FLIR Systems, Inc.
Q3 2012 Earnings Call Transcript

Published: 25 Oct 2012

[Operator:]

Greetings, and welcome to the FLIR Systems, Inc. Third Quarter 2012 Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce Wit Davis, Senior Vice President, General Counsel and Secretary for FLIR Systems, Inc. Thank you, Mr. Davis. You may begin.

[William W. Davis:]

Good morning, everyone. Before we begin this conference call, I need to remind you that other than statements as to historical facts, statements made on this conference call 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 expects, anticipates, intends, believes, 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 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 Earl Lewis, Chairman and CEO of FLIR Systems. Earl?

[Earl R. Lewis:]

Yes, thank you, Wit, and thanks for everyone for joining us this morning. Our third quarter revenue and earnings were in line with our expectations. In Q3, we improved our margins compared to last quarter and produced a significant increase in our backlog from strong order entry. For the first time, all 5 of our segments were profitable. During the quarter, our Government Systems division improved operating margins and significantly increased its backlog compared to the second quarter. Our Commercial Systems division experienced a slowdown as a result of tightened private sector capital budgets. However, it still managed to improve operations both year-over-year and compared to the second quarter due primarily to cost-containment initiatives. Total company backlog increased over $65 million from the end of Q2, driven primarily by our Surveillance and Integrated Systems segment. We maintained the same operating cash flow as in third quarter of 2011 despite the softness in revenue; and year-to-date, we have generated $45 million more in cash from operations than during the first 9 months of last year. Our portfolio approach to capital deployment continued in the third quarter, as we invested $42 million back into the company through R&D and capital investments and returned capital to our shareholders through a $0.07 quarterly dividend and repurchased nearly 2 million shares. We look forward to the fourth quarter of 2012. The challenging macroeconomic environment will likely continue to impact growth across our company. We continue to see revenue about flat compared to Q4 of '11, but earnings per share should be up slightly. As such, we are tightening our previous outlook for 2012 to revenue between $1.4 billion and $1.45 billion and earnings per diluted share of $1.42 to $1.47 GAAP. We announced today our agreement to acquire Lorex Technology, a leading provider of home security surveillance systems that can be installed by the consumer. They are also an emerging provider of video surveillance equipment for larger-scale professional installations. Lorex will expand the product range in our commercial security business, add high-volume product development knowledge and offer key channel experience and direct consumer marketing. The acquisition, which is for a total cash purchase price of approximately $60 million, is expected to close by the end of the year. We expect Lorex to add to net income in 2013. One of our core strategies is continuously lower the cost of ownership of thermal technology. And today, we see the opportunity to accelerate the pace of thermal innovation, affordability and awareness through some specific R&D programs that we've been pursuing for not [ph] a long time. We'll be bringing to market thermal detectors that have lower costs and lower -- and are smaller than today's thermal detectors. These products will increase our industry-leading product volumes, and Lorex should be instrumental in our efforts to bring this technology to consumers in the security market. Andy will now provide you a summary of the Commercial Systems division's Q3 performance. Andy?

[Andrew C. Teich:]

Thanks, Earl. The Commercial Systems division finished the third quarter with an 8% decline in revenue compared to the prior year. Despite this top line decline, division operating margin grew slightly year-over-year and was up significantly compared to the second quarter of 2012, as we continue to focus on cost and on rightsizing the organization for the current environment. While the Americas region grew during the third quarter, the European economic downturn and the weakening of the euro versus the U.S. dollar continue to impact our international business. Revenue in the TVM segment declined 7% compared to the third quarter of 2011 but grew 5% sequentially while also increasing backlog by $9 million, driven by a strong bookings quarter for our Cores & Components line of business. Revenue from our Raymarine business declined 11% year-over-year, with the expectedly slow EMEA region being offset slightly by a relatively strong quarter for the Asia-Pacific region. While the third quarter is the seasonally slowest quarter for Raymarine, the business was able to produce positive operating income despite the revenue declines. Turning to the third quarter bookings activity. Total Commercial Systems division bookings were flat compared to the third quarter of 2011. TVM bookings dollars increased 2% over the prior year, while Raymarine bookings declined by 11%. The division saw the Americas and APAC regions grow bookings dollars 6% and 9%, respectively, but that growth was offset by the EMEA region, which declined 16%. TVM's thermography line of business saw bookings dollars decline 11% from a year ago, as industrial capital spending cutbacks and a weak building market negatively impacted the business. During the quarter, we moved our Swedish thermography operations to a new building that is being shared with a Government Systems division's Swedish operations. The move did cause some disruptions in the quarter that affected cost and deliveries but will result in greater efficiency and lower occupancy cost going forward. TVM's Cores & Components bookings dollars grew nearly 35% compared to the third quarter of 2011. As we expected, some of the orders were pushed out from Q2 came to fruition during Q3, while some remained for Q4. All regions showed strong growth. The security line of business bookings declined 17% compared to last year's Q3. Two sizable oil refinery orders in our EMEA region last Q3 made for a difficult comparison for this year. Weakness in both the Americas and EMEA regions were slightly offset by strong growth in the much smaller APAC region. As Earl mentioned, we're excited about the acquisition of Lorex and the effect it will have on our security business. The near-term benefits we expect to garner from this acquisition are an extension of our product suite in the security and surveillance market, the synergies of adding thermal imaging to Lorex's emerging Digimerge brand, a professional security-grade security systems and the addition of FLIR's international distribution to Lorex's strong North American presence. Additionally, as we continue to aggressively lower the cost of thermal imaging technology, we're excited to integrate a broad consumer distribution capability that currently sell hundreds of thousands of cameras per year through top retail and e-commerce portals. Ultimately, we intend to leverage that experience across several of our commercial lines of business, as we continue to develop low-cost, high-volume, consumer-oriented products. TVM's Maritime business had bookings growth of over 5% despite the very difficult boating sales environment. While the EMEA region was flat compared to last year, the Americas and APAC regions grew despite a difficult comparison that included some large cruise ship orders last year. Accounting for all maritime-related thermal cameras from both the FLIR and Raymarine brands, growth continued during the third quarter with bookings dollars increasing 15% over 2011. The Personal Vision Systems line of business continues to do well, posting year-over-year bookings dollars growth of nearly 40% and booking units growth of over 110% during the quarter. All regions contributed to this growth, as our distribution network continues to grow on a worldwide basis even as many emerging regions remain underpenetrated. Raymarine bookings dollars declined 11% versus the third quarter of 2011, largely driven by declines in orders in EMEA, as boat builders in the region continue to be severely impacted by the weak economy. While APAC showed high-single-digit growth in bookings, the Americas region was slightly down during the quarter largely due to retail channel softness. During the fourth quarter this year, we will begin shipping several new products that continue the evolution of the Raymarine product family, including the all touch a65 and a67 multifunction navigation systems, the e165 widescreen multifunction display and the i40, i50 and i60 mid-tier and entry-level instrument range. We will also be introducing in the fourth quarter our first freshwater product that will open up the small market -- small boat market for Raymarine, a market that has proved quite resilient in the cyclical downturn. While better than Q2, these results are well below what we know the Commercial Systems division can generate. The steps we had taken over the past few months to increase efficiencies and reduce cost structures helped us improve margins during the quarter to a level near our historic levels. We will drive through this global economic slowdown and continue to compete aggressively by focusing on developing cutting-edge products, leveraging our considerable cost advantage and utilizing our established and growing market channels to take advantage of the huge commercial opportunity that exists for thermal imaging. With that, I'd like to pass the call over to Bill Sundermeier, who will discuss the results of our Government Systems division. Bill?

[William A. Sundermeier:]

Thanks, Andy. Government Systems division revenue was down 14% from the prior year but was up slightly sequentially for the second quarter in a row. Bookings were strong during the quarter, finishing with nearly $210 million in order value and a book-to-bill ratio of 1.4. The division finished Q3 with its largest backlog since 2010, growing $58 million over the second quarter to $392 million. Our focus on growing backlog has proven successful in this tough procurement environment and we believe demonstrates the value of our unique approach to government markets. Operating margins for the Government Systems division improved slightly over the second quarter, driven largely by profitability improvements in both Detection and Integrated systems. The Surveillance segment finished the quarter with a book-to-bill ratio of 1.3 and contributed $40 million of the backlog increase over the previous quarter. Order activity consisted of year-end spending from U.S. customers and also some good activity in Europe and the Middle East. On the U.S. side, we won a total of $26 million in contracts with the Navy's Navigational Thermal Imaging System, or NTIS program, for our BRITE Star gimbal system. The U.S. International Guard awarded us $15 million in contracts for upgrades to their fleet of helicopters. We continued our success with the U.S. Army's MEDEVAC helicopter platform with a $9 million order for our Star SAFIRE II system. Our presence in the unmanned aerial vehicles space continue to build with the receipt of several orders totaling over $6 million for thermal systems to be used on the U.S. Military's Fire Scout UAV. We also won a $5 million order to outfit U.S. Customs and Border Protection with high-definition imaging systems for their helicopters. International markets represented nearly 40% of surveillance bookings in the quarter with particularly strong activity from Europe and a consistent pace of activity from customers in the Middle East. The Netherlands Army awarded our U.S. operations orders totaling $11 million, and the Danish Navy and Air Force placed sizable orders for our newest 380-HD gimbal systems. In the Middle East, we booked another $11 million order for 380-HD systems to 2 separate air forces and another $3 million for the Jordanian Armed Forces for ground-based systems. Additionally, we strengthened our long relationship with the Japanese Coast Guard by contracting to provide them with $4 million gimbal systems for their helicopters. The Detection segment ended the third quarter with $24 million in backlog. Orders for our Fido explosive detectors from India and multiple orders for our radiation detectors from China represent important strategic wins that will help us grow in key emerging international markets. During the quarter, our Fido NXT was ordered by several agencies in the U.S., including the Air Force and National Guard, and we also shipped several dozen Fido units to Pakistan. We have also been successfully testing our solutions for building an infrastructure biothreat security for the U.S. Department of Homeland Security, which we are hopeful will lead to product sales next year. During the quarter, we consolidated our radiation line of business into our factory in Oak Ridge, Tennessee, closing our manufacturing operations in Germany. Restructuring activities resulted in charges of approximately $0.5 million in the quarter, but the changes are expected to improve our long-term performance and profitability. Integrated Systems finished the third quarter with an all-time high backlog of $79 million, adding $17 million to the balance after a record booking and revenue quarter that yielded a book-to-bill of nearly 2.0. Order growth was driven by several key wins, primarily the receipt of a $27 million initial order under an $88 million IDIQ award for domestic response capability kits, or DRC, for the use by the National Guard Weapons of Mass Destruction-Civil Support Team. This award and initial order are important in that they are a result of our extensive development work with the Defense Department's CBRN Dismounted Reconnaissance Systems program. Additionally, we received a $5 million contract from the U.S. Air Force Nevada test range to integrate an advanced surveillance network that includes our CERBERUS MX systems. Also during the third quarter, we received confirmation from the U.S. Customs and Border Protection that our MSC system was accepted, and we are eager to begin production and shipments starting in the first quarter of 2013. That concludes my comments on the third quarter, and Tony will now discuss the financial results in more detail.

[Anthony L. Trunzo:]

Thanks, Bill. Third quarter consolidated revenue was $332.2 million, a decrease of 11% compared to $371.3 million in third quarter of 2011. Commercial Systems division third quarter revenue decreased by 8% to $181.2 million. The Thermal Vision and Measurement segment posted third quarter revenue of $149.5 million, a decrease of 7% compared with the third quarter of last year. The thermography line of business represented the entire decline in TVM, as industrial, building and predictive maintenance markets continue to struggle in a weak global economy. Geographically, EMEA was the weakest region, down 20% compared to last year. Raymarine revenue declined 11% to $31.7 million, with virtually the entire decline accounted for by a 19% drop in EMEA revenue. Government Systems' Q3 revenue was $151 million, a decline of 14% from $174.9 million in the third quarter of 2011. Surveillance segment revenue of -- was $115.9 million compared to $139.8 million in Q3 of last year, with the entire decline attributable to lower U.S. Government revenue. Detection segment revenue decreased 27% in Q3 to $15.4 million. The 2 large transactions were delivered in 2011, and there was reduced contract R&D work this year arising from the closure of several facilities. Integrated Systems segment revenue in Q3 was $19.7 million, a 42% increase from last year, as deliveries under the follow-on CLS FPS program began. International revenue was 44.2% of the consolidated total in Q3, similar to the third quarter of 2011's 44.7% of revenue. International sales made up 47.2% of Commercial Systems' consolidated revenue compared to 54.8% in Q3 last year, reflecting commercial weakness in Europe, while 40.7% of Government Systems' revenue came from outside the U.S. compared with 33.2% last year as U.S. deliveries declined. Total sales to the U.S. Government were 27.6% of the consolidated total in Q3, down from 32% of revenue in the third quarter of last year. Consolidated gross margin was 52.2% for the third quarter, 2.2 percentage points lower than last year, due to lower absorption of overhead costs partly offset by a better product mix. Consolidated operating income was $74.2 million, a 13% decline from $85.4 million in the third quarter of last year. Third quarter operating margin was 22.3% compared with 23% last year, as lower gross margins more than offset a 14.9% reduction in operating expenses. Third quarter operating income in Commercial Systems was $43.3 million or 2% lower than last year. Despite lower sales, operating margin improved to 24% largely due to improvements at Raymarine. TVM posted $42.9 million of operating income and an operating margin of 28.7% compared with $47.2 million and 29.3% last year, as a nearly 2 percentage point drop in gross margin more than offset an 11% reduction in operating expenses. Sequentially, TVM operating margin improved by nearly 10 percentage points from Q2 to [ph] a $6.5 million reduction in operating expenses and improved product mix. Raymarine Q3 operating income was $400,000 compared to a loss of $2.8 million in Q3 of last year due to much lower operating expenses. Government Systems' operating income was $41.7 million for the quarter, a 23% decline from last Q3. Surveillance segment operating income was $39.2 million compared to $51.9 million in Q3 of 2011, as an 8% drop in operating expenses was more than offset by lower revenue and a 1.1 point decline in gross margin. Surveillance operating margin was 33.9% in Q3 compared to 37.1% last year. The Detection segment operating income of $1.1 million and Integrated Systems' operating income was $1.3 million in the quarter. Earnings before interest, taxes, depreciation and amortization and stock compensation in the quarter were $95.2 million, and EBITDA margin was 28.6%, just slightly below Q3 of last year. Interest expense during the quarter was $3.1 million, an increase of $1.6 million from last year due to a full quarter's expense associated with the $200 million and 5-year notes we issued in August of last year. Our tax provision for the quarter was 27% of pretax income versus 29.3% last Q3, excluding discrete items including the release of reserves and expiry of statutes, which reduced tax expense by $5.2 million in Q3 of this year and by $5 million in Q3 of last year. Cash flow from operations for the quarter was $46.4 million, representing 83% of net income, as net working capital increased by $32.3 million during the quarter. Through 9 months, cash flow from operations of $172.7 million represents 119% of net income. We repurchased 1.9 million shares of our common stock at an average price of $19.96 and paid dividends totaling $10.5 million. Capital expenditures were $12.8 million in Q3. As Earl and Andy stated, we announced an agreement today to acquire Lorex Technology for CAD 1.30 per share or total consideration of $59 million, representing a multiple of 6.8x trailing EBITDA. For the 12 months ended June 30, Lorex reported revenue of approximately USD 77 million and EBITDA of approximately USD 8.3 million. We expect this acquisition to add to GAAP net income in 2013. This concludes the summary of our third quarter financial results. Let me now turn the call back over to Earl.

[Earl R. Lewis:]

Great. Thank you. Claudia, we're open to questions.

[Operator:]

[Operator Instructions] Our first question is coming from the line of Jonathan Ho with William Blair.

[Jonathan Ho:]

Can we just start out with the Lorex acquisition and maybe some additional detail on how you think this fits in strategically with -- in the commercial division and how quickly maybe we can see this channel open up opportunities for some of the commercial products?

[Earl R. Lewis:]

Sure. Andy, you might as well address that.

[Andrew C. Teich:]

Sure. So the key thesis here is, is that we've recognized, as we've been in the security business now for about 6 or 7 years, that this is a vertical that I think has good legs for the Commercial Systems division. And Lorex brings to the table 2 things

[Earl R. Lewis:]

Yes. Jonathan, I'll just add a couple of comments. The -- this is right in line with what we've publicly stated as our strategy for a long, long time, introducing active thermal into places like Costco and other direct, if you will, marketing activities that these folks do, has clearly been in our strategy for forever so to speak. And this is an extension of it in the security business, should be very positive to us, as the number of cameras they sell now are huge numbers. I mean, I think they can get to 1 million cameras in the next couple of years. So we see this as something that is well within everything we've said we're going to do.

[Jonathan Ho:]

Got it. And can you talk a little bit about the EMEA region? I mean, it seems like that's a continual source of pain here for the past couple of quarters. Are you seeing any signs that this is starting to turn around? Or is it just kind of the same thing, as we look into the first month of visibility this quarter?

[Earl R. Lewis:]

No, you're right. It's too early to really say this quarter whether we're seeing a change, I think. I wouldn't forecast we've seen one yet. I wouldn't forecast we won't see one. It's just too early to tell. Eventually, it'll get better.

[Operator:]

Our next question is coming from the line of Jeremy Devaney with BB&T Capital Markets.

[Jeremy W. Devaney:]

Speaking of acquisitions, wanted to take a look if you can give us some color on what your capital deployment strategy will look like next quarter? And then maybe just some additional color as you think about where the business heads over the next year or so. There was a bit of buyback in the quarter on top of the acquisition, just some puts and takes versus the way that you're looking at putting the cash out there.

[Earl R. Lewis:]

Well, I think we've been pretty consistent in that in terms of what we want to do with our cash. Our -- actually, our cash is significantly higher than it was a year ago. We added, I believe, about $50 million compared to Q3 last year and still purchased, I think, almost 2 million shares. Our cash disbursements are going to be just what we've said they will be. We want to have sort of an equal mix between acquisitions, between buying back our shares and between dividends. And I don't see that changing. I mean, the fact we've made an acquisition means that approximately $60 million we'll spend in this quarter. We'll still try to buy back shares, and we'll still pay a dividend. So we just believe that this should be a balanced approach, and we'll continue to do that.

[Jeremy W. Devaney:]

Is there any thought going on internally that perhaps an increase in your dividend payout ratio should be considered, bring it more in line with some of the other players out there?

[Earl R. Lewis:]

Yes. If you're saying to me, do we think we should increase our dividends? We'll get back to you on that one early next year when we make that decision. The -- it's clearly once you start paying dividends, it would certainly be our objective to see them increase. Whether we would want to match what other people do, I'm not sure we're going to target that. I think we'll target gradual increases more than matching someone.

[Operator:]

Our next question is coming from the line of Noah Poponak with Goldman Sachs.

[Noah Poponak:]

I wondered, Tony, maybe if you could just give us the walk from the old earnings guidance range to the new earnings guidance range because we see the revenue coming in a little bit in terms of the midpoint. Looks like there is tax help. Margins were a little better than I thought, but not sure how they compared to what you thought. Maybe you can just give us the puts and takes in the new range there.

[Anthony L. Trunzo:]

Well, if you look at Q3, the -- down at the EPS line, the $0.37, pretty consistent from an operating profitability standpoint because we had a little bit of tax lift, but we had a bit of tax lift in Q3 last year, in fact, actually nearly exactly the same amount. And we had some -- in the other income line, we actually had a loss on the other income line because of some hedging activity that we've done. So I think Q3 looks pretty consistent with what we expected. If you look at the changes that we made in the outlook, we really tightened things up. We tightened things to the lower end of the revenue range mainly as a result of the challenges in Europe that we're talking about. But the earnings guidance of $1.42 to $1.47 suggest that, overall, margins should come in a little bit better than that earlier guidance range because we're not at the -- even though we're at the lower half of the guidance that we gave on revenue, we're not at the lower half in terms of what we gave on earnings per share. So I think we've made a lot of progress from the standpoint of producing costs. I talked about what the cost reductions sequentially have been in the divisions, and we saw similar cost reductions in our corporate expenses. So we're pretty well positioned. As Earl said, we expect revenue to be basically flattish in Q4 with last year, and we'll see some growth in earnings per share. So overall, I think what we've done is create a situation where there's a fairly significant amount of operating leverage in the business because of the cost reductions that we've made. And I think margins are looking a little bit better than what we thought 90 days ago.

[Earl R. Lewis:]

And we had -- remember, we said that we had some slight price increases. We did. We had some -- a little bit more cost reduction than we had planned. And frankly, if you look at our guidance, it really is saying that in Q4, we're not going to have negative growth, so that, coupled with the fact that I think we have our costs under very good control and our backlog's expanded very significantly. I think, in fact, they're higher now than they've been in 2 or 3 years, I think, as we pointed out. I think we move into next year and into Q4 in pretty good shape now.

[Noah Poponak:]

Super. And just one follow-up for Andy. The Cores & Components bookings strength that you mentioned, any ability to parse out where that's coming from?

[Andrew C. Teich:]

It's the same cast of characters that we have been selling to on that segment. Frankly, there's not -- so we had orders from Northrop Grumman, who’s been a key customer of ours and orders from the fire segment, auto segment, UAV segment. The issue of that business now is that it's a bit lumpy. And those customers, to the extent that those are military government-based customers have had some challenges on their end, again, which has just caused the orders to move around a little bit quarter-to-quarter but basically, the same mix that we have seen historically.

[Operator:]

Our next question is coming from the line of Michael Lewis with Lazard Capital Markets.

[Michael S. Lewis:]

Okay. So, Tony, you gave the trailing 12 months revenue for Lorex. I was wondering if you could give us an idea what the growth profile looks like, what expectation is for the EBITDA margin growth because right now, there's a -- somewhat a margin diluted. And then finally, do you have an average price point for the Lorex product portfolio?

[Anthony L. Trunzo:]

So I'll give you a little bit of color on that. We need to be careful because, a, the transaction hasn't closed yet, and Lorex is a public company. But I think clearly, the operating margins at Lorex are 10-ish percent, which is half or less of the operating margins that we typically expect. The insertion of our thermal technology into their product suite should have a significant positive effect on margins. It's a competitive space, right? I mean these guys are -- they're in big-box retailers in places where if you don't have a differentiated product, you're going to have tighter margins just because of the level of competition. But as Andy said, and I'm sure he'll want to comment on this, we really -- what we really see here are the ability to take our technology and insert it into their product line, which we think will be significantly positive both in terms of revenue growth and margin. And frankly, we see the opportunity to go to school on their e-commerce and their retailing capabilities because those are markets that, over the relatively short term given some of the development work we're doing on low-cost thermal, are going to be important for a lot of our markets. And that's not a trivial piece of this. The lift that we get from learning about those markets and really being able to deploy their capabilities across markets beyond just that kind of do-it-yourself security market is a big part of this.

[Michael S. Lewis:]

And [indiscernible] the average price point?

[Anthony L. Trunzo:]

I don't think we have -- I mean I'm not sure how meaningful an average price point would be.

[Earl R. Lewis:]

Probably isn't actually because they sell kits of cameras. You might by 2 or 3 or 10 in a kit with the DVR, et cetera. If you're asking what the average price point of a camera is, I'm not sure it's relevant because the sale isn't almost always more than one camera. It'd be 4 or 5 and a DVR. Mike, you can go online and -- they are public companies, you see their entire product range or you can go to Costco and buy one, which I think...

[Anthony L. Trunzo:]

You should do that.

[Earl R. Lewis:]

Yes. I mean they sell 2 packages at the Costco, typically 1 for $500 and 1 for $1,000. And I think it's -- one is a 4-camera set, and the other is an 8-camera set with an nDVR, and so that's representative of what they're doing today in the Lorex line. As we've mentioned, I'll just augment Tony's comment to this is that the initial focus with Lorex will -- we will continue to run the Lorex business as is and let it continue to execute and grow on path that it has been. It's a very well-run business and has good solid management. The area of focus, I think, an intersection with FLIR will be at the Digimerge side, which is the professional integrator series of product. And that's where our sales organizations, I think, have a convenient overlap, a beneficial overlap on the integration side. And then also, the injection of thermal initially at our current cost structure will make the most sense. As this long-term investment that we're making in lower-cost thermal comes to fruition, we will then backwards integrate lower-cost thermal technologies into the Lorex line, which will give them a significant differentiating feature in the marketplace.

[Anthony L. Trunzo:]

One other thing I think worth underscoring on Lorex, I think it's a very good example of the fact that we haven't changed our strategy, nor have we stopped investing aggressively in that strategy in the face of some challenging market conditions, right? I mean, we're still committed to ultra-high-volume, ultra-low-cost thermal imaging. We're still committed to getting this technology down to the consumer level. And I think Lorex is an example of that execution plan.

[Michael S. Lewis:]

Yes, if you take that midpoint of the 750 to 1,000 -- or I'm sorry, 500 to 1,000, that implies 100,000 units. But if Earl is on point with the $1 million projection next few -- or I'm sorry, 1 million unit projection next few years, I mean, this is a significant growth market for you.

[Earl R. Lewis:]

But let me make sure -- Mike, I don't want to mislead you. That was not units, units of cameras. And like we said, they sell 4 at a time or 8 at a time, and those are the price points that Andy was referring to. So in the there, the camera's $100 a piece. That's exactly -- so that's more the way to look at it. So if you got a $100 camera, we've got to get our cost down for the thermal part of that to convert that to a thermal camera. But that's our objective.

[Operator:]

Our next question is coming from the line of Tim Quillin with Stephens Inc.

[Timothy J. Quillin:]

The R&D spending was down quite a bit both in dollar terms, both year-to-year and quarter-over-quarter. Can you just talk about where you've cut back spending, where you are spending money on R&D and how you're or where you're targeting R&D as a percent of revenue?

[Earl R. Lewis:]

Sure. But I think probably both Andy and Bill should address it on their divisions. Go ahead, Bill.

[William A. Sundermeier:]

Sure. Actually, year-over-year for us, we're pretty even...

[Earl R. Lewis:]

Yes, I don't think it was down.

[William A. Sundermeier:]

Compared to Q3 last year, total spending. We did our major reduction last year in 2011. Right now, we're targeting right around 8% to 9% in R&D. It's a little bit lower than we've talked about the past, about [ph] 10%. But we're still focused in working on new technologies, new gimbal technologies that we're going to be coming out with in 2014. So we can always say we can use more R&D, but I think we are very well focused right now for the products that we want to come out with next year to stimulate growth.

[Andrew C. Teich:]

And, Tim, from the CS perspective, we took our spending down by about 10% year-over-year in R&D spending, but we're still spending 10% of revenue within the groups. The mix on targeted spend within Raymarine really hasn't changed. We've got a rich cadence of new product development that we have been doing there, and that will continue here again this week at the Fort Lauderdale Boat Show. We've got several new products that we're launching, similarly selling thermography, same cadence, a lot of development. We've got some longer-term development going on there to significantly lower cost as we had done before and then developments to enhance existing product platforms. The one area where the mix has changes a little bit more significantly is in the former CVS segment where, as Earl mentioned in his opening comments, we have been spending over the course of the last 18 months on a targeted program to come out with the next generation of technology that will significantly lower cost and enable significantly higher volumes that will ultimately feed into a Lorex-type channel and low-cost thermography products and so forth.

[Earl R. Lewis:]

The 8%, 9%, 10% range probably will bounce around a little bit depending on economic conditions, but overall, over the years, that's about what we're committed to do.

[Timothy J. Quillin:]

Okay. And then just quickly for Bill, it seems like the bookings outlook could get a little more challenging with the -- at least the threat of sequestration.

[Earl R. Lewis:]

But we didn't promise it's not going to happen. You don't believe that, Tim?

[Timothy J. Quillin:]

I don't believe politicians. Go figure.

[Earl R. Lewis:]

I'll be darned.

[Timothy J. Quillin:]

But what's your outlook over the next 6 months on the bookings front, Bill?

[William A. Sundermeier:]

Sure. Q4 is going to be a reasonable quarter for us, and we might draw down backlog a little bit in Q4. But then as we go into next year, it's really going to largely depend on that sequestration. So we're trying to build as much backlog as we can to have legs to get into next year. But we're judiciously looking and following the palm and watching our programs there, and they haven't been cut for next year, and we'll see and we're trying to get as much as life as we can of where cuts will happen and see how it affects our business. But it's really going to -- have to check out and see where the cuts happen.

[Earl R. Lewis:]

But right now, Q4 looks pretty good for us, Tim, compared to last year actually. So we're slightly bullish on the government orders in Q4 at this point.

[Operator:]

Our next question is coming from the line of Peter Arment with Sterne Agee.

[Peter J. Arment:]

Just first, a clarification on the Lorex, the 100,000 cameras that you kind of mentioned, what is the kind of split right now between consumer and professional grade?

[Earl R. Lewis:]

Okay, let me just make sure I got -- I put a number out that I slipped in the one in that respect because I probably didn't qualify it. Number of cameras, units, I believe, can be 1 million in the next couple of years. It's significantly more than 500,000 now. So we suspect that, that business will continue grow and produce something like 1 million cameras a year. It's that order of magnitude.

[Peter J. Arment:]

Okay. And just is the mix between consumer or -- and professional grade? Is there any color there?

[Andrew C. Teich:]

Yes, today, it's mostly Lorex.

[Earl R. Lewis:]

Yes, it's consumer as majority.

[Timothy J. Quillin:]

So it's a huge opportunity for you on the -- in moving up the professional grade, right?

[Earl R. Lewis:]

It is, and the professional grade is the fastest-growing segment within the business right now. So we think that we can put gas on that fire effectively.

[Peter J. Arment:]

Yes, okay. And then just my main question was you mentioned quite a bit of a kind of, I guess, technology that is finally coming to bear in the CBRNE kind of marketer detection. How do you see the adoption going there? I think we've all kind of waited for some increased adoption from that marketplace.

[Earl R. Lewis:]

Bill, you want to talk about CBRNE? Pay attention, Bill.

[William A. Sundermeier:]

CBRNE in the future?

[Earl R. Lewis:]

Yes, right.

[William A. Sundermeier:]

We really focused, our folks in the detection group, on some burning and proliferating into different and new markets. So we're starting to see international growth out of that group. And when we acquired them, they were only 5% abroad, and that is continuing to strengthen. And with programs like DRC and J2, hopefully, first part of next year, we'll get into an older phase of that and start proliferating that to -- that's a very large program for us ongoing from 2013 to continue to stimulate that. We're still working on a couple of areas with the TSA in mass spec and explosives to get qualified there and have programs for hopeful adoption next year as well, which will help proliferate that technology for us as a gate to moving through TSA then get European adoption. And we're working on approvals in China and Asia right now for all of our products, and so we see those as strong markets in our future. So growth potential continues in the following years.

[Earl R. Lewis:]

Just the -- I've got another comment. The combination of these technologies is where we see a good future of growth. This one order for DRC is really multiple technologies packaged together. Part of the ICX acquisition was basically that. It was put together detection, surveillance, CBRNE technologies all in a box or on a trailer or in the truck to sell to the customer. And that's -- that, we believe, is paying off. We had tremendous good -- very good orders in Q3. We think our orders will be very good in Q4.

[Operator:]

Our next question is coming from the line of Peter Skibitski with Drexel Hamilton.

[Peter J. Skibitski:]

I guess, on Lorex, the one thing that -- the red flag that gets raised for me is don't -- isn't there the danger that you're going to alienate a lot of your other customers in the surveillance market because don't you sell to a lot of the other camera makers currently?

[Earl R. Lewis:]

We don't sell any equipment into this market today, into what I'm talking about relative to Costco and the other ones, and neither do the people we supply thermal equipment to. The do-it-yourself, the people that are installing these themselves are pretty unique market right now. Andy, you might want to comment because I don't think we have a lot of risk in that area right now.

[Andrew C. Teich:]

No, we don't. I -- perhaps, Peter, you're thinking about the integrator space as a more enterprise-oriented space. And there, we sell to integrators. We don't sell to camera manufacturers. So an integrator has the choice of what products he brings to bear in a project. So today, an integrator might pick a FLIR thermal camera and then combine it together with a Pelco, Axis, Bosch, something like that, enterprise-grade camera. And we feel that we can offer to that integrator an enterprise class of a product that will have a compelling value proposition versus those competitors. And at this point, those aforementioned companies are companies that are starting to compete with us as well in the thermal space. So I think we're more than willing to take on that level of competition.

[Peter J. Skibitski:]

Okay. So you're not taking on the role of the integrator?

[Andrew C. Teich:]

No, no, not at all. Not at all.

[Peter J. Skibitski:]

Okay. Okay. Okay. And then I want to follow up again on Europe. It's obviously the big headwind to CVS. I mean, is there any reason to think Europe's not going to sort of continue to be negative? And I mean things seem to be pretty bad over there, and so, Earl, should you be planning for a further cost takeout over there? Or are you kind of at the...

[Earl R. Lewis:]

I think we're where we need to be. I mean, yes, Peter, you can certainly draw some horrible lines on Europe for the next 2 or 3 years. It seems like Wall Street changes their mind on it weekly. I think we're positioned about right on the cost structure for Europe. And I don't suspect we're going to see huge declines from here going forward.

[Peter J. Skibitski:]

Okay. Can you remind us -- I might have missed this -- what your current percentage of sales to Europe are in CVS?

[Earl R. Lewis:]

Yes, we'll look it up.

[Anthony L. Trunzo:]

We didn't break out the -- we don't break out -- we give you international. We don't go deeper than that. So total Commercial Systems sales -- just bear with me. I had it here a second ago. Total Commercial Systems, U.S. was 52.8% and international was 47.2%. That compares to international being 54.8% in Q3 of 2011. So pretty significant decline, about a 22% -- 21% decline in Commercial Systems' revenue outside the U.S. and a 7.8% increase in revenue inside the U.S.

[Earl R. Lewis:]

Yes. And of course, the Far East continues to have some growth, so that's the other piece of total international. So you can kind of draw those lines I guess, but...

[Andrew C. Teich:]

We have moved some assets around there. So for example, just in the last quarter, we moved a key sales management asset from the EMEA region to the APAC region. So yes, but we think we'll see some dividends from the [indiscernible].

[Operator:]

Our next question is coming from the line of Michael Ciarmoli with KeyBanc Capital Markets.

[Michael F. Ciarmoli:]

Earl, what sort of -- what are the puts and takes to the high end and low end of the guidance really for the fourth quarter? Kind of, I guess, the high end, $430 million; low, $300 million. We're into the quarter. Are there any programs? Or is there any end markets that can swing you to one end or the other?

[Earl R. Lewis:]

Mike, I think what you're asking -- because there was some background noise. What's the -- what's given us range in our guidance?

[Michael F. Ciarmoli:]

Yes.

[Earl R. Lewis:]

Yes, okay. Our gross margins bounce around a little bit. They've -- a couple of points one way or another in gross margin, I think, we could see. I think our revenue number is going to be pretty good given the pretty good backlog in the Government Systems business. And we have some risk, of course, in our thermography business. We have a little risk in government on the top line, but I think we'll be all right there. I think it's more in the area of gross margin where we might see a point or 2 difference between internal forecasts, external forecasts.

[Michael F. Ciarmoli:]

Okay. Okay. And then just on -- back to Lorex. What -- if I looked at the revenue trajectory for that company, they did about $53 million in '05, $48 million in '10, and they hit a big inflection point, really growing in '11. Is there -- can you give us a sense of what sparked that growth at Lorex last year? And I guess they're tracking fairly well this year, but is there anything that they introduced or new product lines that really accelerated their growth rate the last year or so?

[Earl R. Lewis:]

I think this is -- this is just a very interesting market. I mean you can go to the store and for relatively short money, do what it cost me $25,000 to do on my house. And that's where I think the nature of their growth is, which is essentially have an IP security system that you spend -- Andy, you spend a day doing in your house, right, with 7 or 8 cameras. We think that's a good, in itself, future growth business.

[Andrew C. Teich:]

I'd add one other thing that I think is -- I bought one of the systems at the consumer level before we started having discussions with the companies that have a consumer out-of-the-box experience, so to speak. And I think one of the thing is the technology-enabling side in this are -- is the connectivity to mobile platforms. So having the ability to go and buy this network for $1,000, install it in your house and 15 minutes later, be watching it on your iPhone or iPad from anywhere in the world, I think is a very strong value proposition. Lorex's also -- one of their unique capabilities is, is that they really have 3 lines business. So they've got this consumer DIY business. They've got this Digimerge enterprise business, but they also have a pretty strong vector in the baby monitoring business, baby cams. And again, the same thing, the technology that's out there today to get an image from a baby cam to an iPhone, many of us are parents on the call, it's a nice feature. It's not something I had when I was raising my kids but would like to have. So I think that those are some of the things that drove the inflection point in the last couple of years.

[Operator:]

Our next question is coming from the line of Brian Ruttenbur with CRT Capital Group.

[Brian W. Ruttenbur:]

Couple of questions. Just looking at Lorex, the public filings, their gross margins are around the 36% mark. Can you talk about that and how that will impact you guys, if you plan to change that at all and how government pricing with your -- kind of the low price technically acceptable, which seems to be the term going forward, how that's going to impact your gross margins, both those things going forward into '13 and '14?

[Earl R. Lewis:]

I'm not sure on your second point, so let's just talk about the first for a minute and come back and try to clarify it. Clearly, when we add thermal technology, we would expect to increase the gross margin. So yes, they're 36% today, but we believe we can get a higher gross margin due to our significantly lower-cost structure in the thermal market and then adoption of thermal technology in these do-it-yourself markets, if you will, and commercial markets. So we would expect that gross margin to improve. I'm not 100% sure on your second question though. Can you rephrase it to me?

[Brian W. Ruttenbur:]

Yes. At least what I am hearing from the defense primes and from others out there is the federal government is going to a low-priced, technically acceptable business model bidding model.

[Earl R. Lewis:]

Wonderful. Hallelujah.

[Anthony L. Trunzo:]

Yes.

[Earl R. Lewis:]

Boy, do you believe them? If you do, that's great. We would love that.

[Anthony L. Trunzo:]

That's right in our sweet spot.

[Earl R. Lewis:]

That's what we've been all about for years, Brian.

[Brian W. Ruttenbur:]

Okay. So that won't impact your margin. That should actually help you guys. Is that correct?

[Earl R. Lewis:]

Yes.

[Anthony L. Trunzo:]

Forced competition like that for best value is everything we want to have happen.

[Earl R. Lewis:]

This is our dream of running this business, as a commercial business that supplies the government, no question.

[Brian W. Ruttenbur:]

Great. And then the -- a little follow-up is in the fourth quarter, you talked about flattish revenue year-over-year from fourth quarter-to-fourth quarter. Is that -- can you just elaborate? Is that government and commercial being flat year-over-year? Is there going to be a mix shift at all?

[Andrew C. Teich:]

Let's just stick with [indiscernible] ...

[Earl R. Lewis:]

I'll give you the total at this point. How's that?

[Operator:]

We do have another question coming from the line of Noah Poponak with Goldman Sachs.

[Noah Poponak:]

I've asked this before, but I want to try again, which is back to the balance sheet utilization and capital deployment topic. The company has a relatively large net cash position, and even after you closed this latest acquisition, that will still be true. Given where rates are, given where the stock is and that you buy back stock, why not get more aggressive with the balance sheet? You could add a lot to the balance sheet and still have it be fairly conservative. Why not do more here?

[Earl R. Lewis:]

Well, we might. But this business -- I guess, I'm starting to feel my age here, but when I came here, we had huge debts, problems baked in our payroll, a lot of real serious issues, and frankly, having a strong balance sheet doesn't bother me. I think that whatever acquisitions we want to make, we can make. We can pay back a decent amount in our dividends, and we can buy back a decent amount in our shares and still have a decent amount in the bank for contingencies or for -- if a large acquisition were to come up, to be able to do it. And I guess I like the conservative position, and maybe that's old fashioned, but I think at this point, we're not alone in having large cash balances on our balance sheet given the uncertainty of, say, the political realms that we deal with. So no, I'm -- we're not going to run out and do something dramatic one way or the other with our balance sheet. Tony, you want to comment?

[Anthony L. Trunzo:]

Yes. I mean, just we -- last year, when we sold our bonds, one of the key things we wanted to do was get an investment-grade credit rating to go along with the strong investment-grade credit profile of the company. We have the ability today to raise several hundred million dollars in the market. Would we do that? It would have to be for a significant acquisition opportunity. To leverage the company to buy back stock, given what we see as the opportunities around us, probably isn't something that we do. We'll continue to buy back stock. We'll continue to do our dividend. And as Earl said, our expectation is that we're going to grow it incrementally. We want to have that conservative credit profile. I don't think that we want to have growth leverage of more than 1x EBITDA. And having the flexibility that's afforded to do transactions like Lorex is something I think we want to continue to maintain. So on the one hand, yes, we're thinking more internally about return on invested capital and return on equity. And that's kind of the thesis behind the fact that we've bought back a couple of hundred million dollars worth of stock. But doing something that's going to significantly change the credit profile or the leverage profile of the company, that's not something we're going to be taking on.

[Noah Poponak:]

No, and that's definitely not what I'm suggesting. It just seems like there is a lot of room in between where you are and sort of the danger zones that you're talking about not wanting to be in if that makes sense. And given where rates are, it would just seem like it would be easy to make the math work.

[Earl R. Lewis:]

Well, it would. I mean Tony said and it's very clear, we could go out and borrow $300 million more in the bond market tomorrow, but then the next day, we get a phone call saying, "What are you going to do with that money now?" And since we don't have a place to put it, we just -- a month ago, we went and looked really hard at going and getting some more money out of the bond market and decided, now what are we going to do with it? And since we didn't have a good home for it, we passed. If we had a great idea and a great application, then certainly having that strong balance sheet would be wonderful. We could go execute it. And I guess, that's a position we want to take. You look and look and look for an acquisition until it finds you is an old saying, and who knows what might happen in the future in that regard.

[Anthony L. Trunzo:]

I mean, I guess, Noah, if you were to talk to the hypothetical that says there was a strategically important $500 million acquisition...

[Earl R. Lewis:]

Or $1 billion.

[Anthony L. Trunzo:]

Or $1 billion acquisition, would we do it and would we take down our cash balances and issue debt within the constraints I just explained? Yes, we would.

[Earl R. Lewis:]

We would. Yes.

[Anthony L. Trunzo:]

It's not that we're spooked at all. It's just that it would have -- in order for us to do that, it would have to be a pretty compelling situation.

[Earl R. Lewis:]

Okay. Operator, I -- there's no other questions, so I think we'll call it a day. Thank you, all, very much for phoning in today. Is there another? Do you want to take -- no. Okay, I guess, we're done. Again, I think we had a -- the kind of quarter we expected to have and the kind of order entry we expected to have. And I think we’re going into Q4 as a very strong company with, as Noah's pointed out, a good balance sheet, a good cost structure, a good backlog and lots of good new opportunities. So we thank you, all, for listening.

[Operator:]

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time, and we thank you for your participation.