FLIR Systems, Inc.
Q2 2014 Earnings Call Transcript

Published: 24 Jul 2014

[Operator:]

Greetings, and welcome to the FLIR Systems Second Quarter 2014 Results Conference Call. [Operator Instructions] As, a reminder, this conference is being recorded. It is now my pleasure to introduce Shane Harrison, VP of Investor Relations. Thank you, Mr. Harrison, you may begin.

[Shane Harrison:]

Thank you, Stacy, and good morning, everybody. 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 Andy Teich, President and CEO of FLIR Systems, Andy?

[Andrew C. Teich:]

Thanks, Shane, and thank you for joining us this morning for FLIR's Second Quarter 2014 Earnings Call. Also with me on the call today is our CFO, Tony Trunzo; our COO, Tom Surran; our Chief of Product Strategy, Jeff Frank; and our Chief Marketing Officer, Travis Merrill. This morning, we reported second quarter revenue of $369 million, and GAAP earnings per share of $0.31. This EPS result included after-tax charges of $3 million related to continuing severance and relocation costs of our previously announced restructuring and realignment plans. Excluding these charges, Q2 earnings were $0.33 per share. Revenue declined 5% versus the second quarter 2013, driven by declines in our government oriented Surveillance and Detection segments. Helping to offset this decline was double-digit growth in our Commercial businesses. Gross margins improved versus both the prior year and the prior quarter. Operating cash flow of $71 million during the quarter was again, well ahead of our net income. Tuesday, we began taking orders for our FLIR ONE iPhone accessory. We anticipate to begin deliveries during the week of August 4. FLIR ONE represents 1 of 2 new products we have announced to date, that incorporates our new Lepton thermal micro core, the other being our Mini Bullet security camera. The FLIR ONE is our first step in bringing powerful thermal imaging capabilities to consumer applications. Our strategy continues to be focused on using the product to evaluate mobile applications while building the awareness of both the FLIR brand and thermal imaging in general. FLIR ONE provides us not only with a strong platform that can be leveraged into new smartphones in the future, but also a deep new experience base for developing and certifying products for the mobile handset market. This should result in quicker development and certification cycles for future products created for this market. We will continue to incorporate Lepton into new products throughout the business and anticipate new launches later in the year. In addition to these FLIR-branded products utilizing Lepton, we continue to develop OEM customers for Lepton and began shipping units to these customers in Q2. The addition of Travis as our Chief Marketing Officer has already had a positive impact on our business. The marketing team recently launched a new, more user-focused FLIR.com homepage in the U.S. that will soon be extended worldwide. This new page is designed for higher user engagement, greater focus on customers and youth cases, and a continual evolution in order to facilitate the changing needs of our customers and markets in which we operate. Additionally, we have implemented a new structure for our marketing organization, that for the first time, places dedicated marketing directors in support of each of our segments, as well as creating centralized, creative and PR teams. We have also launched more cohesive brand standards that will align our various segments, products and operating sites in a way that presents an interconnected and coordinated FLIR. Based on our second quarter results and our current view of the business, we are maintaining our outlook for the full year of 2014. We continue to expect revenues between $1.45 billion and $1.55 billion for the full year, and earnings per diluted share in the range of $1.40 to $1.50, excluding expenses related to restructuring actions. I will now ask Tony to review the second quarter financial results. Tony?

[Anthony L. Trunzo:]

Thanks, Andy. Unless otherwise stated, the following discussion of Q2 2014 results at both the consolidated and segment level excludes restructuring cost totaling $3.5 million pretax. Overall, we finished the quarter with revenue of $369.4 million, a decrease of 5% compared to last Q2, but up sequentially by 5% from Q1. Surveillance revenue declined by $42 million or 28% from last Q2, while in aggregate, the other 5 segments saw a 9% increase in revenue from last year. Consolidated gross margin of 49.5% was 70 basis points better than last year and 1.4 percentage points better than Q1, due to improved mix and production efficiencies in several segments. Segment operating expenses excluding restructuring charges were 1% lower than last year at $102.8 million. Corporate expenses of $17 million, while 10% higher than last year were down 9% sequentially and in line with our expectations for the quarter. Net income before restructuring expenses was $47.5 million and earnings per share excluding restructuring was $0.33. At the segment level, we saw our performance ranging from good to excellent across 5 of our 6 segments. Unfortunately, Surveillance revenue and operating income were significantly below last year, largely due to a number of orders planned for late quarter shipment that we were not able to deliver. Surveillance gross margins were ahead of last year by 1.8 points due to a shift away from poor margin deliveries of MSC program units. Operating expenses declined by 8% from last year, but segment operating income was down 43%, due to the flow-through of much lower revenue. The Instruments segment performed well during the quarter, as good unit growth and strong reception to new products led to a 5% increase in revenue, while operating income rose by 3%. Gross margin remained strong at 59.7%. Year-to-date, Instruments revenue was up 6% and segment operating income before restructuring was up by 11%. OEM and Emerging segment operating income of $17.7 million was up 45% from last year. The segment saw a 21% increase in revenue on strength and uncooled cores and Personal Vision Systems products. Gross margins were down versus Q2 of 2013 due to the inclusion of lower margin revenue from our Optical Components Group, which was acquired in August of last year. Operating expenses were 7% lower than last year, as benefits from our restructuring more than offset higher-than-planned engineering spending on FLIR ONE. Segment operating margin in Q2 was 30%, 4.9% percentage points better than in Q2 last year. Year-to-date, OEM and Emerging revenue was up 14% and segment operating income was up 11% compared to the first half of 2013. As expected, our Security segment performed very well in Q2. Revenue increased by 30% compared to last year due to strong sell-through and expanded distribution of our Lorex products, as well as growth in our thermal camera product line. Gross margin was 2.2 percentage points better than last year due to improved retail margins and higher sales of thermal cameras. Operating expenses declined 150 basis points as a percentage of revenue. As a result, operating income of $5.9 million was up 81% from last year. Year-to-date, Security segment revenue is up 16%, while operating income is down by 1%. Maritime revenue was up 1% from last year and operating margin reached 17.6% on stronger gross margins attributable to improve margins on Raymarine branded products. As a result, operating income rose by 4% versus Q2 last year. Detection saw a significant sequential improvement as revenue rose 42% from Q1 and Q2 operating income of $3.3 million represented a $4.5 million improvement over Q1. Strong orders and deliveries under the DR SKO program aided results in the quarter. Revenue was down 12% compared to Q2 of 2013, due to a $3.3 million decline in contract R&D revenue, while operating expenses were 11% lower than last year, reflecting the positive impact of our restructuring efforts. On a consolidated basis, bookings were strong during the quarter and we saw a 7% increase in 12-month backlog to $548 million. Year-to-date, backlog has increased by 12%. Also, on a consolidated basis, U.S. government revenue declined by 32% year-over-year, while all other revenue increased by 6% for the quarter. Total sales to the U.S. government were 21.3% of the total in Q2, down from 29.5% of revenue in the second quarter of 2013. International revenue was 48.3% of the consolidated total in Q2, up from 45% of revenue in Q2 of last year. Cash flow from operations including the impact of restructuring was $70.6 million for the quarter, representing 158% of net income. During the quarter, we paid $14.2 million in dividends and spent an additional $41.2 million to repurchase approximately 1.2 million shares of our common stock. We ended the quarter with cash on hand of $602 million, providing ample liquidity to continue returning capital to shareholders, as well as to pursue strategic acquisitions. We are actively seeking opportunities for strategic M&A to enhance our competitive position, expand and attract new business segments and effectively deploy our capital. While it's always difficult to predict M&A timing, we feel we are in an excellent position to act as opportunities become actionable. As Andy indicated, we are reaffirming our full year 2014 outlook for revenue and earnings per share, excluding certain restructuring items. We expect Q3 performance to be similar to Q2 followed by our usual strong Q4. Both quarters should see improvements in cost structure as a result of our restructuring efforts. Today, we also announced our regular quarterly dividend of $0.10 per common share will be payable at September 5 to shareholders of record as of August 19. That concludes my summary of our second quarter financial results. I'll now turn the call over to Tom to cover the segment operating highlights.

[Thomas A. Surran:]

Thanks, Tony. While we saw a significantly improved revenue growth in the second quarter in many of our commercial end markets, it was more than offset by continued weakness in our government-funded markets. Order flow from these customers remains lumpy and several order delays caused shipment pushouts to the second half. Segment operating margin, excluding the Q2 pretax restructuring charges of $3.5 million, were essentially flat in the second quarter of 2013. Total order backlog grew versus both Q1 2014 and Q2 2013. Revenue in the Surveillance segment declined 28% versus the second quarter of 2013, in part due to the significant deliveries of MSC units in the prior year, but also due to reduced shipments of our airborne gimbal systems and man-portable products. Surveillance book-to-bill was $1.2 million, resulting in backlog of $308 million up $28 million over Q1 of this year. As a result of the reduced revenue and despite improvements in gross margin and lower operating expenses, surveillance operating income excluding restructuring charges declined 43% year-over-year. We are taking several actions to improve our execution within the Surveillance segment that we believe will enable us to gain market share. The first of these actions is a reorganization of our sales team. We have put a highly capable leader, Steve Williams, in charge of the team. Steve has recently made a number of changes to the Surveillance sales organization that we believe will allow it to significantly improve in its execution. Next, we have adopted a number of processes that will provide greater detail and key execution for understanding the quarter. This visibility will enable a faster corrective action response to issues as they arise. Further, we have adopted many of the product development processes, which have been highly effective in the former Commercial Systems businesses. Finally, we will be scaling expenses in the segment to the level of revenue we expect to see going forward and in accordance with our business model. While the benefit from some of these actions will be longer-term, we do expect to see sequential improvement in the Surveillance segment through the balance of this year. The Instrument segment achieved revenue growth of 5% versus the second quarter of 2013 and camera units shipped by the segment increased 37%. This growth was driven by the continuing success of our entry-level EX-Series camera, our K-Series firefighting camera, as well as our Extech test and measurement products. The automation line of business continue to do well in Q2 with 35% growth over the prior year. The OEM and Emerging segment grew revenue 21% over the second quarter of last year. The driver of the growth came from the shipments of our uncooled camera cores to OEM customers. The PVS line of business contributed to the growth with the combination strong sales of the new R-Series thermal rifle scope, as well as solid performance from our BHS line of thermal binoculars. In addition, there was the contribution from our Optical Components Group, which was acquired during the past year. Organic revenue in the OEM segment, excluding the results of OCG, was 14%. The operating margin improvement, both sequentially and year-over-year, was the result of lower operating expenses, as well as improved utilization from the increased production volumes. It should be noted that during the quarter, we shipped a record number of camera cores. The Security segment saw a 30% increase in revenue versus the prior year, with all 3 product lines showing double-digit growth. Lorex revenue was up 25% versus Q2 of 2013 from a combination of strong retail sell-through and expanded distribution. Additionally, FLIR-branded visible security systems grew 28% versus Q2 of 2013 as we gained share on our distribution channel. Our largest gain from the segment were made by our thermal security products, which grew 40% over second quarter of last year. Security operating margins improved 370 basis points over the last year with stronger gross margins, as well as reduced operating expenses as a percentage of revenue. The Maritime segment saw revenue grow 1% compared to Q2 2013. Strength from the Raymarine products, particularly multifunction displays, sonars and autopilots was offset by weaknesses from FLIR-branded thermal cameras due in large part to reduced deliveries to the municipal first responders market. Maritime operating margins increased slightly compared to Q2 2013, as gross margins improved as a result of our new products having higher margins than prior generation products. Detection segment performance in Q2 exceeded our plans from a bookings, revenue and profitabilities perspective. While second quarter revenue decline 12% versus the prior year, margins were largely in line with the prior year, given much of the revenue shortfall was attributed to lower contract R&D during the quarter as compared to the prior year. As a general rule, the contract R&D work generates lower margins in comparison to product sales. That concludes my summary of the segment's second quarter. I will now pass the call back to Andy.

[Andrew C. Teich:]

Thanks, Tom. As our 2014 outlook suggests, we continue to anticipate a stronger second half of the year. Over the past few years, approximately 50% of our earnings have come in the second half. 2013 was an exception due to weak second half demand in our Surveillance and OEM cooled cores business. We expect 2014 to look more like the historical trend given the impact of the restructuring, the increase in our backlog and the growth trends in our Commercial segments. Upon becoming CEO of FLIR on top of realigning and restructuring our businesses, I also laid out to our employees 5 key initiatives that are intended to drive long-term growth and profitability in the business. These include

[Operator:]

[Operator Instructions] Our first question comes from Pete Skibitski with Drexel Hamilton.

[Peter J. Skibitski:]

There's a lot going on at FLIR these days, that's for sure. Let me ask one on Surveillance, guys, on the big decline. It sounds like you get some orders shipped right. For the first half of the year, it's down, maybe call it mid-teens or so. Is that kind of what you're expecting for the full year at this point in Surveillance or will -- or are things going to -- are those orders going to come through pretty strongly in the second half?

[Thomas A. Surran:]

This is Tom answering that. There's 2 pieces to it. First, there were orders that were missed at the end of the quarter that actually have been now captured in Q3. So we started Q3 nice and solid. And the second piece is the overall performance of how H2 looks compared to H1, and we expect to see improvement as we progress through the year.

[Andrew C. Teich:]

Pete, this is Andy. Obviously, I have one other thing. I mean, we did see nice growth on the backlog, so we'll be executing on that backlog in the second half. The order flow for the second half looks pretty good at this point. It's -- we're not fully back to kind of historical levels, but it does -- the pipeline looks pretty strong. And as Tom indicated, the early weeks of the quarter here have executed pretty well. So at this point, we're feeling okay about what the order prospect looks like.

[Peter J. Skibitski:]

Are you thinking for the full year? Are you thinking international can be up but U.S. down?

[Andrew C. Teich:]

Yes, in the second half, we expect to see strength and it's particularly in the EMEA region.

[Peter J. Skibitski:]

Okay. Okay. And last one and I'll get back in queue. But can you update us on how FLIR ONE pre-orders are coming along?

[Andrew C. Teich:]

Well, so Pete, I don't want to go into specific unit volumes. That's something that we've never done at the company, talk about order unit volumes at a single-product level. We did open up the order site for pre-orders the day before yesterday. And then yesterday was the first day that we took orders from the general public. We've had a good response thus far but it's really too early to tell in 48 hours’ worth of data. And particularly at this point, we're only taking orders from the U.S. markets. It's really too early to call a trend on this.

[Operator:]

Our next question comes from Tim Quillin with Stephens Inc.

[Timothy J. Quillin:]

I think I heard you say in the prepared comments that Q3 would be similar to Q2. I'm wondering if that specifically referred to earnings in terms of Q3 earnings being similar to Q2. And then regardless, so there's -- Andy, you noted there's a pretty strong implied back half and I think implied stronger, significantly stronger margins probably, mostly in 4Q. But if you could go through maybe the -- either the segments where you expected the margins to be up significantly, or what kind of mix, specific mix improvements that you might see that would drive those stronger margins in the latter part of the year?

[Anthony L. Trunzo:]

Tim, it's Tony. Yes, in terms of our -- what we see for Q3, it is a similar quarter. It's looking like a similar quarter to Q2. There are some segments that are going to be a little bit better. Seasonally, we will see a softer Maritime segment. That's just kind of the way it plays out, so there's a several million dollar headwind there. Pretty much everything else is going to be flattish to up a little bit in Q3. Q4, as you know, is seasonally strong in a couple of our businesses. I would say we've taken, in terms of loading the outlook for Surveillance for the second half of the year. I would say we've taken the approach of being cautious in terms of when we expect deliveries of some of the orders that we have in backlog and that recently came in simply because of what we saw in Q2, where some of the late planned deliveries for the quarter didn't happen. And as a result, we think we will see -- our expectation is that we'll see meaningfully stronger deliveries in Q4 than in Q3 in Surveillance despite the strength in the backlog. Overall, looking at the second half, I think everybody is going to see some lift from the restructuring. So overall, expenses on a gross basis are going to come down. Net-net, we are going to invest more in marketing. So you'll see that tick up a little bit. And overall, the engineering expense -- engineering spending continues to be at a pretty meaningful level as well. So globally, for the second half, you're right, Q4 is looking like it will be materially stronger, that's not unusual. It certainly happened in years past and I think a lot of the dynamics from a segment standpoint are laying out pretty much as we've seen historically. As I said, with a possible exception of Surveillance, where we've clearly been cautious about, particularly, with respect to international orders when we expect them to revenue.

[Timothy J. Quillin:]

Great. And then in terms of the Surveillance bookings, the $1.2 billion book-to-bill was actually pretty good and it looked like bookings weren't all that bad. What did you see in terms of a split geographically between U.S. and other parts of the world in the Surveillance bookings. And were there any notable orders that you would call out?

[Thomas A. Surran:]

Tim, it's interesting. We had a larger-than-usual number of kind of medium size orders in the low to mid-single digits. We didn't have a lot of -- sometimes, we didn't really have any blockbuster orders during the quarter. It's actually a pretty nice way to make the number. I think if we had to talk about how we'd like to see that business flow, that would definitely be it. Demand internationally was good. Deliveries there, as we've talked about before, are lumpy. It's tough to predict them. But from a bookings standpoint, we saw good demand pretty much across the board. Sequentially, orders look good as you know, Q2 of last year was an unusually strong quarter. So compared to last year, it wasn't a great quarter but from a book-to-bill standpoint and in terms of the momentum in the business, it was pretty good.

[Andrew C. Teich:]

Tim, this is Andy. I'll add one other thing to that, that we expect to start to see order flow from some of the new products that we've developed in last 12 months in the surveillance space. There are 3 in particular that we'll see order flow most likely from U.S. customers in the second half, and that is our 380-HDc, which is our new compact high-performance gimbal; our SeaFLIP 280, which is the product that was sold into the U.S. Coast Guard PB-EOS program. We delivered the first couple of those units but we expect to see a follow-on order for that product in H2. And then also our Recon 5, which was a product that we've just launched, a really terrific product in terms of its execution on the size/weight/power reduction front, and we expect that we'll start to see some US-based orders for those products in the second half.

[Operator:]

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

[Michael F. Ciarmoli:]

Tony, maybe just a couple of housekeeping items on the numbers. What are you expecting for the full year tax rate? It looks like the tax came in a bit lower this quarter. And then I also noticed there's about $1 million of other income in there, can you just maybe elaborate on those items?

[Anthony L. Trunzo:]

Yes. So I'll answer the second one first. There's a couple of things in other income. We have a Non-Qualified Deferred Comp Plan and the expense on that is typically pretty much neutral because we don't make company contributions to it but there is an expense related to the growth in those balances when the market does well that's offset by a shadow account that we've got of those securities. In this particular quarter, you saw a pretty strong performance in the market, which led to some other income on the NQDC line, that was basically offset by expense up in the corporate segment. So it's just kind of a push from one place to another. We also had a bit larger-than-usual currency gain. If you go back 4, 5 years, we used to have some pretty meaningful quarter-to-quarter fluctuations in other income because we didn't hedge our -- some of our foreign currency exposures. We started doing that I guess, 3, 4 years ago, I guess, 4 years ago and that significantly dampened that activity but I think we had currency gains of a little over $600,000 in the quarter, something in that zip code. In terms of the tax rate, the effective rate for the year is pretty much where we thought it was going to be. There are some discrete items that benefited Q2. There will probably be some discrete items in Q3 and Q4 that will benefit the rate as well or benefit the expense. So yes, for the second half of the year, you'll probably see tax expense if you calculate it as a percentage of pretax income, be a little less than that 23.75% number, 23.75% that we had in Q1. That's really going to be the result of things like expired statutes more than it's going be the result of the tax rate itself on a global basis coming down.

[Michael F. Ciarmoli:]

Okay, perfect. And then just on FLIR ONE, I mean, how are you guys thinking about, you just have the -- obviously, just taking orders and pre-orders now, iPhone 6 is going to be coming out, do you guys have another version for the iPhone 6? I mean, I was thinking that you are targeting, I think, the tech geek market. Those guys do tend to go out and buy the latest and greatest iPhones. I mean, is there any holiday planning in your process? Will you have another product out to capture that holiday push?

[Jeffrey D. Frank:]

Hi, Michael, this is Jeff. Thanks for that question. It's a good one, it's one we think quite a bit about obviously. Break the answer in the kind of 3 pieces first. First is our ability to respond to new platforms or new mobile handsets as they come out. And over the last year, we've spent a lot of time developing what we think is a great product with the FLIR ONE but probably, more importantly is the platform aspect of the design. It's powerful, it's expendable, it's adaptable, and we think we have a great design base to work from as new mobile devices emerge. Another piece of that is, the learning curve we've gone through with physically interfacing to cellular devices, this in general is not as easy as it sounds to do and we've gained a tremendous amount of domain knowledge in the organization. And both of these things kind of combine to -- as a really great foundation so when these new mobile models do emerge, then we can respond much more efficiently with much shorter design cycles. And we've experienced so far this with the FLIR ONE. The second piece, though, it's what do we respond to. The iPhone 6, we know as much about that device as everyone else does, which is basically nothing but rumor. So it's really very difficult for us to take any specific design activity around that until we know what it is. So we're going to be watching that launch carefully. When we see the launch, we're in a position to very rapidly evaluate any design issues and respond appropriately around that. The last piece of this is kind of what's going to happen with the FLIR ONE itself as we get this out in the customers' hands. We're going to be meeting a lot of new customers. We’re going to be learning a lot of things from these customers. These things, with this input that we get from them may impact future design and future product roadmap decisions. So all that's going to play into how we respond to the iPhone 6 and Android devices as they come out. But right now, we're focused -- we're laser-focused on the FLIR ONE launch and making sure that's a success.

[Andrew C. Teich:]

Mike, this is Andy. I'll just add one other thing to it. If you look at the iPhone 5/5s installed base, it's huge. Our penetration into that could be very small and we would still have an extremely successful product. And the other interesting about it is that the FLIR ONE, of course, is still useful even if somebody moves to a different platform. The product, of course, can still use the predecessor hardware. Without a SIM card activated, it's still a functional product. So we think that it's got a lot of legs with the existing platform and then as Jeff says, we will evaluate both our experience set and what the new platforms look like in terms of forming the path forward.

[Operator:]

Our next question comes from Paul Coster with JPMorgan.

[Paul Coster:]

The overall results seemed quite predictable and it's commendably so. As you look at the segment level revenue in particular, the surveillance, OEMs, Security and such, the year-over-year growth rate fluctuates quite widely. I'm just wondering why is that and do you anticipate the sort of the growth rates starting to sort of normalize and be a little bit more predictable at the segment level moving forward?

[Andrew C. Teich:]

Well, I think it depends on the segment, Paul. If you look at our Instruments business, for example, it's a fairly predictable business. Also, if you look at our Security business, it's growing quite nicely right now. We've got a lot going on there in terms of new product introductions, channel development and so forth. So I expect those 2 businesses to continue to execute on the path that they have been so far this year. The businesses that get a little bit more lumpy of course are the ones that have government back end to them or government customer base of surveillance detection and to some extent, the OEM business, and those are a little bit harder to predict. OEM has done well this year and we've had pretty good visibility into what our OEM core customers demand looks like, so I expect it to continue on a nice path for the second half of the year. Maritime, this business is very seasonal. And again, it's one that we understand, the seasonality of that business is quite well understood at this point. It's been modeled into the second half of the year. Second half of the year for the Maritime businesses tends to be softer than the first half of the year.

[Paul Coster:]

And then Andy, as you think about the full year guidance that you've issued, what are the sort of main sort of puts and takes to that guidance in terms of assumptions that might flex us in one direction or another?

[Andrew C. Teich:]

Well, probably the biggest input piece on it is what happens with the leading edge of the business, the book and bill component for the various businesses. We try to take objective and a very measured look at what the book and bill requirements are for the second half of the year based on the experience that we've seen over the last 12 months. And that results with the model that puts us within the guidance. The biggest wildcard on that is -- continues to be the government funded customer portion of the business. I would say that the Commercial businesses should execute to plan then, if anything, there may be some upside in those businesses.

[Operator:]

Our next question comes from Yair Reiner with Oppenheimer.

[Yair Reiner:]

I think on the last call, you mentioned some potential risk. If -- should the U.S. pass incremental sanctions against Russia, I think those have now gone into effect. Do you anticipate any impact there, either to your Surveillance business or any of the OEM core business?

[Andrew C. Teich:]

There is clearly some impact, I don't think it's material in the overall results of either of those 2 operations. We have had customers that we unfortunately, couldn't fulfill their requirements from us because of that, but it's been small. And knowing that that's kind of the rules of the game at this point, we'll be focusing our business development in other areas. Most of the -- most of our products that go into Russia that are controlled products are in our OEM group and they tend to be products that are non-itruck [ph] controlled that are produced in Sweden. We don't sell a lot of surveillance product direct into Russia. So I guess, primarily focused on the OEM segment.

[Yair Reiner:]

Got it. On the DR SKO program, it looks like funding is currently there in all the versions of the FY '15 budget floating around Washington. Assuming that it remains there in the final version that gets passed, what do you anticipate will be the delay between when the budget gets passed and then when it translates into revenue for you? And then also, what is the margin profile look on that program as it moves into a flow rate production?

[Andrew C. Teich:]

So there is -- where we stand with that program is, yes, it's in the budget and the present -- the potential budget actually has been incrementing it up. We are currently in a process negotiating with the customer about the delivery's minimum qualities, timing of those, so that's something that we're real time. In terms of the turnaround time for first orders or when we expect to have that concluded in first orders, it could be in the second half of this year but clearly, by the first part of next year. There's a lot of variables in terms of what those minimum order quantities will be, what the expected volumes will be and then the presidential budget numbers. So we're expecting to see some first flow rate production orders probably in the second half of this year but definitely by the first part of next year.

[Yair Reiner:]

Got it. Good, I'll just try to sneak in one more, if I could. The security margins were pretty impressive in the second quarter, should we think of that as a new basis, kind of hard to understand what the run rate in that business given the volatility over the last 3 quarters.

[Anthony L. Trunzo:]

Yes. So there is -- the security business, we've opened up some channels. And we also introduced some new products and we're expanding the product line quite a bit, in fact, most of our segments were expanding our product line breadth. And as part of that, we had some new products in the recent quarters, which we introduced that some of them were bundles, some of them were our new offerings, that we were a little too aggressive. And as we kind of calibrated ourselves at where we could price those products, we were able to improve our margins. And going forward, we would expect to see kind of the margins that we obtained in this past quarter going forward.

[Andrew C. Teich:]

Yes, Yair, this is Andy again. The one other variable that affects security margins is what the content of thermal is in the overall profile. We had a pretty strong content in Q2, we expect that to continue. We've got new products that are being launched in the thermal space that will come out in the second half of the year. That's kind of a key kind of towards our overall margin improvement in the security business. It's a deeper penetration with thermal technology into the customer base and distribution base that we've established there.

[Yair Reiner:]

And on that front, any early indications of a demand for the IR bullet camera?

[Thomas A. Surran:]

We haven't. It's not shipping yet. So no, it's too early to tell.

[Operator:]

Our next question comes from Jonathan Ho with William Blair & Company.

[Jonathan Ho:]

Just wanted to get a little bit more detail around the sales management changes that you guys were making or self-structure change that you guys are making in the Surveillance division, and what types of actions are you guys taking? And sort of what sort of the goal or the direction that you think this can accomplish?

[Anthony L. Trunzo:]

Yes, sure. So Steve Williams was within our organization. He is a demonstrated performer. He formerly, was in the Reservoir [ph] business for the Surveillance. He is now in the top position. He is very disciplined. His execution is extraordinary. I think that what he'll be focusing more is a deeper engagement earlier with some of the program offices to make sure that we are aligned with where our customers are going on their needs going. And he's also restructured some of the staff, assigning people to those that kind of align the organization with that goal.

[Jonathan Ho:]

Got it. And just as we think about sort of the FLIR ONE, do you guys have much baked right now into the guidance or into expectation? And can you give us maybe a sense of whether this is a fairly modest amount or this is a pretty significant amount, just looking for some rough color around how we should think about the actual FLIR ONE contribution?

[Andrew C. Teich:]

Tiny stuff, John -- Jonathan. We had some expectations. We initially expected that we are going to ship in Q2 and that we would see some revenue in Q2, we didn't. In fact, OEM's performance of -- the strength of that performance is -- on the revenue line is despite the fact that we had some expectations for FLIR ONE deliveries that didn't happen in Q2. H2 expectations are very modest as to be I think not at all significant in terms of the outlook and how the performance of that product is going to affect the second half of the year. We've been very, very cautious there.

[Jonathan Ho:]

Got it. And then, you guys talked a little bit about sort of the Lepton core and some new products that are going to be coming out. Is there any sort of sneak preview you can give us? Just trying to get a little bit of color around that.

[Andrew C. Teich:]

Yes, at this point, we obviously don't want to disclose specifically what we're doing from a product standpoint, Jonathan, but the focus will be new categories within existing segments.

[Operator:]

Our next question comes from Peter Arment with Sterne Agee Group.

[Peter J. Arment:]

Andy, I wondered if you could just give us a little bit of some more color around I guess, how you're developing the OEM customers for Lepton. You've been in the cores business for a long time. Is this -- because it's different channels that you're going after initially, is there --this comes with more challenges or is it very similar?

[Andrew C. Teich:]

Yes, that's a great question, Peter. The interesting thing is that the -- in many cases, the types of customers that we're dealing with are different than historically what we have dealt with. We're seeing more consumer and industrial-oriented customers that have an interest in Lepton. And so I think that the development cycle of those customers are historically but the long-term potential is greater. Early -- very early interest was -- has been particularly strong in the UAV space. So we've engaged with several manufacturers that are manufacturing small, lightweight UAVs that fundamentally, there is no other alternative out there for them today than in Lepton. But we also think that there are a number of new opportunities that are being pursued right now in industrial automation and in some home intelligence products and those are markets that are new that wouldn't have necessarily been attainable using our previous Quark and power cores.

[Peter J. Arment:]

And how would you, I guess, gauge the level of interest comparing it to the CES to where 7 months later now where we are with, like, kind of a lot of those discussions?

[Andrew C. Teich:]

It's been quite steady. The cores group has been quite busy and the level of engagement has been steady. And as I've mentioned in the prepared comments, we've started shipping units at this point. So we've got 2 or 3 OEMs that are already now receiving shipments of product.

[Operator:]

Our next question comes from Jeff Kessler with Imperial Capital.

[Brian Denes:]

This is actually Brian Denes filling in for Jeff. Just a couple of questions for you guys. First one, we see the margins in the Surveillance segment come down from 29% during the first quarter of 2013 to now about 18%, with the backlog that's growing, what cost reduction measures are you guys taking to get those margins back up to historical levels?

[Andrew C. Teich:]

Yes. So we are taking some actions there specifically, in the functional area but we'll also be looking at production operations to make sure we improve the operating margins sequentially through this year and going forward.

[Anthony L. Trunzo:]

Brian [ph], it's Tony. There's some mixed dynamics associated with that as well. I would say that the margins in that business that we saw in Q2 were unusually low. The margins that we saw earlier in the year were pretty good given where the business is currently. But as we see shifts in the mix in that business, it can vary fairly meaningfully. Brian Denes - Imperial Capital All right, great. And this is my last question, so we hear and we believe that long-term trends of the U.S. government business is a reduction of revenues, so with the exception of FLIR ONE, how else can we see the infusion of the Lepton technology in commercially viable products?

[Andrew C. Teich:]

Well, there are a number of different opportunities that we're pursuing with Lepton. We believe that Lepton has sockets within each of the segments that we have in our business today. And again, I don't want to go into specific products that we're working on, but fundamentally, the fact that it is thermal imager that has both night vision thermal imaging capabilities, high sensitivity and temperature measurement capabilities, fundamentally, lends it to any of the markets that we're in today where we're offering thermal imaging technology. And it fundamentally creates a new category of products that can have a considerably lower selling point and also, a reduced feature set. But we believe that each of our markets has an opportunity for that type of product. As we've mentioned a couple of times already on this call, during the second half of the year, we'll bring products to market that will underscore what we're thinking here.

[Operator:]

Our next question comes from Brad Mas with Needham & Company.

[Brad Mas:]

This is Brad filling in for Jim. First off, with regards to Commercial business, wondering about the timing of new product releases and if it's going to be skewed more to Q4?

[Andrew C. Teich:]

Yes, it will be skewed more towards Q4, yes.

[Brad Mas:]

Okay. And then instrumentation is usually seasonally strong in the fourth quarter, do you see that staying the same or changing with the decline in the ASPs?

[Andrew C. Teich:]

Sorry, what segment?

[Brad Mas:]

Instrumentation.

[Andrew C. Teich:]

Oh, instruments. I don't expect that you would see a meaningful difference in the way we execute in Q4 relative to historical levels.

[Brad Mas:]

Okay. And then last one from me. With regard to Security, obviously a strong quarter, just wondering how you would characterize the growth rate on a normalized basis?

[Andrew C. Teich:]

Security is a market we feel very positive about its future opportunities. So you're going to see some stair-stepping going on, we're going to have some products that will become available at the back half of this year. We've talked about some of those at some of the recent -- some of the major trade shows. But we're going to expect to see long-term growth in that marketplace. Now, it's going to be stair-steps so we'll see through the balance of this year, maybe not. We'll see nice growth over prior year but relative sequential, then we'll introduce the new series of products. We're going to add a lot of products here in the second half of the year. We'll be expanding our distribution, especially internationally, on some of our visible offerings and combination of those, we should see kind of the next step, then the distribution bring it to the next step.

[Anthony L. Trunzo:]

Brad, I'll add one other point to that. If you look at our Security business, it's really got their 3 legs to the stool, there is the Lorex consumer DIY space, there is the FLIR-branded professional integrator class of visible product and then there's the FLIR thermal. The latter is probably the most lumpy, the FLIR thermal business, but as we expand that more deeply into commercial and industrial channels, I think it's taking some of the noise out of the volatility in that market. The thing frankly I'm most pleased about is how well that middle segment is doing, the FLIR-branded professional-grade visible products, it's growing at about the same rate that the DIY market is on the kind of high 20% range. But I'm very pleased to say that, frankly, because that's a very competitive space, and it's a space where there's some very strong brands in that space. So to see the FLIR brand getting traction in that space is a very positive thing for us. And also from a offering standpoint, it really strengthens our position because it allows our salespeople and it allows our integrated partners to go in with a complete solution of both visible and thermal products to address a specific customer need.

[Operator:]

We have a follow-up question from Pete Skibitski with Drexel Hamilton.

[Peter J. Skibitski:]

A couple of follow-ups on FLIR ONE, I thought it was a great break that you are going to be in all the Apple Stores, on Apple.com, I just wanted to verify, are you really going to be in every Apple Store nationwide or just kind of select major urban ones? And then do you expect to kind of move on to get into the big box retailers and other distribution channels thereafter?

[Travis Merrill:]

Hi Pete, this is Travis, thanks for the question. As we mentioned in the press release a couple of days ago, we're actually going to be starting selling FLIR ONE direct to consumer initially and soon thereafter, we'll be rolling out in Apple Stores. And that's really going to be done on a regional basis. And we really can't say more than that at this time with respect to the Apple Stores. But the second part of your question, which is sort of expansion beyond that, we're really taking a wait-and-see approach based on the initial dynamics of FLIR ONE, what the demand trends are. And we will -- we'll react accordingly, but we're clearly preparing for additional expansion and channels for that product. But at the same time, given the new nature of this category for us, we will sort of wait and see as we go into the fourth quarter.

[Peter J. Skibitski:]

Okay, understood. And then one follow-up on the apps. You guys mentioned in your July 22nd release, 3 apps in particular, and I was wondering would those be the only 3 apps available initially or will there be others. And then I wanted to know if -- are you going to actually get a fee for when people buy apps, I want to ask you about that?

[Jeffrey D. Frank:]

Yes, thanks, Pete. This is Jeff. We are initially launching actually 5 apps that will appear on the Apple website. Hopefully, they'll all be out there at the time of launch, there is the FLIR MX app, which is kind of the core operational app. Then there's 4, what we're calling accessory apps, that will come along with it

[Peter J. Skibitski:]

Okay, and then I know you've had tons of developers interested in further apps. What's your sense of how those will become available, sort of a timeframe?

[Jeffrey D. Frank:]

Well, we signed up originally about 2,500 developers, which was both exciting and encouraging. Kind of validated our thought of the FLIR ONE like the product was going to encourage innovation and create a bunch of new apps would emerge out of this. But we sort of came to the realization that 2,500 developers was not a manageable number. So we've taken a more structured incremental approach to how we're working with those folks. We've picked a handful -- we've culled through the 2,500 and we picked a handful, fewer than 20 developers that were deemed as early development partners, and each of these were kind of picked based on their viable interesting app idea, their ability to execute it and their willingness to act as a beta tester with our software developer kit that we've launched. And all of those folks currently have pre-production units, they've got beta versions of our SDK and we're giving them a lot of one-on-one support through the engineering team. So we're hopeful we'll start seeing new interesting apps emerge soon. We can't give you specific dates in terms of when it's going to come out or what those are going to be, but I'll just say that there's a pretty broad range of things that I think will be interesting to many different people in the marketplace associated with this.

[Operator:]

We have a follow up question from Tim Quillin with Stephens.

[Timothy J. Quillin:]

Just a quick follow-up on cash flows. But first, if you could give us an update on your strategy for improving inventory turns and how quickly you can get to your target levels. And then also, I think so far this year, cash from operations has been about 1.7x net income. Do have targets of where that might end up for the year?

[Anthony L. Trunzo:]

Tim, it's Tony. I would say that Q2 was -- we did okay, but it wasn't the greatest quarter we've had in the last couple, in terms of making progress on working capital. Part of that relates to what was happening at the end of the quarter on our expectations for some shipments on the Surveillance side of the business. Part of it relates to building inventory in advance with some expectations for deliveries under some programs later in the year. We've -- without going into detail about each individual segment, the performance in Q2 range from really good to kind of flattish. And it's those segments that didn't advance their objectives in Q2 that are going to get the focus in Q3. In terms of when we get to our targets, I'm of the view that you never get to your target because you're always wanting to make it better. But I think that between now and the end of next year, is the window for us to see some pretty meaningful improvement. We're still working to establish what we think the right targets are for each individual factory and that'll eventually roll up to the segment level, where we'll have a perspective in terms of what we think segment inventories ought to look like. We've made good progress over the last 5 or 6 quarters. I would like to see us make even more in terms of proportion. I'd like to see the next 5 or 6 quarters look even better than that previous 5 or 6. To your question about cash from operations, you're right, it was around $170 million relative to net income in H1. We don't typically give guidance in terms of what we expect cash flow to look like throughout the year. But I would anticipate, given kind of what I just described to you, and absent any other kind of major changes to the business that we'd see performance in H2 that was similar to or maybe a little bit better than what we saw in H1.

[Andrew C. Teich:]

Operator, we'll take one more question.

[Operator:]

There are no further questions at this time.

[Andrew C. Teich:]

Great. Good. Well, I'd like to thank everybody for joining on the call today. Again, we continue to be focused on executing against the restructuring and realignment that we've put in place, leveraging the new technologies that we've introduced to the market, and improving our marketing communications as we develop the new markets for our products. We're looking forward to the second half, and we'll see you after Q3. Thank you.

[Operator:]

Thank you. This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.