FLIR Systems, Inc.
Q2 2010 Earnings Call Transcript

Published: 22 Jul 2010

[Operator:]

Good morning. My name is Kila, and I’ll be your conference operator today. At this time, I would like to welcome everyone to the FLIR Systems second quarter 2010 financial results conference call. I will now turn the call over to Mr. Whit Davis, Senior Vice President, General Counsel and Secretary of FLIR Systems. Sir you may begin.

[Whit Davis:]

Good morning or good afternoon, everyone. Before we begin this conference call I need to remind you that other than statements as to historical facts, the statements made on this conference call are forward-looking statements within the meaning of the Private Securities Litigation Reform of 1995 and are based on our current expectations. Word such as expect, anticipate, intend, believe, estimates and variations of such words and similar expressions are intended to identify such 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 forecasted. 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 call over to Earl Lewis, Chairman and CEO of FLIR Systems.

[Earl Lewis:]

Yeah. Well, thank you Whit. And thank you all for joining us this morning. We are very pleased with our performance in the second quarter. We earned $0.37 per share on a 19% increase in revenue or 9% if you exclude Raymarine. Our Commercial Vision Systems Business grew 27% in the quarter and our thermography grew through 7% in a very uneven economy. Government systems performed very well, even as the U.S. funding delays continued. Gross margins and operating margins remained very strong and in line with our expectation. We exited the quarter with cash of 285 million no debt. On May 14th, we completed the acquisition of Raymarine the number one brand in the marine electronics industry for approximately $175 million net of cash. The acquisition was attractive for several reasons; first Raymarine dramatically expanded our maritime distribution network which will enable us to sell more of our thermal images to this large unpenetrated market. Second, our distribution in the higher end commercial marine market will enable us to expand the breath of Raymarine's products. And third we believe the timing though this transaction is very good. We may be in the early stages of a recovery in the market. And finally we see substantial opportunities to improve Raymarine's operating performance and to bring it more in line with that with the rest of FLIR. When we fully integrated we expect to have a large growing maritime business with margins similar to those that we currently enjoy. With that, we’ll let Andy to discuss the Commercial Systems Business. Go ahead, Andy.

[Andy Teich:]

Thank, Earl. Overall Commercial Systems division revenue in Q2 excluding Raymarine was 136 million, an increase of 16% compared to the second quarter results of Thermography in CVS a year ago. Operating income for Q2 excluding Raymarine was 36 million up 25% from the prior year. We experienced generally stable economic conditions in our markets around the world during the quarter with a notable exception of the thermography market in Germany. The thermography revenue in Q2 was 71.4 million an increase of 7% from the second quarter of 2009. Operating margins were 23%. U.S. thermography revenue grew slightly in the quarter, while Asia Pacific continued its strong growth across most product lines applications, and countries. EMEA was down however, as economic conditions impacted our customer activity. We made some changes to our organization in Europe and expect to return to solid growth once these changes take effect in the economic conditions stabilize. From an application perspective, electrical, building and gas imagining were all up nicely in the quarter. Test and measurement was flat and automation and R&D applications were down. Overall, thermography unit volumes increased 40% compared to last year, again illustrating the significant opportunities to penetrate price that last in low and mid range segments such as those addressed by our I 5, I 7 and T series products. The invasion engine and thermography remain strong. In Q2 we launched the A-640 a new product platform for the factory automation market featuring a 17-micron 640 by 480 high resolutions, high speed camera for demanding process and production monitoring application. CVS had a very good second quarter, revenue was 64.7 million an increase of 27% compared to the second quarter a year ago. Backlog remained very strong at 104 million up 3 million from Q1. CVS operating income for Q2 was 19.2 million up 45% from the prior year and the highest in CVS history by far. Operating margins were also a record at 30%, up 4 percentage points from the prior year due to favorable product mix, higher volumes and lower material costs. Demand for CVS products was very strong around the world; growth in Asia was particularly robust as the front end integration of the CVS team with the larger more established thermography team in Asia helped generate demand. Demand in the security and surveillance market was very strong and unit growth was up over 70% compared to last Q2. Of course in components, the largest CVS segment was up significantly from the second quarter of 2009 due to increased orders from several OEM customers for both cool and uncooled cores. The new Tau 17-micron uncooled core which we launched back in April at the SPIE conference is performing extremely well in the marketplace. We believe this camera is the most sensitive, most uniformed and most stable uncooled 17-micro camera available and based on customer interest we expect it to do very well in the marketplace. Growth in auto segment is exceeding our expectations. In the first half of 2010, we shipped the same number of units as in all of 2009 and we expect 2010 volume to approximate the total that we shipped in 2008 and 2009 combined. In addition to our success with the Audi A8, Audi has added our camera to the A6 model which we believe could significantly add to our unit volumes overtime. The recently launched personal vision system segment was created to drive growth of the commercial handheld systems for law enforcement, security professional and personal use. The initial product line with the segment the H series handheld camera has grown rapidly, since its launch and has sold over 1600 units in the first year. We’re very pleased to welcome the Raymarine team to FLIR and are excited about the opportunities to grow their businesses while leveraging their brand and distribution for our core thermal business. Since the acquisition in May, we’ve added thermal cameras to Raymarine's global marketing activity, reduced component supply constraints that were limiting growth and reorganized the management structure. We are also aligning the expense structure to be more in line with the FLIR model and working toward launch of Raymarine branded thermal cameras in time for the Fall Trade Show Season. That concludes my comments. Let me now turn the call over to Bill Sundermeier to comment on the results in the Government System Business.

[Bill Sundermeier:]

Thank you, Andy. In the second quarter, the Government Systems revenue was 167.9 million, an increase of 5% from the prior year. Q2 operating income of 65.8 million was down 9% primarily due to revenue mix and planned increases in operating expenses. Operating margins of 39% remained very strong in the quarter. Second quarter order activity was consistent with our expectations and continued to be impacted by slow U.S. procurement activity. Backlog was 375 million at June 30th, a decrease of 43 million from the prior quarter. Order activity was once again split nearly, evenly between domestic and international. Ground based applications represented the majority of orders with airborne a strong second. Our leadership position and force protection applications is paying dividend beyond the rate platform. In Q2 we received a $14.1 million award from star technologies for Star SAFIRE 3 and Star SAFIRE HD multi-sensor systems to support the rapid fielding of the persistent and ground surveillance system which provides force protection to U.S. nationals in Afghanistan. We are pleased to see the success we have enjoyed with the ray platform carry over to new force protection applications, utilizing advanced sensors such as the Star HD. There was no order activity in the quarter for either the G-Boss or BETSS-C programs and we do not expect any large orders for the remainder of the year. However, we may receive small orders for maintenance, sparing or service related demand. While U.S. order activity remains slow, strong international activity continued unabated with both order size and breadth increasing during the quarter. Our established sales and customer support presence in numerous locations across the Middle East are key to our strong position in this marketplace. During Q2 we received two contracts in excess of 11 million to supply a Middle East allies ground forces with recon 3 thermal binoculars. These ground systems will compliment the nearly 60 FLIR airborne sensors this ally is already operating. Also in the Middle East we received a $5 million order from the navy of Kuwait for C-FLIR 3 systems, we look forward to continue growth in other Middle Eastern countries that are working to improve their security. In Europe, we received a multimillion dollars order from finish Defense Company, Patria Oy for the direct fire sight system. These units will be deployed on Patria’s 120-millimeter unmanned mortar turret which can be mounted on to various track in a wheel chassis. The remote weapon stations site market is emerging and we are well positioned to participate in its growth. In South America, we received an $8 million order to supply Star SAFIRE III to support Brazil's army, navy and air force. We enjoy a long-term relationship with the Brazilian military and look forward to additional potential orders for this program. The interest in attendance to this year's Farnborough air show which is happening this week has been very good. We have been show casing our new Star SAFIRE HD Gen II with full HD imagers for IR, visible and low-light operation. We are also showing our new HD common architecture solutions which are being well received by aircraft integrators. Our outlook for all of 2010 hasn't changed. We see Government Systems revenue as flat to slightly up for the year, based on the current level of backlog and the order forecast. Our current outlook for the U.S. is a bit uncertain, but we do expect third quarter orders to be better than what we have experienced in Q1 and Q2. That concludes my comments. Let me turn it back to Earl.

[Earl Lewis:]

Thank you, Bill. FLIR continues to perform well across all its markets and geographies. We are especially pleased with the recent growth and profitability trends in our Commercial Vision Systems business and with the continued strong operating margins generated by our Government business. Our strategy to expand the market for infrared technology by driving down costs continues as our outstanding operating model. It does however appear to us that economic conditions remain hard to predict and that was actually written before Ben Bernanke said he couldn't do it. This environment is problematic so we have decided that in this call we will leave our earnings per share outlook as we had at the end of the year. Our revenue outlook however will increase by approximately $100 million to reflect the impact of the Raymarine acquisition. With this, now it’s my pleasure to turn this over to our new CFO to discuss the financials in detail. Tony.

[Anthony Trunzo:]

Thanks, Earl. Second quarter revenue increased 19% overall and 9% excluding Raymarine. Commercial vision systems increased 27% as a result of very good growth in virtually all geographies and market. Thermography sales increased 7% for the quarter and Asia was again very strong while Europe was impacted by uncertain economic environment. Government systems revenue increased by 5%, entirely due to growth internationally. International revenue was 37% of the total NGS the highest in at least ten years. For the entire company, international revenue was 49% of the total compared with 41% in the second quarter of 2009. Sales to the U.S. Government represented 32% of total sales and 34% of sales excluding Raymarine compared with 41% in the second quarter of last year. International sales as a percentage of our total was the highest in four years and our U.S. Government sales as a percentage of the total was the lowest in four years. Consolidated gross margin was 55.4% compared with 58.3% last year. Excluding Raymarine, order 2 2010 gross margin was 57.6%. The remaining difference compared to Q2 of last year was due to lower gross margin in Government systems resulting from an expected shift in mix. Consolidated operating margin in the second quarter was 27.1% and 28.4% excluding Raymarine. This compares with an operating margin of 30.5% last Q2. Government systems operating income for the quarter was 65.8 million compared with 72.4 million in the second quarter of last year. GS operating margins remained very strong at 39.2% versus the record level of 45.2% reached in the second quarter of 2009. Thermography reported operating income of 16.7 million for an operating margin of 23.4% up about 35 basis points from last year. CVS’s operating income for the quarter of 19.2 million yielded a record operating margin of 29.7% up 3.6 percentage points from last year. Corporate expenses for the quarter were 15.4 million including 3.2 million of expenses related to the Raymarine acquisition. This compares with 16.4 million in corporate expenses in quarter two of 2009. Raymarine performed very well, since the acquisition of May 14th, revenue was 27.2 million and operating income was 3.4 million from an operating margin of 12.6%. Excluding reserves free structuring of approximately 1.4 million is contained in the Raymarine results, the Raymarine operating margin was 17.8%. The second quarter is a seasonally strong quarter for the marine electronics business, so we don't expect margins at this level for the second half of 2010, but we're very pleased with the progress being made to improve profitability at Raymarine. We did not report any amortization of intangibles arising from the Raymarine transaction during Q2 as we have not yet completed the final purchase price allocation. Based on the current analysis we expect to record between 1.6 and $1.8 million per quarter of amortization relating to – amortization of intangibles related to Raymarine beginning in the third quarter of this year. As a result, we expect Raymarine to be slightly dilutive to GAAP earnings per share in the second half. Changes in currency rates had a minor impact on our second quarter results. Excluding Raymarine, revenue growth in constant currency terms was 8% with the largest impact driven by the change in the Euro relative to the dollar. Excluding Raymarine, approximately three quarters of consolidated second quarter revenue was reported in U.S. dollars, with the next largest currency, the Euro representing approximately 1/6 of the total and the remainder in the range of currency. Other income for the quarter totaled 1.9 million a swing of 3 million from last Q2. Included in this quarters other income was a currency gain of 576,000 and a gain on investments of 775,000. Our tax rate for the quarter was 34.6% compared with 32% last Q2. The tax rate was unusually high in Q2 due to the continued delay in approving R&D tax credits in U.S. as well as the non-deductibility of the expenses associated with the Raymarine acquisition. We expect our rate for the full year to be in the range of 32 to 34%. Cash flow from operations for the quarter totaled 42.7 million compared with 57.7 million in the second quarter of last year, due largely to a $20 million increase in net current assets excluding the impact of Raymarine. This increase was related to the timing of orders within the quarter. Significant cash outlays in the quarter included 175 million net for the acquisition of Raymarine, 7 million for capital expenditures and 33 million for the repurchase of 1.2 million shares of common stock at an average price of $27.59 per share. Major balance sheet changes for the quarter reflect the acquisition of Raymarine. Cash balances declined by 177 million, while other long term assets increased by 125 million reflects the access purchase price over the net asset value of Raymarine of 123 million. This balance will be re-categorized into goodwill and intangibles upon completion of the Raymarine purchase price allocation in Q3. This concludes the summary of our second quarter financial results. I’ll now turn it back to Earl.

[Earl Lewis:]

Okay. Thank, Tony. Welcome to your first CFO conference call. Nice, the numbers are positive. Operator, we’re ready to take questions. We do just for everyone that’s on the line have a very, very hard stop at 9

[Operator:]

(Operator Instructions) The first question comes from Jonathan Ho of William Blair.

[Earl Lewis:]

Jonathan

[Jonathan Ho:]

Good morning, guys. Great quarter and congratulations Tony on your first opportunity. Just wanted to talk broadly first about the government business and particularly what your expectations are as we look at sort of backlog in 2011, given everything that's happening around defense budgets worldwide and sort of the delay that we are seeing in the supplemental at this point?

[Anthony Trunzo:]

Well, Bill is going to talk in detail on that, I am not. But I did have a chance to attend Farnborough with Bill in this week. And we’ve had a tremendous amount of interest in our products at Farnborough and this is a pretty good news particularly since that is international. And I do think the international side of our business is going to grow fairly well over the next year. As you know, this is a very difficult thing for us to forecast. It really is but our base business has been growing well and with the numbers we looked at recently.

[Whit Davis:]

It is growing about 30% per year for last two years four our base business.

[Anthony Trunzo:]

And that excludes the rates progress. So, I feel good about it, although I understand your questions of uncertainty. Backlog went down this quarter. We expect backlog will not go down next quarter but we will see.

[Bill Sundermeier:]

Exact. We have a pretty good look into Q3 and of course, it is hard to predict what the Government is going to spend at the end of the fiscal year which is at the end of this quarter, although in the current climate we will see what that does bring and that certainly will delay the supplemental, it is really hard to forecast how that money will flow. Typically, we’ll get to see a flow a quarter or two afterwards. So maybe that will start flowing in Q4. That makes it very difficult for us to predict the remainder of this year. But certainly, I mentioned in the script, Q3 looks much stronger than Q1 and Q2 from where we sit and Q4 is a little harder to predict but it looks like it’s going to be at least at the current run rate. And we certainly hoping to perhaps win some other programs and move that on up.

[Anthony Trunzo:]

We are certainly engaged in enough activity there. I mean, that’s – we are not short of that as we have been adding staff in order to cover that in our business development model. We’ve added quite a few people this year already. So we will see.

[Jonathan Ho:]

Great. And just as a follow up, now that you guys have had a little bit of time to digest the Raymarine acquisition, what is your, I guess full-year revenue target, I guess, operating margin targets and what are some of the low hanging fruit that are still left there in term of operating improvements?

[Anthony Trunzo:]

100 million is the revenue number for the year for us for this stub year. That's what we added to guidance a minute ago. I have never liked the term low-hanging fruit. Everything you do in business is work and requires thought and has consequences. With that said, we think the business can be improved significantly. We have a new CEO if you will or President of Raymarine, a man we have known for a long time, Tom Saram [ph]. He is tackling every part of the business in terms of cost reductions, in order to improve gross margins, in terms of distribution channel, in terms of development of new products that are exciting. We just had to review with Tom a minute ago. I would say he's on track to improve every area of the business. That will take a while and I think it is safe to say that probably if you include the acquisition costs and everything, this year will not be accretive to our earnings. But absolutely it will be accretive next year.

[Operator:]

Our next question comes from the line of Noah Poponak of Goldman Sachs.

[Noah Poponak:]

Hi. Good morning.

[Earl Lewis:]

Morning.

[Noah Poponak:]

Just wanted to follow up quickly on that Government international topic and I guess, the concern is you've got a slowing U.S. budget and so you’ve literally got every defense company out there telling us they're going to go after international and increase international sales. And I wonder how concerning that is to you and the extent to which you see other companies kind of going after the same thing and therefore pressuring, pressuring margin as maybe there's undercutting on price and things of that nature?

[Earl Lewis:]

I don't see that relative to us at all. I think that's a sort of a different issue in many, many respects. I will start with the idea that the U.S. Government is cutting their budgets and the DOD. Yes they are, of course. I don't think that in itself is what's an issue with our growth. Our growth in that business is a function of what the products do and how they perform. And those activities will continue independent of what the budget is. We are not a – we're a provider of a component that can significantly improve a platform and upgrade and he knows et cetera. Our issue with the U.S. Government orders is the change in the rate program which has been such a big change in us. Our base business is still growing and I think our base business will grow this year and next year as well. It is that big slug that moves through the snake, that's the issue for us much more than a change in DOD budgets of 5% to 10%. The reason international is so interesting, I think, for us right now isn't the DOD problem if you will. It is more that there are a lot of international opportunities, we think, that our products particularly ground base where we starting, remember so much at all into ground base programs, internationally are starting to come about. I think Bill mentioned the higher percentage. I think this quarter than it has been in (inaudible) and three years ago, I don't think we sold anything, for the most part ground based. So those products are really starting to take hold and we are starting to take hold with some vehicle programs internationally. So this is an expansion of our markets as opposed to a defensive move because the DOD has cut the budget.

[Bill Sundermeier:]

We are already in those international markets as you can test over the last several quarters, not only are we there already prospecting those areas but we have significant investment in service facilities around the world and that's one of our major strengths in that we can provide great after sales support. It is not something that needs to be developed. It exists, it is there. We can provide great turnaround times and direct training and support for those customers abroad. So there might be some pressure but I’m very confident in the position that we have abroad and we have already been there and made that a focus of our business model.

[Noah Poponak:]

Thanks. That was very help. And as a follow-up, could you address your thoughts on capital deployment, going forward, presumably you want to digest Raymarine for at least a little bit before thinking about maybe the next acquisition? When do you return to repurchasing shares and how are you thinking about that balance going forward?

[Earl Lewis:]

Tony mentioned that we had 1.2 million shares last quarter during the same period of acquiring Raymarine. So the two things have always in our mind been a little bit separate. If we think the stock price is at a favorable, very favorable, I guess, it’s more like it, position we will buy independent. If the right acquisition were available tomorrow for $300 million, the balance of our cash, we would do it tomorrow. And the reason I think that's okay is because the management in place at Raymarine with Tom and Andy, I believe, we are in very, very good shape there. This is not going to suck our management down and be a long-term turnaround proposition. I think it will be basically completed by the end of this year and we will look at it as part of our business. So if there was an opportunity or if you know of one let us know.

[Noah Poponak:]

That's very helpful. Thanks a lot.

[Earl Lewis:]

Okay.

[Operator:]

Our next question comes from the line of Brian Gesuale of Raymond James.

[Brian Gesuale:]

Hey guys, nice quarter. Wanted to ask a little more about Raymarine as you look at taking out cost and hopefully seeing a better boating market over the next couple of years. If I look at may be the closest comparable to that business, it’s government business and it looks like about a 30% operating profit there. Is that kind of a long-term target or is it something that could clear and even drive beyond those levels.

[Earl Lewis:]

That's absolutely in our sights. And when we bought Raymarine, we, of course, modeled that. I think when it comes to making the prediction about the operating margin performance in two years, I will let Andy do that.

[Brian Gesuale:]

Okay. Great. Then just a follow up, I wanted to talk about Thermography. We have certainly had a lot of economic talk in Europe over the last several months. Can you maybe just give us a flavor for maybe the most, you mentioned, Germany being down but can you give us a flavor for what you are seeing across western Europe at this point in time whether things have deteriorated from the second quarter or whether it looks like stabilization or whatever you can see with the crystal ball. I am sure it is limited in length but whatever color you have would be helpful.

[Earl Lewis:]

(inaudible) and the answers, are you really asking what are we seeing so far Q3.

[Brian Gesuale:]

Yeah. That's pretty much it, Earl.

[Earl Lewis:]

Okay. I am going to talk about what we have seen in the first half.

[Brian Gesuale:]

Yeah.

[Earl Lewis:]

But the, Brian, the Germany has been the big problem for us and it’s been a combination of a number of things. It has been economic factors. It has been – we have made some pretty significant organizational changes in EMEA as a result of the integration of CVS and thermography to include a new leader running the organization. But it is an individual who ran that organization five years ago. He is quite experienced and I am confident that he is going to do the right things there. So Germany has been a bigger problem for us than the other countries. We have seen modest growth in the U.K. and some of the other major European countries. The peak countries, we hear a lot about in the news these at a bit their growth area problems for us, you know, Portugal, Italy, Greece. We – I think that, that and I’m hoping that, that situation is going to recover both in term of the organizational structural changes that we have made in the first half. I’m hoping that those will, that surgery will heal and that the organization will take hold them. And we will see result together, with an economic improvement in the second half. The rest of the thermography business, we had descent growth in U.S. in the first half. And I think as long as we don't have a W situation here. I think we will have a good second half for the U.S. market. And APAC continues to be very well, double digit. So in all countries in Asia-Pacific except for Australia was little bit slow in the first half.

[Brian Gesuale:]

Great. That's very helpful. I appreciate it.

[Operator:]

The next question comes from Tim Quillin of Stephens Incorporated.

[Tim Quillin:]

Good morning or afternoon, I guess, where you are. But Andy, just following on that question, on Thermography, you know, how much of the weakness if we call it that, thermography is attributable to internal issues in your mind versus external forces?

[Andy Teich:]

I guess it depends on who you ask. If you ask the internal people, they will say it is all managements’ fault. And if you ask the manager, he will say it is all the economy, so. It is hard to say, Tim. I think it is a mix of both things. I mean, given the fact that we see such a high concentration in Germany. And there we've had a fair amount of organizational tumult , I think that certainly points to that being a problem. But you can't help but look at the news everyday and look at economic problems in Europe. So I think we have a little bit of both going on.

[Earl Lewis:]

I think that the rest of the world, if you will, is in pretty good shape. You know, given the world malaise that we seem to have – I didn't do the numbers if you exclude the delta in Germany what was our growth.

[Andy Teich:]

I think, we can do that but I think it would have been double digit. That's my – I am pretty sure of that. I didn't check it but I am pretty sure. So I don't – you know, they had a very good profit. We know we have a management issue with Germany and we will fix that. I view it as pretty good quarter with that one exception.

[Tim Quillin:]

Okay. And then, just…

[Andy Teich:]

The world.

[Tim Quillin:]

And just a quick question for Bill as well. You know, you mentioned that your potential for spares and maintenance and some service activity in the back half of the year. I wondered, if you could also comment on what might be behind or in addition to the PGSS order that you have already received, you know, in other words, what kind of follow on orders might you see in that program. And then what do you expect on GBOSS and BETSS-C next year, if you don't expect orders this year? Thanks.

[Bill Sundermeier:]

We just met with the PM, his group which is the group that's from with the main group became and it’s real focus was on service and that’s what was shadow of that, not expecting large systems orders that are there for the remainder of the year. We might get starting there and I think that might continue in the first half of next year. Certainly, we’re going to be heading to the program record for 2012 and we might see, you know orders for that, the second half of next year. Right now, they're in a process of still moving towers from Afghanistan to the other way around, Iraq to Afghanistan and the marine core seems to be somewhat satisfied with what they have. We’re going to see this small orders, I think for the second half of this year and the first half of next year until we have better definition of what the program of record could bring. That's – the PGSS program is a nice program and we may see more orders for that in second half. I see some requirements forming there but can't promise anything quite yet.

[Tim Quillin:]

Okay. Perfect. Thank you.

[Operator:]

Our next question comes from Brian Ruttenbur of Morgan Keegan.

[Brian Ruttenbur:]

Great quarter. How much of and you may have already mentioned this but I missed it. How much of your backlog drop and the Government area is directly related, GBOSS and BETSS-C? Can you address that?

[Anthony Trunzo:]

Well, I think we didn't actually give that number. We really have it but I think we can tell you is that we come into Q3 with a deminimus amount of backlog in GBOSS and BETSS-C deliveries. There's always going to be some service and that sort of things but in terms of unit deliveries, we got to have a very small backlog remaining of GBOSS and BETSS-C.

[Brian Ruttenbur:]

Okay. So then the third-quarter build and Government has nothing do with GBOSS and BETSS-C. Is that correct?

[Bill Sundermeier:]

Not anticipating any orders in Q3 for GBOSS and BETSS-C.

[Anthony Trunzo:]

Yes, correct.

[Brian Ruttenbur:]

Okay. So what are the main programs that are building back?

[Earl Lewis:]

Okay. We should get out the shipment schedule for us.

[Andy Teich:]

We had over 90 individual orders in Government systems in Q2. As we talked about before, our business isn't comprised particularly in any given quarter of deliveries with the exception of what we have seen with Ray, GBOSS, BETSS-C for the last several year. Our order book and our delivery book is rarely comprised of four or five things that make up a significant percentage of it and that's certainly true in Q3.

[Brian Ruttenbur:]

Very true.

[Operator:]

Our next question comes from Peter Arment of Gleacher & Company.

[Peter Arment:]

Hi. Good morning. Most of my questions have been answered. Bill discussions with some of your people at the Farnborough air show alluded to lot of the opportunities to display some of the competition on the international militaries. And you have given us some color there but can you talk a little bit about what you’re seeing in just border opportunities in general?

[Bill Sundermeier:]

Sure. You have to be careful when you walk into a shell lay in the middle of a proceed.

[Earl Lewis:]

Talking to a customer.

[Bill Sundermeier:]

Yeah. So, I think worldwide we see the importance of order applications and both, Andy and I share that through OEMs and dealers which has been very good and us directly and we definitely see more U.S. opportunity, money shifting to the HS [ph] there for that. And there was money there for SBInet and it’s in the fund. And they're starting to spend some of that. And certainly, internationally, all of the Middle Eastern countries are very focused on border protection and security. General Atomics just announced that they have a license field to show their predator XP and export version in the Middle East now. And that's primarily for monitoring borders and doing surveillance. So I still think that there's a very growing interest both in the U.S. and abroad for border potential. I think we’re going to see that in the second half of this year and next year as a growing part of our business.

[Peter Arment:]

Yes. I think it is important to remember, you know, there's been a couple of questions about others talking about getting into the international business as they see the U.S. flow. Well, we’ve started to see, well we have seen good growth in the international business for a long time and we have really gotten traction in the last couple of years in those marks. So this isn't something we are just starting and a lot of the ground work has been laid and a lot of critical markets based on the activity that we have been doing for the last couple of years really in particular. So, you know, we are – we are reminding you of the numbers that we just gave, you know, 35% to 40% of our business is currently coming of our Government systems business is currently coming outside, from outside the U.S. And that's a percentage that, that we see an opportunity to continue to grow. And I think it is a percentage that is dramatically higher than most of the companies that you guys are asking about?

[Earl Lewis:]

It has been growing. You know, we have a track record of growing the international now for two years. It has been pretty outstanding.

[Peter Arment:]

That's great color. Thanks very much. Good quarter.

[Earl Lewis:]

Thank you.

[Operator:]

The next question comes from Paul Coster of J.P. Morgan.

[Paul Coster:]

A question is for Bill and Andy regarding margins, first of all, Andy, on the CVS side, it sounds like you're approaching record levels there. Is it sustainable? Is it going to change, moving forward and if so, why. And Bill, sounds like you are making investments below in operating expenses and can you elaborate as to what they are and what your outlook for your margins are? And you mentioned that I think a mix shift, is that going to continue or is it a one-time thing?

[Andy Teich:]

I will go first, Paul. This is Andy. CVS margins are going to move around a little bit as they have in the past and that's driven by our mix. So to the extent that, for example, I am delivering on the Border programs where we are selling through integrators and are buying product through GS, where they're produced by those factory. Those show up as CS margin that are a little bit lower and hold down my overall gross margin and we have had very, very good success in the Middle East in particular border programs. So I have got a bunch of that revenue that will be going through the income statement in Q3 and Q4. So those may pull the CS margins down slightly but it also adds internal margins to the GS division. So it is good for the company overall. The other thing that we are doing as we design new products, we strive to design products that have better gross margins. So when we have been doing that since the formation of CVS back in Q2, 2006 and I think you have seen that in the model, that the margins have growth.

[Bill Sundermeier:]

And the Government systems side, operating expenses have been plan to increase primarily to expand our sales and marking foot print and we’re pretty much done that in the first half of this year with a little bit more expansion perhaps in the second half although, we’re going to try and hold our operating expenses relatively flat for the second half as we look at the order prospects that are coming in. Our margins have been exceptionally good, obviously since that peak in Q2 of last year. And our mix is starting to shift from range to a little more mix of our BRITE Stars for the U.S. market. We have some cost reductions planned for the second half of this year. Hopefully, we will get those engaged and be able to hold our margins at these high levels but I don't expect or anticipate a large shift in operating margin in the second half.

[Paul Coster:]

Thank you. That was very helpful.

[Earl Lewis:]

Paul, let me comment for just a second. When Andy talks about margins being slightly less because there's more Bill’s product [ph] flowing through. That actually produces a higher margin at the corporate level effectively. So this didn’t let you get the wrong impression on that answer. And secondly we made the decision knowing full well that the revenue was going to be more difficult this year, late last year and early this year to expand our international operations. And so that's where you’ve seen the cost come up in Bill side but you also should see the revenue come up.

[Paul Coster:]

Makes sense. And the other question is probably, if you, for those of us who are unfamiliar with Raymarine, can you just help us a little bit understand what the addressable market is and what segments of the marine market, you are really going after here? Is it the ledger and or is it some other segment that we should be aware of.

[Earl Lewis:]

Raymarine's existing business for the most part, Paul, has been in the ledger side, if you will or leisure as we say for us home. That has been their business. Now, we believe that we have an entry as a result of sort of our, what you call, high-end government sales into the volume market to move some of their products up into that market. Typically, (inaudible) dominated more of the commercial side and Raymarine has been more in the leisure side, if you will. But we see an opportunity to expand our business up a little bit, if you will, into the larger ships.

[Paul Coster:]

Okay. Addressable market?

[Earl Lewis:]

The size.

[Paul Coster:]

The addressable market is – you know, that's a tough one because the, it is just absolutely went to nothing two years ago. I mean, with that.

[Andy Teich:]

Well, a couple of things, Paul. I mean, some reports that have been done on the industry, the marine electronics business, it also is tagged at about $1.8 billion. It was roughly 100,000-GPS units, multifunction GPS in dash that are sold annually. So you can sort of look at take rates off of those kinds of numbers and we think thermal as a descent chance of penetrating.

[Earl Lewis:]

What Andy said is that using this, new acquisition, we think we will be able to significantly increase the thermal side of it. You are asking about the existing market which is something we planned to penetrate some large well but that would be new market.

[Operator:]

Our next question comes from Jim Ricchiuti of Needham & Company.

[Jim Ricchiuti:]

Hi. Thank you. Good afternoon. Question on the thermography business, it sounds like you continue to see good growth in Asia Pacific. I wonder if you could talk a little bit more about that and just the business activity, you’re seeing in China, which is, I guess emerging as a pretty good market for you.

[Bill Sundermeier:]

Tim well – Jim, in Asia, China is now our number one market in Asia and it’s actually the number two market compared to the U.S. for thermography world wide. And we have made quite a strong investment in China and have a large number of sales offices and employees there at present. The other market that also seems to be emerging fairly nicely in the APAC region is Japan and we’ve also opened up our own sales office and are hiring direct employees. We sell through distribution but we have direct employees to manage in the Japanese market. And then the third is Korea and we bought out our distributer in Korea, that was 18 months ago or so. And that’s been a very good acquisition for FLIR and has turned out quite well. So those are three strong points in APAC region, right now.

[Jim Ricchiuti:]

So you see that as pretty much sustainable, Andy?

[Andy Teich:]

We do. I mean the growth rates, double digit growth rates, I think are sustainable in the APAC region for some time to come. Earl mentioned also rightfully so that we have now plant a flag in India. And we will be opening three or four regional offices in India over the course of 2010 and early 2011.

[Jim Ricchiuti:]

Okay. Just putting aside Germany for a second, as we think about the concerns people have on a macro side, I wonder, if you comment on your expectations for the U.S. market in the second half of the year?

[Andy Teich:]

My expectation is that it is continue to grow. It sort of had high single digit growth rates in the first half of the year and my expectation is to push those into low double digit growth rates in the second half of the year. And just not – we need a good economy to do that. The economy has to get out of this sort of wait and see period and get back into a buying mode to have that happen.

[Operator:]

Our next question comes from …

[Bill Sundermeier:]

I was just going to comment to Jim that it is still pretty soft in the upper end of the U.S. market. It seems like the capital rebound really hasn't really quite gotten to where we would like to see it yet.

[Operator:]

Our next question comes from Josephine Millward of The Benchmark Company.

[Josephine Millward:]

Morning everyone.

[Earl Lewis:]

Morning.

[Josephine Millward:]

This is a question for Bill and Andy. My understanding is customs and border protection is in the process of evaluating mobile surveillance solution. Can you talk about your competitive positioning and when we might see a contract award?

[Bill Sundermeier:]

Hello.

[Josephine Millward:]

Hello.

[Bill Sundermeier:]

Can you hear me, Josephine?

[Josephine Millward:]

Yeah. I can hear you.

[Bill Sundermeier:]

And as to the program, that we are certainly getting sensors into but not the complete solution. So, I think it is it could happen this quarter, I wonder it happens. Andy, you want to add something.

[Andy Teich:]

Well, yeah. So you are asking a little bit about the competitive, how we feel about our competitive position in the equipment that we’re selling to that application is just seen as the same equipment that we sell into for applications globally. And we compete quite favorably there. I think, that when our sensors get put up against our competitive sensors out on the border and they look for targets of distance, we tend to win those competitions. And last year around this time, we released the system we called the HRCX which we think has highest focal link, the largest modifications in the business and it is a continuous zoom system which most of the competitor systems are not. They are (inaudible) system. So we think we compete very favorably there and I think that if it is a competition is done on fair and objective basis, that will do well.

[Josephine Millward:]

Can you help us quantify this opportunity?

[Bill Sundermeier:]

Sorry.

[Josephine Millward:]

Is that a no?

[Bill Sundermeier:]

That's a no.

[Josephine Millward:]

Okay. And this is a question for you, Bill. It is starting to look like the fiscal year ‘11 defense budget could be delayed beyond September. So, if that happen, how do you think this might impact your outlook for defense in the second half of next year? Can you just talk about that?

[Bill Sundermeier:]

Well, it is a delayed supplemental and we’ve been striving for long and we have been doing pretty good.

[Josephine Millward:]

Great.

[Bill Sundermeier:]

I just think we’re going to see a shift here in what we expected supplementals needs to get approved or else we could have a continued resolution and the 2011 budget will happen. So I think, we just having a big range shift in the spending. And I still anticipate the spending to be conservative over next year and see what the impact is and we still think that ISR and night vision products are a main part of the budget.

[Earl Lewis:]

Okay. Operator, just one more question, please.

[Operator:]

Our next question comes from Michael French with Morgan Joseph.

[Michael French:]

Hello. Good day, everyone.

[Earl Lewis:]

Hey.

[Michael French:]

I have another follow up on the budget for Bill given delay in the supplemental, is it possible that pentagon could dip into the procurement budget to fund operations and if so does that pose any risk to you?

[Bill Sundermeier:]

It's possible. Typically, what we see is some kind of continuing resolution to take care of the basic needs and that delays some procurement. But we are not wholly bound to that. I think, we will still see the money flow eventually and still get pieces and parts of what is necessary for a reset off of the supplemental. I don't think they're going to get too much of a procurement budget. I think doesn’t happen in the past too much. I think it’s just to being a right shift of when this is going to happen.

[Michael French:]

Okay. Very good. Thank you. And on this new program of record, when do you expect to start seeing more data from, in terms of the specks?

[Bill Sundermeier:]

Well, in order for them to make it a program of record for 2012, they're going to have to start some time in the second half and try to conclude it in the first half of next year for it gets written in. So, it should be doing some more things the second half of the year and get better resolutions into the specks the second half of the year.

[Earl Lewis:]

Okay. With that operator, thank you all very much for tuning in, appreciate and I look forward to telling you how we did next quarter. As of right now, we’re feeling pretty good about it. So look forward to talking to you then. Bye.

[Operator:]

Thank you. This concludes today's conference. You may now disconnect.