IDIQ contract from the U.S. Navy to supply the second generation Combatant Craft Forward Looking Infrared or CCFLIR2 were used by the U.S. special operations command. Imperative to winning this award was our ability to quickly design and demonstrate a fully functional system during the bid process. Great example of how our commercially developed, military qualified, or CDMQ operating model provide the competitive advantage. Turning to Slide 12, Instruments segment third quarter revenue decreased 9%, compared to the prior year, finishing at $74.8 million. Growth was seen in our science, fire fighting, and test and measurement products. However, it was not enough to overcome the combination of a $6 million foreign exchange headwind, reduced capital spending from the oil and gas industry for our optical gas imaging systems and softness in our higher end tomography products. Instrument unit volume shipments increased by 62% in Q3 as compared to the prior year and approximately half of the total unit shipped during the quarter were Lepton based. This increase in unit volumes represents a significant expansion of the user base for thermal imaging. Operating margin, excluding the impact of restructuring charges, dropped 340 basis points, to 29%, as a result of the revenue decline, and flat operating expenses for the quarter. As Andy mentioned, we recently introduced a new flagship product, the T1K series of professional thermal cameras. As you'll see on Slide 13, the T1K brings together, high-definition thermal imaging, the most advanced thermal image processing software, with our UltraMax and MSX technologies, as well as our new OSX, high-precision ultrasonic driven optical system. We began shipping T1K units to customers during the fourth quarter. We also introduced, two new FLIR branded test and measurement products, the CM174 all-in-one clamp meter for electrical professionals, and the MR176 imaging moisture meter for building and remediation professionals. Both products are similar in form factor to the tools professionals currently use. But they also incorporate a Lepton sensor to provide Infrared Guided Measurement or IGM, a solution that allows the professional to find problems by visualizing temperature anomalies. Slide 14, summarizes the results for the OEM & Emerging segment, where third quarter revenue increased 3% versus last year to $51.4 million. Improved shipments of thermal imaging cores, more than offset the $4 million of revenue headwind from foreign exchange, and the divestment of our OCG business in Q3 of 2014. Excluding these two items, segment revenue was up 12%. OEM & Emerging operating margin, excluding the impact of restructuring charges improved 200 basis points compared to the prior year to 28%, primarily due to reduced operating expenses. During Q3, we introduced the FLIR Vue PRO, for the UAS market. The Vue PRO, built on the successful small format, easily integrated Vue platform, and adds thermal video in 14-bit still imagery, as well as Bluetooth connectivity to ease pre-flight configuration. The Vue PRO is most suited for applications such as agriculture, security and solar panel inspection. Turning to Slide 15. The Maritime segment finished the third quarter with revenues of $38.9 million, which was 13% below the prior year. This business has significant exposure to currency movements and as a result the segment saw a $4 million of foreign exchange headwind in the quarter. On a constant currency basis, revenue declined by 4%. Multifunction display unit volumes increased 40% during the quarter as compared to the prior year and part due to an increased penetration in the fresh water market with the Dragonfly product line. Raymarine, MFDs now support the integration of FLIR's AX8 thermal imager for continuous monitoring of critical electrical, mechanical equipment during the voyage. The Lepton based AX8 provides the user with MSX imaging to provide more detailed imagery, as well as providing both visible and audible alarms from conditions exceed preset thresholds. Our thermal maritime product revenue was up in the quarter. Foreign exchange and increased price competition of Raymarine's in-markets negatively impacted the segment. Maritime operating income was $1.8 million in the quarter down $2.8 million from Q3 of 2014. Profitability was negatively impacted by both currency and pricing pressures. On Slide 18, you'll see our security segment results. Revenue continued to grow in the segment, up 22% year-over-year reaching $59.3 million. Strength in both Lorex and FLIR-branded visible systems drove this growth. Security operating profit was $7.2 million up 3% from the prior year. Operating margin declined 220 basis points, the result of lower gross margins due in part to greater penetration in the retail market of the Lorex products. During the quarter, we announced the FC ID line of thermal bullet cameras as shown on Slide 19. Featuring our TAU thermal core, these cameras are equipped with our proprietary onboard video analytics that automatically and reliably detect humans, vehicles and other objects, significantly enhancing the capability of the world's most popular thermal security cameras. The market is becoming increasingly aware of the significant advantage thermal imaging provides for accurate and reliable video analytics. During the third quarter, unit volume shipments of Lorex and FLIR Visible imagers increased 30% as compared to the prior year and unit volumes for FLIR thermal imagers increased 50% over the prior year. On Slide 20 is the summary of the Detection segment's third quarter. Revenue was $25.8 million, which was up 7% over the prior year. Revenue from both the radiation and handheld explosive trace detection product lines doubled in size compared to the prior year, which was partially offset by a planned reduction in non-strategic contract R&D revenue. Operating profit grew 26% as gross margins improved with better product mix and lower product costs. Detection backlog finished the quarter at $72 million, which was down compared to the end of Q2, as we began shipping against the $51 million DR SKO order that we received in March of this year. Also in the last few weeks, we introduced two significant new products in the segment. First the Fido X2 is our latest handheld explosive trace detector that uniquely offers high sensitivity of a broad range of chemicals used in manufacture of homemade, commercial, and military explosives, and does sell at a price that will allow more law enforcement first responder professionals to benefit from this life saving technology. Also in Q3, we introduced the new Griffin 410 portable gas chromatograph/mass spectrometer that is designed to provide in-field lab quality chemical detection with its ruggedized and transportable form factor. That concludes my summary of the segments' third quarter. I'll now pass the call back to Andy.

[Andrew C. Teich:]

Thank you, Tom. While the third quarter came in below our expectations, we saw many reasons for enthusiasm for the future. First and foremost, our product teams continue to introduce cutting edge and market creating products across our various product line value ladders. Lepton continues to be a key component creating differentiated solutions in many markets. In this quarter, we introduced the ninth and tenth new products utilizing our revolutionary Lepton sensor. As a result of this innovation coupled with our selling and marketing investments and our initiatives to reduce our operating costs, growth and profitability has improved significantly with revenue on a constant currency basis growing 7% and operating margin up 200 basis points year-to-date. Our government businesses have responded to cyclical spending softness by focusing on our unique CDMQ model and the recent CCFLIR2 and international program wins are good examples of how we can be successful with the strategy. Additionally, our product volumes continue to grow at a very strong pace, which is helping to build brand momentum and further reduce cost by leveraging our vertically integrated capabilities. That concludes our comments on the third quarter. We'll now ask the operator to open the call up for your questions. Operator?

[Operator:]

Ladies and gentlemen, thank you for holding. It is now time for question-and-answer session. Our first question comes from the line of Saliq Khan with Imperial Capital. Please proceed with your question.

[Saliq Jamil Khan:]

Okay. Thank you. Hi, Andy. How are you?

[Andrew C. Teich:]

Good, Saliq.

[Saliq Jamil Khan:]

One of the questions that I have for you was, you had mentioned that inventory was up by about $67 million during the quarter. What is the product composition of the increase in the inventory? Has it been largely the newer detection products or is it some of the legacy solutions that you were previously selling?

[Andrew C. Teich:]

Actually, the increase comes from three areas, two are related to new product developments and those are in the Instruments and Maritime segment. So, both of those areas we've had a fairly strong cadence of new product developments towards the end of the quarter and as a result there was an inventory build-up to build the initial stocking inventories of those products as they go into distribution channels. The third area is related to the security business, that's a fairly cyclical business, we were pretty strong sell-through in Q4 in that business, particularly at the retail outlet standpoint and as a result we've got a fairly strong build of inventory as those products go into the channel.

[Saliq Jamil Khan:]

And the second question that I have for you was the two new detection solutions that you had just introduced recently and I saw this at the most recent security conference at the West Coast. Was this a byproduct of you reaching out to the customers and trying to push a solution that you believe they needed or did they come to you and said hey these are our needs we believe we're missing this when we're out there out in the field. How do that come about, the introduction of the solutions?

[Andrew C. Teich:]

Sure. Those are good questions. We always develop products based on feedback that we hear from the customer base. There's also an element of innovation that comes from our engineering teams that we utilize to enhance the products. One of the other things that's unique about these new products that are coming through detection and I mentioned it in the prepared comments is that these are the first products that really represent a very strong injection of FLIR's DNA from a industrial design standpoint, from a user interface standpoint, and from a efficiency of manufacturing standpoint. If you look at these products, particularly the Fido X2 is a great example of it. There is a situation of product where you'll see a very strong correlation from an industrial design standpoint to the products that are on our Instruments segment. We've also really innovated this product in terms of ease of use. These are products that get deployed in the field typically with users that may not have a lot of training in this. We went quite a long way in this product to embed training materials into the product, videos, and so forth that explain how the product is used and also have a very intuitive operation of the unit such that users can use it without a training. Also, that particular product represents a lower price point, so we expect to be able to address a larger portion of law enforcement oriented customers with that products given the lower price point and the value proposition that it provides.

[Operator:]

Thank you. Our next question comes from Peter Arment with Sterne Agee. Please proceed with your question.

[Peter J. Arment:]

Yes. Good morning, Andy. Andy, could you give us a little more detail what you're seeing in Europe. I mean sequentially its – it was down year-over-year it's down, I mean obviously excluding FX, I know there was pressures there but what are the kind of challenges I guess you're seeing is just the overall slowness in the end market or is it just something structural going on?

[Andrew C. Teich:]

Yes. Thanks, Peter. It's a good question. One of the things that you'll note in Europe is that the majority of the downturn that we've seen from a revenue perspective in Europe is driven by the currency exchange that we've seen the fluctuations in the currency rates. If you look at our businesses from the standpoint of the businesses where we're well established, we saw a decline there that was pretty consistent across all of the segments. So, it's a double digit decline in the low 20% range that we saw in Q3 on a revenue basis. And again very closely tied to what we saw in terms of currency fluctuation. In the areas where we don't have an established business in Europe, we're actually seeing growth. So we've had a fairly strong push of our security products, both at the retail level under the Lorex brand and at the professional level under the FLIR brand, and there we're actually seeing growth, but it's off of a very small base.

[Peter J. Arment:]

Got it. And then if I could just ask one follow on regarding Lepton. I think, you said 10 products that are now shipping and it sound like it's 50% of the instrument volume is based on kind of Lepton. What was kind of the overall plan at some point, is it going to be based on, you've rolled out 20 products and we begin to see a more material impact on the top line? I mean, how should we be thinking further rollout of Lepton? Thanks.

[Andrew C. Teich:]

Sure. Lepton really has a – we have a three-pronged approach with Lepton. One is what you've seen quite a lot of is the injection of Lepton into our existing market verticals. And the initial products that were launched into Lepton verticals, there were some overlap with existing products if you look at a product like C2 for example, it had some overlap with the product like our E4 series and that is addressing a similar application base with a different form factor. What's interesting that's happening now with Lepton is the more recent products that have been introduced are really creating completely new categories. So the new class of what we call IGM, Infrared-Guided Measurement products, where we're injecting Lepton technology into traditional test and measurement products like electrical, clamp meter, or a moisture meter. Those are going to address really a new customer base that I don't think was considering the use of thermal imaging at all and we have fairly high expectations relative to the performance with those products. Existing products, I mentioned previously products like C2 and the TG135 are doing very well. So the unit volumes there have actually exceeded our expectations and as was mentioned by Tom, it's about 50% of the total volume that we have in the instrument space. We got a couple of areas also with Lepton where – there in the other segments. So in Maritime for example, we talk this quarter about the AX8 product which is creating a new Lepton based engine monitoring product for boats, that's a very tight integration with the Raymarine network and Raymarine MFD system. And again, I think, it's a really strong value proposition because an overheating situation, potential fire in an engine room and boat obviously is a major concern to boaters and having that capability of detecting those kinds of situations before they become a big problem is a really key value proposition. And then the last area of course is, we've created a new price point in the firefighting market with Lepton with K2, that's a product that hasn't started shipping yet, but we'll start shipping here on the next couple of weeks. We've got a nice already selling the units in to distributors, there they'll be delivering in Q4. And then of course we've also launched products into the security space that are just now starting to get traction that are Lepton based.

[Peter J. Arment:]

Got it. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Peter Skibitski with Drexel Hamilton. Please proceed with your question.

[Peter John Skibitski:]

Thanks. We have – it looks like the outline of a two year DoD budget agreement, I think it will be good for you guys in terms of visibility. You had a good growth quarter in Surveillance, good backlog quarter, any sense of getting closer to the trough there on an annual basis? And I was wondering if you could help us with Surveillance in the fourth quarter whether or not you thought it will be up sequentially or not.

[Andrew C. Teich:]

So there I agree with you, Pete. It's nice to see the progress that's been made in terms of a budget. It's an environment that we very much would like to be sailing into. Q3, we had stronger DoD bookings than we have had historically and it was encouraging to see that. And I would also say that the general vectors that we're seeing from DoD purchasing behavior are encouraging for us. We're seeing increased activity in the product categories that we're strong in. So Tom mentioned this a little bit in his prepared comments, but in the Maritime space, in the land space, and in handheld instrument space for our surveillance products we're seeing demand build there and a scenario where we're quite strong. We've invested pretty heavily in product development in that area over the course of the last couple of years and we believe that our CDMQ model is producing products that are pretty strongly differentiated in that space and...

[Peter John Skibitski:]

Right.

[Andrew C. Teich:]

...we're seeing some good traction there. The recent CCFLIR2 contracts went for example the IDIQ that we mentioned today is a good example of a nice contract that we won there with a differentiated CDMQ-based solution. Tom, you want to add any comments about Q4, how Q4 is looking for Surveillance?

[Thomas A. Surran:]

We have a normal seasonality to the surveillance business. We obviously have government purchasing for the U.S. coming in Q3 for the bookings. We typically see strong bookings. Q4 benefits from those bookings and we'll see that normal seasonality of revenue increase. In terms of comparison to prior periods in our bookings, we're encouraged what we're seeing currently, but I don't think we can call a long-term trend at this point. We are thrilled that there seems to be resolution on the DoD budget.

[Andrew C. Teich:]

Yes. One other thing, Pete, I don't think we'll see Q4 revenue for Surveillance be up versus prior year. We had a very strong Q4 last year. We had big shipments of MSC products and LTV vehicles into the Middle East. So, there were – that was an order that we received back in Q1 of 2014, so we've got a pretty tough comp there, but I think it'll still be a good quarter for us.

[Peter John Skibitski:]

Okay, understood. If I could just do one follow-up on Europe in Instruments. Just wondering that you guys on the ground over there, you've got new products rolling out. Do you get the sense that there people are very worried about the global macro backdrop? Do you get the sense that there is more headwind in Europe or do you think you can stabilize things over there with the new products coming out?

[Andrew C. Teich:]

Yes, I think it's more so the latter. Certainly there was a headwind there, but we're going to see less of a headwind from a currency standpoint in Q4. The relative change Q4 over Q4 is certainly less significant than we've seen in the first three quarters of the year from a currency standpoint. And the second thing is that we do have a lot of new products that we're launching and we've worked hard in terms of developing new channels for those lower cost, test and measurement oriented products. So those are going to be addressing new markets. The other thing that we've got going in Europe is also launch of the T1K. So, I mean it is – it's a turbulent market and we've had some headwinds there, but I really expect us to see the situation stabilize in Q4.

[Peter John Skibitski:]

Okay. Thanks, guys.

[Operator:]

Thank you. Our next question comes from the line of Jim Ricchiuti with Needham & Company. Please proceed with your question.

[Jim A. Ricchiuti:]

Hi. Thank you. Just with respect to the implied guidance for Q4 revenues, the range that you're providing, I guess it's not all that dissimilar from what we've seen from you guys in previous years, but I wonder if you could just help us think about maybe what some of that major variables that might contribute to this range, both at the high end and low end?

[Andrew C. Teich:]

Sure. Sure. So, a couple of variables there. I mean, one is book and bill. We don't have a huge book and bill requirement in Q4, but in the areas that I would say that we are – that are being conservative about are relative to the Maritime and Instruments segment, where we did see some pressure in Q3. So, we're looking at that conservatively and expecting that we're going to continue to see those pressures in Q4. The other variable that we deal with is in Surveillance and it's related to the challenges of executing revenue that we have in the backlog and that usually revolves around customer acceptance issues, payment issues and licensing issues. It's nothing new for us. We've been – this is an environment that we live in every quarter and we manage quite aggressively, but it is a variable in the business.

[Jim A. Ricchiuti:]

Okay. Andy, just a question on gross margins. Given the new product rollouts and given in light of what you're going to be introducing, how might we be thinking about your gross margins going forward?

[Andrew C. Teich:]

Well, I think gross margins you're going to continue to see gross margins on the 48% to 50% range. The new products that we're launching support historical gross margin levels. So, there is no issue there. The issue that we see with gross margins tends to revolve around mix both within a segment and between the segments. So we do have some of the segments which on a general level produce lower gross margins – I'm sorry, I mean security produces lower gross margins on the visible-based products. The nice thing that we're seeing in security though is an increased cadence in our thermal business, so that business continues to grow both from an overall revenue standpoint and a unit volume standpoint. But again, that's the – the primary mix is run – the primary changes are driven by mix change within a segment and mix changes between the segments in our total business.

[Jim A. Ricchiuti:]

Okay. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Tim Quillin with Stephens, Inc. Please proceed with your question.

[Timothy J. Quillin:]

Hey. Good morning and thank you for taking my question. There is always a certain amount of constructive cannibalization in your business where your price points are coming down and that might impact the high end products. I'm just wondering in the Instruments business right now where we will see volumes up 60%, but revenue down. If you're seeing any greater degree of cannibalization because of the relatively rapid uptake of the Lepton-based products?

[Andrew C. Teich:]

Yes. Hi, Tim. So, it's an interesting term that you use constructive cannibalization because I do look it at that way. The lower cost products that we're introducing in the Instruments segment I think are necessary for two reasons. Number one is that there will be competition in the low-end space. We've got a technological advantage with Lepton, but there are other technical solutions out there, so we're going to see lower price products that are going to enter that segment over time and I think that we need to lead that charge rather than follow it and that's a general strategy that we have here in the business. As I'd mentioned earlier though, some of the products that we have launched that have lower ASPs are – have more overlap with existing products versus some of the more recent product that we've launched. I'm very encouraged by the significant increase in unit volumes because this does two things. Number one is it builds the base of people understanding the value of thermal imaging in general. And we found a general trend that once people start using thermal imaging that over time they have a desire to move up that value ladder and get a greater capability. The other area is that by deploying these technologies into the trades through these test and measurements products, we're building brand awareness significantly for FLIR. And I think that ultimately, not only does that help the insurance business, but it helps our other businesses as we get into consumer spaces and maritime space and in the security space, that combined with the efforts that Travis' group is doing, is building overall brand awareness for the Company, which we expect is going to benefit unit sales across each of the segments.

[Timothy J. Quillin:]

Great. Thank you. And then on the security business, it's hard to complain too much about a 22% growth quarter, but it is the slowest growth quarter over the past six quarters and revenue was down a little bit versus the second quarter. Where there any pockets of weakness in the security business either geographically or by product line? Thank you.

[Andrew C. Teich:]

Yes. Well, there is some lumpiness in that business, Tim, relative to revenue execution. And it's all on the thermal side. If you look at the growth from the retail perspective, the business did quite well. And really the change that you're seeing in the growth rate is just driven by the major programs that we get in that business, what we call infrastructure class programs that are thermal product related and there is just some lumpiness in that business. We're very well positioned in that space. And frankly I think the things that are going on in the world drive a greater need for perimeter security and situational awareness in outdoor environments. And we've got the broader suite of products of any company in that space in the thermal spectrum and we continue to innovate with new product developments. The products that were just released this quarter are F-Series ID and the F-Series R products are both new products that are going to drive volumes and adoption in the security space. So I'm feeling pretty good about what the mix and the growth rates look like for that business for the future.

[Timothy J. Quillin:]

Great. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Michael Ciarmoli with KeyBanc Capital Markets. Please proceed with your question.

[Michael F. Ciarmoli:]

Hey, thanks. Good morning, guys, and thanks for taking the question.

[Andrew C. Teich:]

Good morning.

[Michael F. Ciarmoli:]

Andy, could we just go back to the gross margins, I mean this was the lowest I think gross margin you guys have ever put up, I mean, even with a stronger performance in Surveillance. I guess as we look forward and you guys see more commercial and more retail, how do we get comfortable thinking that the gross margins are going to hold steady here? I mean it seems like they'd be on a course to continue to track lower and lower? Can you give us any comfort as you can kind of hold these margins in that range?

[Andrew C. Teich:]

Well, so I'm going to have Tom answer the first question and just talk about what we saw in Q3 and then I'll come back and talk about the longer term view.

[Michael F. Ciarmoli:]

Okay.

[Thomas A. Surran:]

Well, I think that the question in general was a longer term question, what's the trend going to be in gross margin so what do we think? So if you look and Andy spoke to the mix and you saw – you heard the comment about the security area that there was lower margins. I am actually thrilled with the roadmap we have for execution and security, and currently – let me say the amount of differentiation and the technology we will be bringing to the marketplace and the product lineup will have the ability to increase our gross margins in that area over the longer-term. So, I think that's one key piece. I think, the other area in Maritime, there was clearly FX which I think is something that hit us particularly hard in the quarter, but again in that marketplace, we also penetrated the low-end. The longer term, we're going to have to create product differentiation in a very price competitive market. I think the current situation is not sustainable for the – overall in that marketplace where it's price competition. It's going to have to be won by product differentiation and that's something we do very well.

[Andrew C. Teich:]

Yes, Michael, I'll add just three points to this relative to the long-term perspective, I think it really comes down to these things. Number one is the injection of thermal technology and that's really what Tom is alluding to in the Security space. But, when we inject thermal into a product class, we have the ability to drive the traditional gross margins that we've had at FLIR. The second issue is differentiation in the products and we've got a very strong focus on differentiation through video analytics and image processing within our products, and you see this very strongly I mentioned in – the T1K has got a very high level of video processing, it's going on inside the camera that creates a very strongly differentiated output in the premium segment. But we also see this in the security space, product like the FCR and the FC ID are products that have processors inside them that are doing video analytics to create a differentiated value proposition there, which are going to support the higher price points and higher gross margin margins. And then, the last area is relative to new categories and this is something as a Company we've been very focused on creating new product categories. And one of the benefits of creating a new product category is that you typically operate for some period of time in that category with a lack of meaningful competition and that allows us to drive appropriate gross margins in that segment.

[Michael F. Ciarmoli:]

Got it. That's helpful. And then, just one last one. I don't think you guys called it out. I may have missed it. Can you just talk about, how your business has been performing in China, maybe some trends there?

[Andrew C. Teich:]

Sure. So, if I look at China from a couple of different perspectives. First, I can look at it from a bookings perspective is on an uptick. Year-to-date bookings in China are actually only up a couple of percentage points but Q3, the bookings were quite strong. They were just shy of 30% and we've got a pretty good forecast for Q4 for bookings in China as well and that's based on traction that we're getting there primarily in the Instruments, OEM and Maritime space. We've been adding sales resources in China to drive that growth as well. If I move over to a revenue perspective, the overall growth rate is sort of in line with the rest of the business. It's high single-digits and within that same range year-to-date, but as we drive those higher bookings increases that I spoke about previously that will allow us obviously to drive the revenue up. I think the real big issue for us is China is still a pretty small piece of our total revenue. We don't do any revenue to speak of in the government oriented businesses, of course, in China due to export regulations. So it's really more about our commercial and industrial businesses. Well, it's a small piece of our revenue today. I think it presents a fairly significant opportunity for the Company and it's an area where we're focused. We're not seeing any of the sort of effects that you see in the news in terms of downturns of the demand in China that has not manifested itself in our bookings or revenue profile to-date.

[Michael F. Ciarmoli:]

Great. Thanks guys.

[Operator:]

Thank you. Our next question comes from the line of Jonathan Ho with William Blair. Please proceed with your question.

[Jonathan F. Ho:]

Good morning. Just wanted to talk a little bit first about the Marine segment and maybe what you're seeing from a pricing competition standpoint. And do you actually see that stabilizing sort of in the near-term or this is going to continue now that you've entered into this more competitive segment?

[Andrew C. Teich:]

Sure. I may have Tom respond to that.

[Thomas A. Surran:]

Yes. In the near-term, I think you will see a very price competitive marketplace and there is also – the lower end products will become more and more featured. You're seeing a migration off of some of the more sophisticated systems into more simplistic systems because they are meeting the need. I think that's the short-term view of it. I think the longer term I would also go to kind of the products that we've been introducing and we're trying to introduce best of class products that are differentiated. We introduced new sonar line. We've introduced a TP370, TP470 and TP570, which gave best of class performance and that's the kind of thing that's going to take us out of a price war into a product differentiation war and that's where we're going to find our success.

[Jonathan F. Ho:]

Got it. And then can you give us maybe an update in terms of what's happening with the automotive OEM opportunities and maybe some of the new platforms that you guys have potential with?

[Andrew C. Teich:]

So, there is not a whole lot that we can provide publicly on that. We have spoken earlier about that we will be debuting on a new Cadillac platform that will be coming out either later this year or early next year. There are still a number of OEMs that are in the hopper that we can't speak publicly about yet, but I'm encouraged about the long-term adoption in that space. The value proposition is still quite good and I think that having another manufacturer and OEM out there with the product feature, and particularly an American brand like Cadillac, is going to help to continue to drive awareness and motivate other manufacturers to join the fray of offering this feature.

[Jonathan F. Ho:]

Got it. And then just lastly as we talk about sort of Lepton going into these adjacent markets particularly in Instruments, can you talk about where we're in terms of global distribution and are we going to start seeing this show up more in big box stores? Is this going to be hardware specific retailers? I just want to get a sense of where you're targeting the distribution and sort of the progress there.

[Andrew C. Teich:]

Sure, Jonathan. The new products that we have just recently launched where you have Lepton embedded in these test-and-measurement products as an IGM feature opens up really a different type of distribution channel for us. And it's distribution channels more in line with what you just mentioned, distribution organization is focused on the trades, and that's everything from dropper type distribution center all the way through to a home improvement type of retail outlet. We have more products to come in that area. So we haven't let up at all on our cadence of product development in the instrument space utilizing Lepton. And many of those products are on the drawing board will find themselves in more retail oriented distribution spaces. So we're encouraged about bringing that technology to the consumer level user as well.

[Jonathan F. Ho:]

Great. Thank you.

[Andrew C. Teich:]

Welcome.

[Operator:]

Thank you. Our final question comes from Pete Skibitski with Drexel Hamilton. Please proceed with your question.

[Peter John Skibitski:]

A couple of follow-ups on cash flow. CapEx looks like it's up over 20%-plus year-to-date, despite the fact that you guys have done some consolidation. So, I am wondering what's driving that and is that kind of the level of growth we will see for the full year? And when does that slow or decline? And I just was wondering if someone could talk about free cash conversion if you can get the one-time or exceed one-time for the year and kind of what your go forward targets are? Thanks.

[Andrew C. Teich:]

Well, I'll handle the first question about CapEx and then I'll have Amit talk about free cash conversion. The increase in CapEx spending is really driven by the fact that we've got a new facility that we are just completing in Santa Barbara. So, we moved from a multiple leased facilities in Santa Barbara to a single owned facility there, which included moving our fab, our development foundry which is just a fairly expensive project. The ultimate intent of that puts all of our operations there in a single building, consolidating from five separate buildings there. It lowers our overall expense on an annual basis as well. The depreciation expense versus the rental expense and obviously it's a much more modern facility and we expect to be able to get the stronger yields out of our development foundry there as a result of having a new facility. So you'll see that CapEx taper off as we go forward. That was really a spike. We also built and just completed this summer a new factory in Estonia and that's reflected in the CapEx spending as well, but again it's a great platform for low cost labor, very high-quality output there. Many of our new Instruments products are coming out of this factory that's based in Tallinn. And it has a lot of capacity for expansion, and we expect that we'll be moving some other product lines into that factory in the coming 12 months to 24 months. Amit, you want to talk a little bit about cash flow?

[Amit Singhi:]

Yes. So, yes, thanks, Andy. So, in terms of free cash flow, you'll see that last year, quarter three, we were about $20 million free cash flow, we had about $15 million of CapEx. Obviously, that improved significantly this quarter to almost over $50 million. And obviously, the use of that cash will depend on our investing and financing activities. As we look forward on the free cash flow, as Andy mentioned, the capital spending will probably taper off a little bit. It'll still be at a decent level; both based on the changes that we're making, but also internal investments as we look at new R&D opportunities, and as the net income improve. So going forward, the free cash flow should be a little bit of an improvement from where we are in this quarter.

[Peter John Skibitski:]

Okay. I guess since I'm the last one, I'll ask one last one, how is the M&A pipeline?

[Andrew C. Teich:]

We'll let Shane talk about that.

[Shane Harrison:]

Not a lot of updates yet, Pete. We're casting a wide net. We're pretty excited about the opportunities we have in a lot of the segments. So, we're talking at various levels with a lot of different companies across all the segments really. So hopefully we will have something to update you with in the coming quarters, but it's kind of more the same. It's a lot of discussions; M&A is an art, not a science always, so it's a lot of – keeping a lot of irons in the fire, and there's a couple of good ones that we're pretty excited about. But again, nailing down timing can sometimes be very difficult, especially on a call like this. So, keep – stay tuned.

[Peter John Skibitski:]

Got it. Thanks so much guys.

[Operator:]

Thank you. I'd like to turn the call back to Andy Teich for closing comments.

[Andrew C. Teich:]

Great, thank you. Well, our Q3 results were somewhat below our expectations. I'm pleased with our continued progress on developing new markets for our sensing technologies, making our products smarter and easier to use and continuing our leadership in building awareness of the benefits of thermal imaging on a global basis. We're on a path that will lead to continued long-term growth and profitability. Before I close, I do want to underscore my appreciation for continued hard work and dedication that is exhibited by the more than 2,800 FLIR employees around the world. We're making great progress in our vision of being the World's Sixth Sense. And with that I'd like to thank you all for joining us today.

[Operator:]

This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.