FLIR Systems, Inc.
Q2 2013 Earnings Call Transcript

Published: 25 Jul 2013

[Operator:]

Greetings, and welcome to the FLIR Systems, Inc. Second Quarter 2013 Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Wit Davis, Senior Vice President, General Counsel and Secretary for FLIR Systems, Inc. Thank you. Sir, you may begin.

[William W. Davis:]

Good morning, everyone. Before we begin this conference call, I need to remind you that other than statements of 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 Andy Teich, President and CEO of FLIR Systems. Andy?

[Andrew C. Teich:]

Thanks, Wit, and welcome to FLIR's Second Quarter 2013 Earnings Call. With me on the call today is our CFO, Tony Trunzo; Bill Sundermeier, the President of Government Systems; and Tom Surran, who I'd like to welcome in his new position as President of our Commercial Systems division. In the second quarter, we reported revenue of $389 million and earnings per share of $0.35. This represented a year-over-year increase of 15% in revenue and 30% in earnings per share. Organically, revenues increased 6% over Q2 of 2012, which represents the first quarter of organic growth since early 2011. The additions of Traficon and Lorex to TVM and significant deliveries in our Integrated Systems segment drove the top line increase, while margin improvement in Commercial Systems positively impacted earnings. Total company backlog increased to $528 million on a book-to-bill ratio of 1.1 as we saw the highest quarterly bookings in nearly 5 years. Additionally, we reached an all-time high in quarterly operating cash flow, with $134 million generated, and when coupled with $150 million we added under a new 6-year term loan, our cash balance at the end of the quarter was nearly $500 million. Commercial Systems revenue was up 17% in the second quarter, the best performance in 5 quarters. We still face a challenging macro environment, however, particularly in the high-end science and predictive maintenance markets. Our Government Systems division had very strong bookings during the quarter, particularly the Surveillance segment, which increased backlog by nearly $24 million over the end of the first quarter. While bookings were good both domestically and internationally in Q2, we remain cautious regarding second half U.S. DoD bookings due to continuing risks associated with sequestration and the continuing resolution. However, we expect continued strength internationally, as well as from non-DoD customers in the U.S. Our international business development team has done a very good job identifying and capturing meaningful bookings throughout the world. We continue to progress well in the development of our next-generation high-volume low-cost sensor technology. We are achieving our technical milestones on schedule and are now focused on manufacturing and supply chain development. We expect to have the first products featuring this technology next year. The fundamentals in some of our markets are improving, while, in others, they remain relatively challenging. Overall, we anticipate slow improvement. With this economic environment, we will continue to focus on innovative product development, marketing communications and operational execution. We are developing efficiency initiatives that are expected to improve our operations and position us for scalable growth. Taking into consideration our first half results and forecast for the second half of the year, we are maintaining our outlook for the full year 2013. We continue to expect between $1.5 billion and $1.6 billion of revenue and earnings of between $1.56 and $1.66 per diluted share. With that, I'll now let Tony review the second quarter financial performance. Tony?

[Anthony L. Trunzo:]

Thank you, Andy. Second quarter consolidated revenue was $389.3 million, an increase of 15% compared to the second quarter of 2012, the first quarter of organic growth since Q1 of 2011. Commercial Systems division revenue in the second quarter increased by 17% to $221.8 million. The Thermal Vision and Measurement segment posted second quarter revenue of $175 million, an increase of 23% compared with the second quarter of last year. Lorex and Traficon, 2 businesses we acquired late in 2012, both performed well and accounted for $31.6 million of TVM revenue in Q2. Organically, TVM was up fractionally, as slightly lower revenue from the thermography and security lines of business was offset by good growth in the OEM and maritime systems businesses. Raymarine revenue declined by 1% compared to Q2 of last year to $46.9 million. Government Systems Q2 revenue was $167.5 million, an increase of 13% compared to $148.5 million in the second quarter of 2012 due to a $21.2 million increase in the Integrated Systems revenue to $34.5 million as a result of significant MSC and DRC program deliveries. Surveillance segment revenue was $118.6 million, down 1% from Q2 of last year and the best year-over-year change since Q4 of 2010. Detection segment revenue was $14.4 million, a decrease of 9% from last year due to a $1.8 million decline in contract R&D revenue. International revenue was 45% of the consolidated total in Q2 compared with 55.1% last year. U.S. government revenue increased by 52% to $114.8 million due to MSC and DRC deliveries, as well as improved U.S. shipments in Surveillance and TVM. Commercial Systems international sales made up 52.5% of its consolidated revenue in Q2 compared to 62.9% in Q2 last year due to the recovery of U.S. OEM deliveries from a soft Q2 last year, as well as the impact of Lorex, which is mostly U.S. revenue at this point. 35.2% of Government Systems revenue came from outside the U.S. compared with 45% last year. Total sales to the U.S. government were 29.5% of the total in Q2, up from 22.4% of the total in the second quarter of last year. Consolidated gross margin was 48.8% for the second quarter compared with 50.3% last Q2 despite a 1.7-percentage-point negative impact from lower margins at recent acquisitions and a 2.7-percentage-point negative impact from Integrated Systems. TVM margins increased by 6.6 percentage points on an organic basis. Consolidated operating income was $70.3 million, an increase of 16% compared with the second quarter of last year, and operating margin was 18%, similar to the 17.9% in Q2 of 2012. Second quarter operating income in Commercial Systems was $48.1 million, an increase of 45% compared with Q2 of last year. TVM posted $41.8 million of operating income, up 53% from last year, while Raymarine operating income of $6.3 million represented a 10% increase from last Q2. Government Systems operating income was $36.7 million for the quarter compared with $39.4 million in last Q2. Surveillance segment operating income was $35.3 million, down 13% from last year, while Detection swung to a $1.3 million operating profit from a $1.8 million loss last Q2. Integrated Systems was breakeven compared to operating income of $300,000 last year. Earnings before interest, taxes, depreciation and amortization and stock compensation in the quarter were $92.6 million, a 12% improvement from Q2 of 2012. Our tax provision for the quarter was 24.7% of pretax income, and we continue to expect a tax rate of approximately 25% to 26% for the full year, excluding the R&D credit for 2012 that was recognized in the first quarter of this year. Cash flow from operations for the quarter was $134.3 million, equal to 268% of net income and easily a quarterly record for FLIR. Inventories declined by 7%, while accounts receivable declined by 9% in the quarter. We repurchased 636,000 shares of our common stock during the quarter, including 286,000 shares delivered to us in early April to complete an accelerated share repurchase program. Year-to-date, we have repurchased 4.5 million shares at an average price of $26.05 per share. Q2 capital expenditures were $10.6 million. As Andy mentioned earlier, we have reaffirmed our revenue and earnings per share outlook for the full year 2013. In Q4, we expect to have approximately $3.5 million in transition-related expenses associated with the payment of retirement benefits. In addition, we are reviewing our global operations for further efficiency opportunities, and it is likely we will take a modest restructuring charge in the third quarter to account for the cost of any such changes. Any restructuring charges in Q3, as well as the Q4 onetime retirement benefit costs, are excluded from our outlook for the year. This concludes the summary of our second quarter financial results. Let me now turn the call over to Tom Surran to discuss the Commercial Systems Q2 performance in greater detail. Tom?

[Thomas A. Surran:]

Thank you, Tony. The Commercial Systems division finished the second quarter of 2013 with a 17% increase in revenue and a 45% increase on operating profit compared to the prior year. Organically, the Commercial Systems division was flat in revenue, but increased operating margin by over 6 percentage points versus last year. We saw strong revenue growth in our OEM line of business, and this includes our Cores & Components and automotive products, as well as in the maritime product line. There was continued softness in Thermography, particularly in EMEA and in Japan, where an ownership change in a key distributor disrupted order flow. Margin improvement was due to higher production unit volumes, which improved overhead absorption, as well as a better product mix. The success of our vanguard freshwater Dragonfly product helped Raymarine offset softness in the Americas and EMEA regions. Lorex and Traficon came in slightly ahead of the revenue budget and both were profitable. Commercial Systems division Q2 bookings increased 19% over the prior year and organically grew low-single digits. TVM bookings increased 24% over the prior year, while Raymarine bookings declined less than 1%. TVM's Thermography line of business saw bookings dollars decline nearly 10% from a year ago as European end markets continue to lag. However, we have seen good results from our shifting of sales resources from EMEA to higher-growth markets. For example, Thermography orders in China increased over 20% during the quarter. The introduction of our K-series firefighting camera has gone very well, and we are investing and building out the distribution channel for this highly valuable, life-saving product. In fact, we recently won a competitive tender for over -- nearly 100 cameras for a European customer. Looking forward, our customers continue -- can expect to see exciting new products and an increased focus on building awareness of the benefits of thermal imaging. TVM's OEM line of business grew bookings dollars nearly 10% year-over-year, driven by strong order activity for military OEMs for our cores. Booked units in OEM increased over 20% compared to the second quarter of 2012 due largely to increases in our automotive line of business. The rollout of our thermal imager in Mercedes 2014 model year cars contributed to this growth. Security line of business bookings increased organically by over 40% versus last year and nearly tripled when including Lorex. For the first 6 months of 2013, security bookings are up over 60% organically versus the first 6 months of 2012. Several large border security orders aided this performance. Lorex outperformed our expectations with good growth in their professional grade line of cameras, which we have now migrated to the FLIR brand. We also saw strong sales of Lorex's new IP-based full HD security systems to retailers such as Costco. Lorex continues to bring new products to market, and we remain excited about the opportunities their products and distribution channels will bring us in the future. With our December acquisition of Traficon integrating well with our thermal traffic camera business, we are encouraged by the prospects of penetrating the worldwide smart traffic market. Our intelligent traffic systems line of business had bookings revenue growth of over 30% compared to the pro forma second quarter of 2012, which includes both FLIR's traffic camera business and Traficon's results prior to our acquisition. Large projects in Russia and Singapore account for much of this growth. TVM's maritime business bookings were up nearly 40% compared to Q2 of 2012. This growth was broad-based across all regions and was driven by both our light commercial customers, as well as the initial deliveries of our fixed MD-Series camera and our high-end MV- and MU-series multi-payload marine vision systems. The Personal Vision Systems line of business was flat on bookings basis compared to last year. The PVS Americas region grew bookings nearly 20% year-over-year. However, softness in the EMEA and Asia Pacific regions offset this growth. Unit orders for our popular PS-Series camera increased nearly 40% versus last year. Raymarine bookings dollars declined 1% versus the second quarter of 2012, mainly due to a tough comparison in the Asia Pacific region related to a large order in China last year. Bookings in the EMEA region were down 1% versus last year, the best rate we've seen in more than a year. These declines were offset by a 9% bookings growth in the Americas region. The launch of our Dragonfly sonar GPS unit impacted Raymarine's bookings positively, and the product has proven to be a successful entry into the freshwater boating market, with the photo-like sonar capability of its DownVision technology. We recently announced several other new products which feature our DownVision technology. The CP100 black box sonar unit brings DownVision capabilities to network Raymarine systems, and DownVision technology is also now available as an embedded option for our a Series full-featured touchscreen MFDs. We have additional product targeting the freshwater segment under development. Our recently introduced Evolution autopilot with its unique auto-calibration capability and our premium glass bridge gS series MFDs are also both doing well. We will be introducing several new products in the near future that will showcase our technology, quality and performance lead over competition. That concludes my comments, and I would like to pass the call over to Bill Sundermeier, who will discuss the results of our Government Systems division. Bill?

[William A. Sundermeier:]

Thank you, Tom. Government Systems division revenue was up 13% versus second quarter of 2012, and we ended the quarter with backlog of $339 million, $5 million higher than both the previous quarter and the previous year. As expected, quarterly operating margin was negatively impacted by product mix as much of the increase in revenue was derived from initial MSC deliveries to the U.S. border patrol and essentially, no margin. We will complete deliveries under this portion of the contract in Q3, and we expect any additional orders to carry better margins. The Surveillance segment grew backlog 8% over Q1 of this year, finishing with $269 million. U.S. government bookings grew nearly 20% over the prior year as lower DoD orders were offset by much stronger order flow from other U.S. federal agencies. Bookings activity from non-U.S. customers grew 30% versus Q2 of 2012, and the percentage of our orders that came from outside the U.S. reached 45% of total bookings in the quarter. The largest order in the quarter for the Surveillance segment was $23 million from the U.S. Coast Guard to outfit their H-60 and H-65 helicopters with our midsized Talon gimbal system. With a low total cost of ownership, quick delivery capability and a highly configured solution for the intended mission, this product highlights the benefits our customers can gain from our Commercially Developed Military Qualified model. We also received 2 large orders totaling $26 million from the U.S. Army for gimbal systems for their MEDEVAC helicopters. One of those orders was delayed order from Q1 while the second was quickly received follow-on for $7.5 million. Order activity in the Middle East was robust as well. During the quarter, we received a $16 million order for our Recon handheld thermal systems from a U.S. ally that is a long-time customer of FLIR. We also booked a $9 million order from another Middle Eastern country for several of our Star SAFIRE gimbal systems, a $7 million order for our remote weapon station thermal imagers for another critical U.S. ally in the region and a $4 million order from the UAE for our Recon handheld. At the Paris Air Show in June, we demonstrated the Star SAFIRE 380-HDc gimbal, a revolutionary, new high-definition imaging system designed for airborne applications that has market-leading size, weight, power consumption and ground clearance. We have seen strong interest from many customers and expect this product to be an important driver of bookings in 2014 and beyond. The Detection segment finished the quarter with $23 million in backlog, largely unchanged from Q1 of this year. We received a $2 million order from a Middle Eastern country for our new Fido X3 handheld explosive detectors, as well as a $2 million order for our identiFINDER radiation detectors from U.S. first responders, European and South American environmental monitoring agencies and a border patrol agency in Asia. Orders for products represented over 70% of the Q2 bookings dollars as we continue to reduce Detection's exposure to low-margin contract development work. And 50% of those product orders came from international markets. Margins and costs continue to be a focus on the Detection segment, and thus far this year, the business is ahead of the plan for profitability. We're continuing to focus on improving margins in this segment. Integrated Systems backlog declined by $18 million during the quarter due to significant shipments of MSC systems to the U.S. CBP for the Southern border. The final units under our initial order from the MSC program have been shipped, and we expect to recognize revenue for these units in Q3. We are encouraged by the customers' response to the MSC thus far. Our product, technology, service and delivery capability positions us well for further programs for the U.S. border initiative, as well as numerous opportunities that exist outside of the U.S. In addition to MSC, the Integrated Systems team delivered several DRC systems to the U.S. National Guard civil support teams, completed a project for the Nevada test range that generated nearly $5 million of revenue and booked nearly $3 million in maritime security products during the quarter. That concludes my comments on Government Systems second quarter. I'll pass the call back to Andy

[Andrew C. Teich:]

Thanks, Bill. I've had the opportunity to visit many of our operations, particularly in the Government Systems division, over the past 60 days and have come to more fully appreciate the depth and breadth of FLIR's technologies and capabilities. I also see opportunities to improve our operations and more efficiently deploy our resources to benefit all of FLIR. And I've seen the enthusiasm, dedication and skill of our employees who really make it all happen. These visits have me more excited than ever about the opportunities ahead for us. We are uniquely positioned to continue to lead our industry, innovate exciting new technologies and bring them to market and provide exceptional returns to all of our stakeholders. With that, I'd like to open up the call for your questions. Operator?

[Operator:]

[Operator Instructions] Our first question comes from the line of Pete Skibitski from Drexel Hamilton.

[Peter J. Skibitski:]

I just want to ask you on the macro. It's interesting that you said, it sounds like China orders were up pretty good and Europe was still down a little bit. It sounds like almost the macro is switching a little bit with the Europe flash PMI improving, it came out yesterday, and China maybe starting to deteriorate. Are you guys seeing that at all as we head into the summer months here? Is Europe actually picking up? And is China deteriorating for you? Any early signs there?

[Andrew C. Teich:]

So we have not seen any deterioration in China, and I think that -- I saw the same indications that you did, Pete. But I think that, that market is so nascently tapped in terms of the market potential over there. And with our shift in moving sales resources out of the EMEA region and into a region such as China, I think we've still -- we're still going to see growth there irrespective of what's going on in terms of the macroeconomic activity there. The one area I think -- and we haven't seen much improvement in the Thermography segment in the EMEA region. I'm going to have Tom comment on what's going on in the Raymarine business in the EMEA region because I think we've seen a little bit of a pickup there.

[Thomas A. Surran:]

Not material. I would say that it's executing according to plan. That's about it, we haven't seen a big step-up.

[Andrew C. Teich:]

Yes. I mean, at least the -- in terms of the quarter, the decline sort of leveled off.

[Thomas A. Surran:]

That's right. So at the end of the second quarter -- we saw some weakness in the first part of the second quarter, and this back half of the second quarter, it seemed to improve in EMEA. And right now, we're executing according to plan.

[Peter J. Skibitski:]

Okay, understood. And then I wanted to switch to corporate expenses. I guess post Traficon and Lorex, this $14.5 million or so, is that kind of the new run rate for corporate expenses, that $14 million to $15 million type of range?

[Andrew C. Teich:]

Pete, the big variable in our corporate expenses tends to be legal expense, and that was a little higher than budget in Q2. It's probably going to run a little higher in Q3 and Q4 as well. I think you can expect somewhere in that zip code in the next couple of quarters. The other variable that comes in there is bonus, and that will bounce around a little bit based on how we're tracking for our performance parameters. When you look at the, what I'll call, controllable pieces of corporate spending, i.e. the accounting, the IT, those kinds of things, expenses are well controlled. They're actually down sort of mid-single digits from what they were last year, and I expect that trend to continue.

[Operator:]

Our next question comes from the line of Tim Quillin with Stephens.

[Timothy J. Quillin:]

With regards to the MSC program, can you give us a sense of the magnitude of the third quarter shipments just in terms of revenue contribution versus this quarter? And then when you say that margins should improve with additional orders there, what kind of magnitude are we talking about? Is it always going to be lower than corporate gross margin?

[Anthony L. Trunzo:]

Well, MSC in Q3 will be about half of what we shipped in Q2. Sean, do you have the...

[Sean Jordan:]

That's $8 million to $9 million -- it's about $9 million.

[Anthony L. Trunzo:]

About $9 million in Q3. And of course, those will continue to go out with little or no margin. But subsequent orders which we would receive from that program are international. We're going to certainly try to push back towards our typical margins in that IS space, which have tended to move towards 38% and higher.

[Andrew C. Teich:]

Tim, I'll mention a couple of other things about that program. These remaining deliveries that we have in Q3 complete the first tranche of deliveries, and we are anticipating receiving another contract award on this. That subsequent contract award should come in at slightly higher prices due to the terms that were in the contract. The other issue is, is that we have opportunities within the product construct there to increase the level of FLIR content. There are some components of that system that are not currently manufactured by FLIR but could be manufactured by FLIR. And we believe that, that has benefit to both FLIR and to the customer, and we're working with the customer there to make those changes because, again, those would be bidirectionally beneficial. The combination of pulling out the amortized R&D that was in the deliveries, this first tranche of deliveries, plus picking up potentially more FLIR content and a little bit higher pricing will all push the margins up. The margins are never going to get to the kind of margins that you see -- traditional surveillance margins because there are a lot of bought-in components in that product. But when you flip to international, as Bill mentioned, the international margin is actually going to be quite good on that, and we have already sold some -- we have not delivered yet, but we have booked some units, international variant of the MSC. We call it the MVSS, and we've seen pretty good interest for that product internationally. So we think it has a good future. And then the last thing is, with the border patrol reform act that's in Congress right now, we think that we -- that, that product has some promising future for it.

[Timothy J. Quillin:]

Okay, perfect. And then second question is regarding the proposed or a planned restructuring charge in Q3. I just wondered if you can give a little bit more details about what that might involve and what you hope to accomplish?

[Anthony L. Trunzo:]

Yes, we're still framing it out, Tim. I mean, as I indicated, any charge associated with it is going to be pretty modest. But basically, we're looking at finding ways to streamline some of our operations. There are opportunities on the manufacturing side to get better at our manufacturing and give some lift to the gross margin line. And there is still some back-office consolidation work that we can do as well, and I think we're going to be looking in those areas to generate some savings.

[Operator:]

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

[Peter J. Arment:]

I guess this question is for Tony. Tony, you had a nice tick-down in terms of overall inventory levels. I know this has kind of been something you've been focused on and trying to improve the overall turns. Is there anything -- can you give some more color there? Or was this just kind of a one-off this quarter?

[Anthony L. Trunzo:]

Well, we're all hoping it was not a one-off. A couple of things about it. I mean, it was a nice decrease, but we're still not even back to our own peak in terms of what our inventory turns have been. If you go back a couple of years, we turned our inventory globally about 2.5x. Turns today are still about 2x. The improvement was isolated in a couple of segments. There were a couple of segments that did not make a lot of progress, so I think there is still some meaningful opportunity there. Tim asked a minute ago about restructuring. I think I don't know if there's going to be restructuring associated with it necessarily that will be transparent to you guys. But from a supply chain standpoint, we think there's opportunities to do things better there that can probably give some structural lift. Frankly, I think, this quarter, I hope that part of the improvement was a response to the fact that we now have cash flow from operations as one of the metrics in our annual incentive plan for all of our employees. And certainly, in my travels around the company, I've seen people respond positively to that, they know that it's part of the incentive plan, and people are more focused on it. So I think it's a good start, but there's $100 million in inventory opportunity that is simply the delta between where our turns were in the first part of this year and where they were at their peak back 3, 4 years ago. And I'd like to see us in a position to harvest that over the next 4 to 6 quarters.

[Peter J. Arment:]

That's great color. If I could just ask one unrelated to Tom. Tom, the predictive maintenance market had been soft. What do you think we need to see just to get that back? Is that just overall manufacturing activity? Or what -- could you give us any more color there?

[Thomas A. Surran:]

One, yes, sure, there's still some economic delay in Europe, but beyond that we're working on a new generation of products that we'll be bringing to the market in the second half of this year, early 2014. So the capabilities of that product are such that we are going to also spend resources on communicating the benefit they'll bring to our customers, and we're very enthusiastic about what it will do for our business.

[Operator:]

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

[James Ricchiuti:]

I just wanted to again go back to the issue of gross margins. On the acquisitions you talked about, I think a 1.7-point hit from, I'm assuming, Traficon and Lorex. How do you see that playing out over the next couple of quarters? Is there going to continue to be some drag there? How soon could we see some margin improvement in some of those acquired businesses?

[Andrew C. Teich:]

Jim, it's Andy. I think that what's really going to drive margin improvement in those businesses is going to be the injection of thermal into the businesses. The margins within Traficon are actually pretty good today. There are some improvements that can be done in terms of G&A spending there, and that's one of the issues that we will address here in H2. Relative to Lorex, though, that's a business that is primarily Asian-sourced product and resold, the margins are not terribly good there. There, again, we can pick up some improvement on the G&A line, but ultimately, the plan for Lorex will be to inject low-cost thermal technology into those products, which will differentiate them significantly enough that we can derive higher margins from them. That won't happen until -- the latter part of 2014 is probably when you'll see the first emergence of that. In the meantime, we're also -- we mentioned in the prepared comments that we've seen some growth on the professional end of Lorex product group. Those products are currently branded under the FLIR brand. They carry a little bit higher margin and -- but it's a small piece of the business today. As that grows, that will allow us to see some margin improvement there as well. But this is really a 2014 phenomenon and slow growth from that point.

[James Ricchiuti:]

Got it. And Andy, I just want to go back to your comment that you made, I think, in the initial presentation, where you talked about fundamentals improving. And I wondered just if you could elaborate a little bit more on the markets, either the product areas or the geographic areas where you're seeing that improvement.

[Andrew C. Teich:]

Well, the U.S. is -- from a geographic standpoint, that's the primary area where we have seen some improvement in the Raymarine business and the TVM segment. And in the GS segment, relative to U.S. federal, bookings have been doing pretty well. We're cautious about that, though, because we also are concerned about what's going to happen in the DoD segment in the second half, so we're being conservative on that front. The APAC region looks like it could show some promise for the second half of the year. I don't have much hope for the EMEA region performing much better in the second half of the year. We could see some improvement also in the manufacturing sector. As Tom mentioned, we've got some products that we'll be launching in the second half of the year in the TVM segment that we think will stimulate some additional activity globally. And when we launch those products, we'll shift some spending from R&D to marketing communications to support those product launches.

[Operator:]

Our next question comes from the line of Brian Ruttenbur with CRT Capital.

[Brian W. Ruttenbur:]

I have a question -- a couple. I guess I can narrow it down. R&D trends on the year and maybe talk about sequestration impacts in the second half of the year to guidance. If sequestration was -- yes, didn't take any impact, how much would you see revenue higher? And how much have you accounted for in sequestration? So the R&D question and the sequestration question.

[Anthony L. Trunzo:]

Brian, it's Tony. I'll take the R&D question, and then I'll let Bill comment on sequestration. The R&D spending has been kind of in that 8% to 10% range. I don't think in the short term you're going to see much variation in that. We've got a pretty clear plan for what we want to execute on in the second half of this year. The project list is pretty well established. We have some products that we're focused on getting completed. We have some new technologies that we've talked about that we're focused on, on getting completed. So I don't think you're going to see a lot of variation in the R&D spend relative to revenue. Going forward, as the company grows a little -- as the company sees more organic growth, you could see that percentage come back down to the lower end of that 8% to 10% range that we've talked about for a long time. It's been in the lower end of that range during robust growth periods in the past, and I think that's possible that you could see that, but not for the second part of this year. Bill, you want to...

[William A. Sundermeier:]

Sure. Brian, it's Bill. With regards to sequestration, we have seen a general order slowing here with the U.S. military. As we went into this year, we anticipated about a 20% decline in U.S. DoD orders, and it's actually been slightly worse than that. But our U.S. federal business has offset that, and we've had pretty good order flow in Q2. And our international orders have been pretty good at offsetting that as well. So as our outlook, we look in the next half of this year, we're still continuing to look very conservatively at U.S. military spending and see that to continue, but remain cautiously optimistic that our CDMQ model really embodies a fiscal responsibility that hopefully will win out in the long run.

[Operator:]

Our next question comes from the line of Jonathan Ho with William Blair.

[Jonathan Ho:]

Just wanted to understand -- first of all, around the Mercedes product launch, what was the initial reception and what are your thoughts around what the potential take rate could be for this product?

[Andrew C. Teich:]

I'll comment on this first, Jonathan. The one thing that I find differentiating about the Mercedes launch is that this was the first product to come out to include this feature, the dynamic spotlight feature, and it really adds a level of usability for this product that wasn't there before. So what that does is when a target is detected, either a person or an animal -- and that was another feature that was added in this revision of night vision 3 was animal detection. But whether a person or an animal is detected by the system, it's then illuminated by this spotlight, which is pointed from the front of the vehicle. So it both alerts the driver to the object that is in front of them, and also, if it's a person or something, they know that the vehicle is coming and sees them because the spotlight illuminates them. So I think that's a differentiating function that we feel good about in terms of delivering added user experience. Tom, you want to talk about what we're seeing on the. . .

[Thomas A. Surran:]

Yes, without getting to the specifics of the Daimler shipments -- or the Mercedes shipments, what we did see in the second quarter as we've commenced shipping to Mercedes is strength year-over-year, significant strength in our automotive, so much so that it actually made up for the softness in the first quarter. And as we look to the back half of this year, we see continued growth.

[Andrew C. Teich:]

And I think that's also a positive thing from the foundry perspective, is that it moves significantly higher volumes through the foundry and gives us a little more absorption there as well.

[Thomas A. Surran:]

Yes, significantly higher.

[Jonathan Ho:]

Got it. And just in terms of the Raymarine business, just wanted to understand whether you're actually seeing much of a pickup at this point. I know the macro has still been tough. Boating shipment has still been tough. But are you starting to see any inflection points? And perhaps a little bit more color on the freshwater introduction as well.

[Thomas A. Surran:]

Yes, the freshwater introduction has gone extremely well, so we were very pleased with that. The orders for it outstripped our ability to deliver the Dragonfly. That was one of the products we carried significant backlog into Q3. What we have seen -- normally, there's a seasonality that is really strong Q2. What we've seen so far is a fairly good start to Q3. So we have been encouraged by that. It may be weather patterns where we saw a late start to the season. But right now, the end of Q2 and the start of Q3 were good.

[Andrew C. Teich:]

I would just add to that, that the Dragonfly is a product that we're really excited about. Not only did it bring in this new DownVision capability, which has been very well received by the market, and even to include markets like law enforcement, where they're looking for things in the water. It's an impressive capability. But I'll add to that, that we challenge the team with some very aggressive goals on the cost front and on the usability front in terms of presenting a very simple but powerful user interface. And the team, the Raymarine team did an outstanding job of delivering against this. This unit is aesthetically pleasing. It's got the unique mounting capabilities. It's very bright. It's very easy to use. It has a new lever -- level of graphical user interface for our products, which has been very well received by the market from a usability standpoint.

[Operator:]

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

[Michael F. Ciarmoli:]

Maybe this one for Bill. If you could just help us understand -- the MSC program, clearly a nice contributor now. Sounds like you're looking for more orders. But how does this program sort of interact with the integrated fixed tower that's out there for the U.S. border? I mean, could this be complementary to that or will that be a headwind for this potential program for you guys?

[William A. Sundermeier:]

That's a good question. IFT and MSC certainly are going to have to work together for CBP as 2 different methods for border patrol. But I don't see -- and if you look at the immigration reform packages coming out, there are different line items and have different procurement dollars and requirements behind them. So I don't really see it as a headwind. As a matter of fact, the MSC capability and being able to be mobile and adaptive as compared to a stationary position, with -- our experience out there with the existing fixed towers, the folks on the other side figure out where they're at and how far they can see and work their way around them. And we believe that our mobile capability is much better capability in being able to deploy it wherever the target is and wherever the threat is. So I don't see them -- they are complementary and there's -- certainly that and the immigration reform budget today have complementary line items.

[Andrew C. Teich:]

I would just add 2 other things to that, Michael, is that MSC is fielded now. It's a complete fielded solution that is deliverable today. And I think that when the funding starts to flow on this program that, that's what the border patrol is very likely to gravitate towards, something that they can apply funding to and get deliveries quickly on. And that's where we stand with MSC. And I'll underscore Bill's comments about mobile versus fixed. We've had a lot of experience doing border patrol on the eastern European border and their mobile solutions have won out hands down. And for just that reason that Bill stated, is that people figure out where the fixed towers are and they just don't go there anymore, and it's a big border. The mobile towers can be moved around easily, and they also have a much higher level of serviceability because when something fails, they can bring the MSC vehicle back in for service, whereas an IFT has to be serviced in the field. And I think those are strengths for our product solution.

[Michael F. Ciarmoli:]

Okay, fair enough. And then maybe just one more. On the guidance, you talked about the conservatism with sequestration, but you've got a pretty substantial EPS ramp in that second half of the year versus first half. I mean, you talked about being optimistic on U.S. Where's the conservatism built into that sort of EPS ramp? I mean, it seems like if sequestration doesn't play out, you might even have some more strength. So just trying to understand the confidence, I guess, in that second half ramp.

[Anthony L. Trunzo:]

Sure, yes. Mike, it's Tony. If you look at our Q2 outlook for this year compared to last year, it's actually for fairly modest growth. It's basically for, at the low end, a little lower earnings and at the high end, a little better earnings than last year. You got to remember Q4 is always our strongest quarter. We expect that to be the case again this year, so that part of the ramp is fairly standard. When you look at the amount of growth we saw in the first half compared to the second half from an EPS growth standpoint, H1 of '12 to H1 of '13 in percentage terms is meaningfully higher than what the outlook suggests for H2 of '12 to H2 of 2013. The contours of the guidance, it's still a $0.10 range, and it's a $0.10 range for a reason. There's risk in the government business associated with sequestration. Q2 was very good from an order perspective, but we're not all that optimistic that we're going to see the typical Q3 bump that a cop's business and a CDMQ business like ours typically sees. So I think we're a little cautious about that. And from the standpoint of the commercial businesses, we -- as Andy and Tom explained, we don't see a lot of growth there. So when you kind of wrap it all together and put a bow on it, it's a flattish outlook compared to the second half of last year. And given the dynamics in the business, we think that's reasonable. I wouldn't put it in the conservative or the aggressive camp. I think that $0.10 range encompasses the zone of risk pretty well.

[Operator:]

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

[Brian Gesuale:]

Looks like a lot of the indicators are rolling positively here for you. Wondering, Andy, maybe if you could tackle the volume question. It appears that you guys are ramping up volumes nicely, and some of the businesses you're in, over the next 12 to 18 months, will see further volume increases overall for the company.

[Andrew C. Teich:]

That's true. Our strategy here is to develop sockets for sensors that we build. And the acquisitions that we've made recently all support that strategy of creating sockets for thermal sensors that represent significant volume capabilities. There's work to do in order to actually enable those sockets because many of them require a much lower-cost sensor. Many of them require some level of video analytics to deliver the proper value proposition to the user. And the 2 recent acquisitions that we've done, of Lorex and Traficon, were done specifically to enable those 2 things. And the teams are working hard on making that happen now. This is a big area of focus for Tom in his new job. And we expect it to manifest itself in an increasing volume.

[Brian Gesuale:]

Great. Are you -- do you have any percentage terms that you can share with us? And maybe any multiyear goals in terms of how you want the volumes to expand over time? Just any color you can add there.

[Andrew C. Teich:]

Well, we haven't quantified that yet. I mean, we have seen -- and as were mentioned in Tom's comments, we've seen significant growth in volumes particularly on the uncooled side. And that's frankly what I'm really focused on. I don't think the volumes in our cooled business, on the high-end business, are going to increase significantly. They'll probably be flat. We're focused on the uncooled opportunity in terms of growth. Obviously, the new low-cost sensor that we've talked about a bit, it will likely have some very high volumes associated with it when it's deployed through these channels. We aren't quantifying that just yet, but safe to say that we think it's significant. There's also the opportunity to sell uncooled more aggressively into the gS channels. So it's a thing that Bill and I have been discussing quite a lot with his business development team. We think that there are good opportunities to sell more uncooled into the military and also to sell existing CS product into military and paramilitary accounts, both in the U.S. and internationally. So we'll be focused on that in the next 6 months.

[Operator:]

Our next question is a follow-up question from Pete Skibitski with Drexel Hamilton.

[Peter J. Skibitski:]

Just to get some more color on a couple of things. It sounds like security bookings, as well as maybe cores, were way up this quarter. I think you said security revenue was flattish. So given the bookings trends, specifically in security and cores, kind of organically, are you expecting revenue in those units to be up nicely in the second half of the year?

[Thomas A. Surran:]

Yes, so in the case of security, we are -- the bookings came in. We'll be delivering on some of the larger orders that came in. During Q2 -- during the second half of the year, we should have those contracts, for the most part, completed. We will not see quite the level of growth we saw -- I mean it was exceptional growth that we saw so far. We were very pleased with it. That's probably too high of a bar to try to maintain for the balance of the year, but we are encouraged by continued growth in the security business.

[Andrew C. Teich:]

So 2 other things on that, Pete. One is on Security, that business can be lumpy based on the cooled portion of that business. So we had some nice bookings come in, in Q2 for cooled border patrol, international border security business. And we have not seen that for a while. That's been pretty dry for quite a long time. So we'll turn that into revenue in the second half, and that's where we'll see the growth that Tom talked about. I expect the uncooled business will continue to kind of grow at the pace that it has been growing at. You also asked about the cores business. I think that's where we have the biggest risk and where we're being cautious about the second half. There's a pretty big component of the cores business that is driven by U.S. DoD spending through partners such as Northrop Grumman, AeroVironment. And we -- while we did receive orders from some of those customers during Q2, we think that the second half could be slower than usual, and that will affect revenue at some level as well.

[Operator:]

Our next question is also a follow-up question from Tim Quillin with Stephens.

[Timothy J. Quillin:]

Just a couple of quick questions. One, is your intentions for capital allocations in the second half of the year buybacks versus keeping powder dry for acquisitions? And the second question is in the Thermography business, and I understand, especially in the predictive maintenance world, where that's -- there's some challenging macros, but in an area like building diagnostics, where you have a pretty strong value proposition and maybe not the penetration levels that you should have, in addition to shifting resources geographically like Europe to Asia, are you also able to shift some resources to maybe generate some awareness on some of those type of products?

[Anthony L. Trunzo:]

So Tim, it's Tony. I'll take the first part, and then Andy will take the second. There's -- globally, there's no shift in our priorities from a capital allocation standpoint. We're going to continue to look to find opportunities to take capital off the table where it's appropriate. We spent a fair bit of time as a team, over the last several months, continuing our discussions around getting our returns on equity back up to the 20%-plus level, and I think that's clearly a priority for us. Part of that is going to be through being more efficient in getting margins up. Part of it is going to be through taking some capital off the table. We're going to obviously continue to generate capital. There's no -- I would say there's no shift. We weren't as aggressive in Q2, but we had a big Q1 in terms of share buyback. And you'll see it bounce around quarter-to-quarter based on what we see from a potential priority standpoint and also valuation. We're not going to be buying a little bit of stock every day just to get the capital structure right. We'll buy it when we see opportunities. So I wouldn't read anything into the fact that the Q2 was light other than we had other priorities going on, and I would expect that we're going to continue to put a meaningful proportion of our capital deployment against share buyback. Andy, you want to. . .

[Andrew C. Teich:]

Sure. Yes, Tim, on the -- relative to the Thermography, TM and building diagnostics segment, there's a couple of things there. One is, as Tom mentioned, we've got some new products coming in the second half of the year that will be targeted at the building diagnostics segment. We've seen a good opportunity there in the HVAC segment, and we have been doing pretty well there, but I think that there's significant opportunity for growth there. It's very nascently penetrated today. And specifically, as we develop products that have some bespoke features for that segment. And then marketing communications targeted at that segment and training targeted at that segment through our ITC division, I think, will all help to drive growth there. We've said many times in this market that the 2 levers that we can pull on in terms of driving growth in this are price and awareness. We will be addressing both of those things with these actions. And specifically on the awareness side, that's an area where we do need to focus more investment, and we will be doing that, as I've mentioned, developing an organization such that we can flex between engineering and marketing spending when we do it. We're sort of exiting a phase of fairly high R&D activity relative to these new products and then we'll enter a phase where we'll focus more on marketing communications. And the team is ready to execute on that.

[Operator:]

Our next question is a follow-up question from Jim Ricchiuti with Needham & Company.

[James Ricchiuti:]

Just wanted to go back to some of the commentary around MSC, and it sounds like you see the potential for follow-on business there. And you also commented about getting perhaps more FLIR-related content into that. Can you talk a little bit about that? And secondly, is there an opportunity to perhaps become a little bit more vertically integrated? Or are there any areas where you might be able to acquire some of the technology that's going into this?

[William A. Sundermeier:]

Sure, Jim. It's Bill. In the area of MSC, we're quite vertically integrated. We build the entire thing, and really, the biggest pieces of that puzzle are Star SAFIRE 380-HD system, which provides the fantastic long-range imaging and a radar system that's on there. And for all of our international shipments, we incorporate a really great radar that's produced by our group in Surveillance. And what we'd like to do is be able -- that radar is really coming on strong and providing great capability and be able to add that to the system for the U.S. And that would be able to be serviced in the U.S. and provide jobs in the U.S. So I think that there's some great advantages to putting that on the system as well. From a service perspective, of course, that just is fantastic for us and for the CBP. So provided it's a great, tightly integrated solution, but the software, the major systems, we build the whole infrastructure there. And there's just some of the minor components that we outsource, so we're quite well integrated into that solution. And as we export those, we'll continue to grow in that business segment.

[Andrew C. Teich:]

One other thing, Jim, that we will be pursuing in that space, and that's related to the display and the man, machine interface. Those units have a couple of fairly high-end displays in them presently, and we've got a real strength in that area, obviously, with Raymarine, that are -- that produces high-volume, low-cost field rugged displays with a great user interface, touchscreen user interface. So over time, we'll be developing a solution there that not only will lower our cost, but will significantly improve the usability experience from a user perspective. I think the border patrol operators are really going to like what they see there when they -- when we deploy this touchscreen capability. Okay. With that, I'd like to bring the call to a close. I do want to thank the employees at FLIR, not only on their performance in Q2 and in supporting the leadership transition that has taken place here at the company. But also I have to say that in the last 60 days, Tony and I have been maintaining a very aggressive travel schedule, visiting the different sites amongst FLIR to better understand the businesses, the technology, the integration opportunities and also to communicate the vision for this business for the future. And I have to say that the reaction that I've seen from the employees has been outstanding. They've been very enthusiastic, extremely supportive. A lot of people coming in with very good ideas for growth and innovation, and it's a collaborative effort that I'm seeing from the FLIR employees on a global basis, that I'm very encouraged to see. And I think it's going to support the vision for growth of this business in the future. So with that, I'll say thank you for your attendance, and we'll see you next quarter.

[Operator:]

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.