FLIR Systems, Inc.
Q3 2014 Earnings Call Transcript

Published: 24 Oct 2014

[Operator:]

Greetings, and welcome to the FLIR Systems Third Quarter 2014 Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It's now my pleasure to introduce your host, Todd DuChene, Senior Vice President, General Counsel and Secretary for FLIR Systems. Thank you. Sir, you may begin.

[Todd M. DuChene:]

Good morning, everyone. Before we begin this conference call, I need to remind you that statements made on this call other than historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and are based on our current expectations. Words such as anticipates, estimates, expects and believes and similar words and expressions are intended to identify forward-looking statements. All of these statements are subject to risks and uncertainties that could cause actual results to differ materially. Please refer to the press release we issued earlier today for a description of factors that could cause actual results to differ materially from those forecast. The forward-looking statements we make today speak as of today, and we do not undertake any obligation to update such statements to reflect future events or circumstances. Let me now turn the call over to Andy Teich, President and Chief Executive Officer of FLIR Systems. Andy?

[Andrew C. Teich:]

Thanks, Todd, and thank you, everyone, on the line for joining us this morning for FLIR's third quarter 2014 earnings call. With me on the call today is our CFO, Tony Trunzo; COO, Tom Surran; Chief of Product Strategy, Jeff Frank; and our Chief Marketing Officer, Travis Merrill. I'd also like to introduce our new General Counsel and Secretary, who you just heard from, Todd DuChene, who joined FLIR last month. Todd brings more than 20 years of public company experience, most recently with Nuance Communications, National Semiconductor and Solectron. His experience with commercial contracts, litigation, intellectual property management and M&A will be a welcome addition to our team. This morning, we reported third quarter revenue of $375 million and GAAP earnings per share of $0.37. 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, Q3 earnings were $0.39 per share. Revenue increased 5% versus the third quarter of 2013, as 11% growth in our 4 commercially oriented segments was partially offset by a 4% decline in Surveillance and Detection segments. Our profitability continues to improve, with operating margin before restructuring charges increasing 200 basis points over the prior year and reaching 20% in the quarter. Our restructuring efforts are nearing completion, and we experienced approximately $6 million of benefit from these actions in the third quarter, with similar savings expected going forward on a quarterly basis. Additionally, our total backlog grew $31 million over Q2 to reach $579 million, which is our highest backlog in 5 years, and was driven by strong order flow in all segments except Detection. Our Lepton-enabled FLIR ONE iPhone accessory began shipping in August and is currently available on the FLIR website, at Apple Stores and on apple.com. Customer and media feedback has been positive, and we're very encouraged by the exposure the FLIR ONE launch has provided to the FLIR brand and by the many new potential customers who've been educated on thermal imaging and its applications. We expect to continue to develop and launch additional FLIR ONE variants for other mobile platforms in 2015. During the quarter, we announced 2 other products that incorporate our revolutionary Lepton thermal core, the AX8 unattended temperature sensor, and the $499 TG165 imaging spot temperature gun, both of which will begin shipping in Q4. These products create new categories for us, which we expect to drive incremental demand. Based on our third quarter results and our current view of the business, we are narrowing our outlook for the full year 2014. We now expect revenues of between $1.48 billion and $1.53 billion for the full year and earnings per diluted share in the range of $1.43 to $1.48, excluding expenses related to restructuring actions. With that, I'll now pass the call over to Tony to review the third quarter financial results. Tony?

[Anthony L. Trunzo:]

Thanks, Andy. The following discussion of Q3 2014 results excludes restructuring costs totaling $4.1 million pretax or $0.02 per share. I'll also refer everyone to the summary presentation of third quarter financial results available on our website at www.flir.com/investor. Overall, we finished the quarter with revenue of $375.4 million, an increase of 5% compared to last Q3. Consolidated gross margin was 49.1% and was 80 basis points better than last year. Segment operating expenses, excluding restructuring charges, were up by 1% compared to last year, while corporate expense of $15.1 million were unchanged compared to last year and down by 11% compared to Q2 of this year. Net income before restructuring expenses was $55.9 million and earnings per share excluding restructuring were $0.39, an increase of 22% compared to Q3 of 2013. Surveillance segment revenue of $119.1 million was 6% below last year, but up 13% sequentially, while segment operating income improved by 2% compared to last year, due to a 3 point increase in gross margin and a slight decline in operating expenses. Year-to-date, Surveillance operating income before restructuring is down by 24% on 13% lower revenue. The Instruments segment continued to perform well in the quarter, with a 7% increase in revenue and a 31% increase in operating income. Gross margin improved by 2 percentage points, and operating expenses before restructuring were 7% below last year. Year-to-date, Instruments operating income of $74.5 million represents an increase of 18% compared to last year on a 6% increase in revenue. OEM and Emerging segment revenue increased by 2% compared to Q3 of last year, while operating income of $16.1 million was down by 4%. Segment gross margin declined slightly, while operating expenses increased by 6% due partly to higher research and development spending. Segment operating margin in Q3 was a strong 28.7%, but down 2 percentage points from last Q3. Year-to-date, OEM and Emerging revenue is up 10% and segment operating income is up 5% compared to the first 9 months of last year. Our Security segment performed very well again in Q3. Revenue of $48.6 million represented an increase of 37% compared to last year due to very strong sell-through and expanded distribution of our Lorex-branded products as well as growth in our thermal camera product line. Operating income increased by 57% to $7 million as gross margin improved by 1.2 percentage points and operating expenses declined by 60 basis points relative to revenue. Year-to-date, Security segment revenue is up 24%, while operating income is up by 20%. Maritime revenue increased by 8% from last year, led by strength in our Raymarine product line. Gross margins were up 60 basis points from last year and operating expenses were flat, resulting in a 3.2 percentage point increase in operating margin. Year-to-date, Maritime revenue is $152.5 million, up by 4%, while operating income of $23 million is up by 13%. Detection revenue increased by 6% compared to Q3 last year and operating expenses were down by 13%. Operating income was up by 2% and was negatively impacted by lower gross margin due to unfavorable mix. Year-to-date Detection revenue of $59.5 million is down 13% from last year, while operating income of $6.3 million is down 40% from last year. Operationally, the restructuring actions we announced in Q4 of last year are nearly complete and we are seeing meaningful benefits. As Andy mentioned, during the most recent quarter, we saw cost savings in excess of $6 million from these activities and anticipate benefits at this level in Q4 as well. Restructuring costs during the quarter totaled $4.1 million before tax. $3.7 million of this amount was booked in our Instruments segment and was due to additional employee termination costs related to the closure of our former French operations. During the quarter, we concluded the sale of certain noncore assets of our Optical Components Group for $12 million in cash. Post-sale, we retained the strategically important intellectual property and other assets associated with the fabrication of wafer-level optics. The transaction resulted in a pretax gain of approximately $4 million that is reflected in other income. On a consolidated basis, during the quarter, we saw a 6% increase in 12-month backlog to $579 million. Year-to-date, backlog has increased by 18%. Revenue from the U.S. Government declined by 24% compared to Q3 of last year and constituted 18.2% of consolidated quarterly revenue. Consolidated revenue from sources other than U.S. Government increased by 14% compared to Q3 of 2013. Year-to-date, U.S. Government revenue is down by 23%, while revenue from all other customers is up by 8%. Cash flow from operations, including the impact of restructuring, was $33 million for the quarter, representing 62% of net income and the poorest showing in 3 years. This result was primarily due to higher accounts receivable in our Surveillance and Detection segments, which we expect to reverse during Q4. Year-to-date, cash flow from operations of $163.4 million represents 128% of net income. Our Q3 tax provision of $17.6 million was equal to 25% of pretax net income, reflecting a 50 basis point uptick to our expected tax rate for the year. During the quarter, we paid $14.2 million in dividends and spent an additional $33.6 million to repurchase 1 million shares of our common stock at an average price of $33.62 per share. Capital expenditures were $15.1 million in Q3 and are expected to tick up in Q4 as we progress the build-out of our new facility in Santa Barbara, California. We ended the quarter with cash on hand of $565 million, providing ample liquidity to continue returning capital to shareholders as well as to pursue strategic acquisitions. We continue to actively seek opportunities for strategic M&A to enhance our competitive position, expand and attract new business segments and effectively deploy our capital. Today, we also announced our regular quarterly dividend of $0.10 per common share that will be payable on December 5 to shareholders of record as of November 18. This concludes the summary of our third quarter financial results. Let me now turn the call over to Tom Surran to cover the segment operating highlights.

[Thomas A. Surran:]

Thank you, Tony. We saw year-over-year revenue growth in 5 of our 6 segments in Q3. While Surveillance was the only segment with a decline in revenue versus last year, this segment grew revenue sequentially, improved operating margins and generated good order flow. Segment operating margin, excluding the Q3 pretax restructuring charge of $4.1 million, was 2 percentage points better than the third quarter of 2013. Total order backlog reached $579 million and was up materially over both the prior quarter and prior year. Revenue in the Surveillance segment declined 6% versus the third quarter of 2013 due to higher shipments of MSC and its international variant in the prior year, as well as weaker revenue from man-portable systems this year. This softness was partially offset by good growth in our airborne systems. Surveillance had strong order flow with a book-to-bill ratio of 1.3, resulting in backlog of $340 million, which is up $32 million over Q2 of this year. With cost savings from our restructuring initiatives, beneficial product mix shifts and improved product costs, Surveillance operating profit, excluding restructuring charges, grew 2% over the prior year and 56% over the last quarter. The Instruments segment. Third quarter revenue grew 7% versus the third quarter of 2013. This growth was driven by our entry-level Ex-Series cameras and our automation products. This revenue growth, combined with improved gross margins and lower operating expenses, resulted in a 31% increase in operating profit, excluding restructuring charges, which represents a 600 basis point improvement. The Instruments segment introduced a host of new products during Q3, including the 2 new Lepton-based products mentioned by Andy. The AX8 is a Lepton-based, small-format network thermal camera that supports multiple network protocols and video formats and is designed to provide automated equipment monitoring and pre-emergent fire detection. This product's small form factor is optimized for constrained environments, such as electrical panels, engine compartments and factory production lines. The AX8 also utilizes our proprietary MSX software, so users can stream pure thermal, pure visible or MSX video for reporting and monitoring. The second Lepton-based product introduced was the TG165 handheld imaging thermometer. This rugged product mixes a non-radiometric thermal image of a scene with a spot temperature measurement of a laser thermometer. Priced at $499, the TG165 fits nicely between standard spot thermometers and our thermal imagers. Both of these products will begin shipping in volume during Q4. Instruments also introduced the G300 a, a gas-imaging camera core for integration into either fixed or mobile enclosures to provide continuous monitoring of pipelines and installations. Also introduced were 4 new additions to the FLIR-branded test and measurement product line. We will be continuing to expand this product line as we establish it as a premier test and measurement brand. The OEM and Emerging segment grew revenue 2% over the third quarter of last year. The introduction of the FLIR ONE added new revenue to the segment. However, that growth was partially offset by reductions in our intelligent traffic business and our low-light camera core products. In September, the OEM business launched our latest camera core called Muon. This low-cost thermal core utilizes industry-standard interfaces to ease system integration for OEM customers. The Muon core will begin shipping in Q4. The Maritime segment achieved year-over-year revenue growth of 8%, driven by strong sales of Raymarines, multifunction displays, autopilots and instruments. Maritime's thermal camera revenue was flat versus last year. However, we built backlog during the period of the recently introduced MU, MV product line, which was recently awarded the 2014 National Marine Electronics Association, or NMEA, Technology Award. The MU, MV was 1 of 3 of our products winning awards from the NMEA, with the other 2 being the Evolution autopilot for Best Autopilot and the MV-604 thermal imager for Best Marine Specialty Product. Also introduced during the quarter was the CP200 sonar, which provides Raymarine's proprietary SideVision technology to network systems. Maritime operating margin increased over 300 basis points, resulting in a 57% growth of operating profit as compared to Q3 of 2013. The Security segment grew revenue 37% versus Q3 of 2013, driven by strong results from all lines of business. Our thermal security business saw over 50% growth year-over-year, driven by high-end cooled camera projects. Lorex-branded product revenue was up 30% versus the prior year as a result of an expanding retailer footprint and better sell-through. Additionally, FLIR-branded visible security systems grew 37% versus Q3 of 2013, as we continue to penetrate the professional level of the market with our brand. Security operating margin improved 180 basis points in comparison to the prior year and 120 basis points compared to the prior quarter. The Detection segment's third quarter revenue increased 6% versus the prior year, due primarily to shipments of low-rate initial production units to the DRSKO program. Detection operating margin was largely in line with the prior year, as restructuring cost savings experienced during the quarter were offset by weaker gross margins. That concludes my summary of the segment's third quarter. I will now pass the call back to Andy.

[Andrew C. Teich:]

Thanks, Tom. We're pleased with the results of this third quarter and are seeing the positive effects of our new organizational structure. Our key initiatives to drive long-term growth and profitability in the business continue to pay off. As we look forward, we expect to see further leverage -- we expect to further leverage our core technology platform, product innovation cadence and our rapidly developing marketing capability. I also want to thank the employees of FLIR for their continued support and dedication to executing against our growth plans. That concludes our comments on the third quarter. We'll now open the call up for questions. Operator?

[Operator:]

[Operator Instructions] Our first question today is coming from Pete Skibitski from Drexel Hamilton.

[Peter J. Skibitski:]

Andy, so what's your feeling on Surveillance now? I mean, you've had 2 straight quarters of pretty meaningful backlog growth. Does it feel like the business has about bottomed at this point? Should we expect to see it up year-over-year in the fourth quarter and going into 2015 with the backlog that you're seeing?

[Andrew C. Teich:]

Well, a couple of things on that, Pete. First is that we did see good order flow in Q3, so more typical to what we would expect to see in a Q3 from a seasonality standpoint. I would say that that's what we're expecting for Q4 as well, and what I mean by that is more typical sort of, from a seasonal basis, orders in Q4. So it would be similar to what we saw in Q4 of last year. I think at this point, we're not in a position that we can call a bottom on this. There's still a fair amount of uncertainty in terms of funding availability where we've seen strength in the Middle East region, which has been a trend that we've seen over the last several quarters, but we're also seeing a little bit of weakness in the European region. So -- and I would say that the U.S. DoD environment continues to be one that we're concerned about in terms of its predictability.

[Peter J. Skibitski:]

Okay, got it. Understood. And then one last one, I'll hop back in the queue. Security, the growth has obviously been kind of blistering the last 2 quarters and you mentioned all 3 of the lines of business are up. Can you get to -- help us understand what's driving that? Is that all just -- I know Lorex you've been building out distribution. You've got some new product. Can you give us some more color maybe on what the driver is now and how long it can last?

[Anthony L. Trunzo:]

Sure, Pete. I'll mention a couple of things, and I'll flip it over to Tom for a couple of comments as well. Lorex, the -- in the Security segment, as you mentioned, we've got a 3-segment approach to that market, and that is the Lorex brand for consumer, the FLIR brand for professional video and integrator class of product and then the FLIR thermal products. And all 3 of those cylinders are firing well at this point. It's fueled by good demand, so we've got a good product offering and value proposition there. It's fueled by new product development, so we've been -- had a fairly rich cadence of new product development there. And then we've also been building out our distribution strategy fairly aggressively there. We saw good growth in the first 3 quarters of the year. I think it will probably cool off a little bit in Q4 based on our current forecasts. But overall, we'll see the year finish quite strong. Tom, you want to add any comment?

[Thomas A. Surran:]

Yes. The one part of it was the question about the sustainability of that growth. Clearly, the growth will not be perfectly linear, but we expect that the growth to be a long-term phenomenon. We are introducing a number of new products to all 3 of the markets that we're targeting, both the home, the professional visible, as well as the thermal that we think are going to be driving that growth. And as Andy mentioned, we are expanding our distribution outlets, both in the number of outlets we have in the markets we currently serve, as well as expanding geographically.

[Peter J. Skibitski:]

Tom, let me just do one follow-up. When do you drop a thermal core or a Lepton into the Lorex systems?

[Thomas A. Surran:]

We would have liked to have had that already out there. But what we did is we pulled back and we're going to be introducing it here in the fourth quarter. And one of the things we've added to it is a multi-protocol kind of interface, so that one product can be used by an installer to have an analog stream of video, a digital stream of video, or a digital over coax stream with one product, and we'll have that here in this fourth quarter.

[Andrew C. Teich:]

Pete just one clarification, that will come out under the FLIR brand, so we don't yet have a defined date when you will see thermal products under the Lorex brand [ph].

[Operator:]

[Operator Instructions] Our next question is coming from Noah Poponak from Goldman Sachs.

[Noah Poponak:]

Andy, I wondered if you could just elaborate on the comment you just made there about still being concerned about U.S. Government revenue. Obviously, sequestration's still flowing through, and so it's not the best backdrop. But you can see where sequestration ends, you can see the bottom in the total budget. Presumably, you can see that in some of your programs. You had good order flow. So I'm just wondering if that is something you see from a budgetary perspective in your specific programs or something your customer is saying to you versus just you're saying that because this business has been so brutal that you're just being cautious and you don't want to get ahead of yourself.

[Andrew C. Teich:]

Well, some of your last statement in there is correct. But I would say 2 things. I don't think that we can clearly see the end effects of sequestration here. That's not what we're hearing from our customers. I think that they're increasingly concerned about it, having an increasing impact in 2015 and in 2016 as the full effects of sequestration roll out. The second issue is, is our conservatism, and I would say some level of concern in the space is also based on just trends that we're seeing in the marketplace, which are programs that get delayed and the lack of new program starts involving ISR technology. Generally, we feel -- we still feel that the equipment feeding into the ISR space has got a good future in terms of the futility. It's a great force multiplying technology. And as I've stated many times before on these calls, we very much believe in the concept of fielding equals funding, and FLIR technology was extensively fielded in the most recent conflicts, but that has yet to drive defined and funded programs of record that we see increasing our revenue in the near future.

[Noah Poponak:]

So what has the peak to trough been now in your U.S. Government revenue?

[Anthony L. Trunzo:]

I'll get that while we're -- Noah, it's Tony. I'll get that while we're talking here. I mean, quarterly, it was -- I can go back to...

[Andrew C. Teich:]

If we look at it as a percentage of revenue, is that what you're asking, Noah?

[Noah Poponak:]

Yes.

[Anthony L. Trunzo:]

So in…

[Andrew C. Teich:]

That was the highest on these.

[Anthony L. Trunzo:]

On a quarterly basis, the highest we ever got was 48% in Q1 of 2009. And in that quarter, that was nearly $300 million in U.S. Government revenue.

[Andrew C. Teich:]

Yes, we had 2 things going on there. We had the rate program at its peak in terms of revenues, number one. And then on the other side, there was some economic downturn drag on the commercial businesses at that time.

[Noah Poponak:]

Right. Yes, I guess the real question is what's the peak to trough been excluding that? But, I mean, we have the numbers, and I can take that offline. I also wanted to ask you if you could just speak to what you're seeing in the commercial businesses in Europe broadly, just given what we're all seeing from a macro perspective there.

[Andrew C. Teich:]

Well, at this point, we're certainly a bit concerned about what the trends are going forward in the European market. We haven't yet seen any meaningful effect from that. I would say that Q3 executed within our expectations on the commercial side of our business for Europe, but we're a bit concerned about what we might see in Q4.

[Noah Poponak:]

Okay. So you haven't actually seen much yet, you're saying? You haven't seen much disruption recently?

[Andrew C. Teich:]

No.

[Thomas A. Surran:]

No, we haven't.

[Andrew C. Teich:]

You're talking about the commercial businesses there?

[Noah Poponak:]

Yes.

[Operator:]

Our next question today is coming from Tim Quillin from Stephens Inc.

[Timothy J. Quillin:]

Could you give us some sense of how we should think about margins as we progress from here? So it looked like you saw quite a bit the benefits of your restructuring in the quarter, and I think you said you expect that $6 million in savings to carry on. But -- and do you have any kind of gross margin or operating margin targets you could share with us or ways that you could help us think about where margins might go next year or the year after?

[Anthony L. Trunzo:]

Tim, it's Tony. The way the business has evolved, you sort of have to look at margins on a segment basis. And the mix between segments is going to have some impact on margin. I would say, overall, from a gross margin standpoint, we'd like to continue to progress margins up, and we'd like to see them trend up back over the 50% line. I was -- just as we were getting ready for the call, I was looking at our sequential numbers, and we haven't -- the last time we had gross margins over 50% was in Q1 of 2013. I'd like to see us get up over that again. It's obviously going to depend on mix. We've got some businesses that have gross margins in the 30s, and we've got some businesses that have gross margins well into the 50s and products that have margins well above that. But overall, I think we'd like to see an upward trend in gross margins across the businesses. In terms of spending, we're going to try to grow spending slower than we're growing -- than we grow revenue. The benefits of the restructuring have been masked a little bit by the fact that particularly in Q3 -- last Q3, we had a slight reversal, basically a slight credit, globally in the company related to bonus accrual for the year. This year, we had an expense because the business is doing better. But overall, the restructuring, I think, is going to drive more than that $6 million a quarter as we roll into 2015. And I think you'll see a lot of what I'll call soft benefit from the standpoint of improved documentation of products, improved quality of products, maybe lower warranty costs, maybe some additional production efficiency associated with the fact that we've got fewer, small, relatively high-cost locations, and we've brought our production into a more consolidated, more sophisticated, better cost structure kind of environment.

[Timothy J. Quillin:]

That's helpful. And then maybe I'll have 1.5 follow-ups we'll call it. But first, you explained in terms of FLIR ONE the primary benefit of that product is in branding and exposure. But maybe if you could talk about how that has gone so far, the sales of that product and then maybe sales targets or where you are going to be relative to breakeven on it. And then the half question is if you could just discuss the currency impacts that you saw or might see in the future.

[Andrew C. Teich:]

Well, I'll start with that, Tim. This is Andy. The -- in terms of sales volumes for FLIR ONE, we don't want to talk about specific volumes. But I would say that the sales of the product to date have been within our expectations. The channel development of the product has been going well. We've seen very good sales of the product online through the flir.com channel and through the Apple channels that we have. And at this point, the product has only been available from a geographic standpoint, largely in the U.S. and then we just recently brought a couple of channels on in Europe, and we'll continue that geographic deployment in Q4. The other issue though with FLIR ONE has been its exposure from a brand standpoint, which has been quite successful. And I'll actually pass it over to Travis to talk about that. But then you brought up one other thing, before I pass it over to Travis, which is the issue of breakeven, and that's not an issue. I mean, we're well through breakeven on the product right now. Financially, it's been very successful. So Travis, why don't you talk a little bit about the exposure metrics that we've seen on the product.

[Travis Merrill:]

Sure. Thanks, Andy. As Andy indicated and as we've stated, really, since we introduced this product, one of the major objectives of it is really to raise our brand awareness, as well as introduce a lot of new customers to thermal imaging technology. We feel like thus far that's been going extremely well. We've seen essentially a doubling in the traffic on flir.com. Year-over-year, if you were just to look at Q3 period, which has been very encouraging, a lot of that has been driven by FLIR ONE as well as some development that we've done on our website and enhancements we've made to our website. Secondly, I would mention as well, just in terms of the media effort that we've had around it. First, in terms of paid media, we've developed a lot of video, both sort of educational as well as more consumer-focused humorous video. We've seen in excess of 20 million views on video related to FLIR ONE, both FLIR-developed as well as third-party video. So that's also been a banner for this company in terms of the number of eyeballs that we've received just over the past few months. And then the third thing I would mention is just around PR. It's also largely been the highest acclaimed launch that we've had at FLIR, and we've received over 600 articles on the PR side. So all of that combined really equals a lot of new people who know about FLIR, a lot of new people who are learning about thermal imaging technology. And from the data that we've seen thus far on the buyers of the FLIR ONE, the majority of those are using it for personal use. So we're really opening a new market and that was really the primary goal from the start.

[Anthony L. Trunzo:]

And then, Tim, relative to your question about currency. This is Tony. If you look at Q3 of last year compared to Q3 of this year, currency was about a 20 basis point headwind to revenue, so not a huge impact. Obviously, the September strength of the dollar had a little bit more impact. So if you look at Q2 of this year to Q3 of this year, it was about a 1.3 percentage point headwind to revenue. I think you notice that we have a fair bit of costs in non-U.S. currencies. We've got a fair bit of euro costs, some sterling costs and pretty substantial costs in Swedish kroner. So the impact, when you flow it all the way through to P&L, tends to be muted by that natural hedge. But the number Q3-to-Q3 was -- frankly, was a little less than I had expected given what had happened with the dollar in the most recent quarter.

[Operator:]

Our next question today is coming from Peter Arment from Sterne Agee.

[Peter J. Arment:]

The question, I guess, maybe for Tom. In the Instruments segment, you talked about, I believe, firefighting and the automation product revenue being up very strong. What's behind that? Is there -- I know you'd changed some of the distribution channels in firefighting going back. And maybe a little more color on that first.

[Thomas A. Surran:]

Sure. Two -- so actually, the answer's just kind of the same for both, and it's the products. I mean, we've introduced 2 new products already to fire. And so year-over-year, we're gaining traction in the marketplace, creating greater awareness. And people who are experiencing the product are realizing the caliber and the quality that it offers to the firefighter. And in automation, we've introduced new products that are expanding the capability. Even prior to the AX8, we had some new offerings that were lower cost, had better integrations. We've modified our software. We've made it easier for installers to get information out of the units. And the combination of the stronger products has driven that revenue growth. And as we look forward to both of those markets, we're going to also have some new product introductions coming up in the next year in both segments that we think will further drive revenue growth.

[Peter J. Arment:]

Okay, that's helpful. And, Andy, just unrelated to that. On the OEM and Emerging, part of the strategy with Lepton is obviously to drive adoption for the Lepton sensor with OEMs. Can you update us on any color on the discussions with that and how that roadmap looks?

[Andrew C. Teich:]

So 2 aspects to the roadmap. One is the market development, and we continue to develop new OEM partners for the Lepton product. And there is, as we've mentioned on previous calls, a fairly long time cycle related to that in terms of their integration of the product into their end systems and bringing those to market. But we've got several vectors that we're pursuing there, and the interest continues to be quite high on the Lepton product. The second area is with regard to product development, and we also have mentioned this previously, but I will underscore it, that the Lepton is the first product to come out, in that family of product, utilizing the core technologies that we've developed to enable that low-cost core. And we will have subsequent introductions around that product line in 2015. At this point, we've got Lepton available in a couple of different variants with different wafer level, optic configurations, offering different fields of view that allow the product to be fielded in different applications, and a couple of those we're using ourself right now in our security and automation base products.

[Operator:]

Our next question today is coming from Jim Ricchiuti from Needham & Company.

[James Ricchiuti:]

Just a question on the OEM and Emerging markets. The deceleration in growth that you experienced in this past quarter, how much of that is just due to the fact that you had it looks like a pretty strong quarter a year ago? But just in general, can you comment on that? And then I have a follow-up, Andy.

[Andrew C. Teich:]

Well, I think that the growth that we saw in OEM and Emerging came from each of the segments within there. We saw -- there was no real standout in OEM. Tom?

[Thomas A. Surran:]

Yes, I can add some comments. So it is a lumpy business. So I think Andy has covered this many times about the nature of that business. And in particular, what we saw in the recent quarter was a bit of softness in our cooled cores for that customer. Now the timing of that particular customer, both in the product deliveries as well as the service for that customer is such that, that also is lumpy. And we have continuing business, and we would see that. Overall, we don't see other than -- actually, in our uncooled cores, we actually see fairly good strength in the base that we've seen as well as the take rates those customers that are taking.

[Anthony L. Trunzo:]

Yes, there was good volume growth in uncooled cores. There's very good volume growth there. And as Tom said, we mentioned in the script that the intelligent traffic business, which is part of that segment didn't have particularly a great quarter. There were some deliveries in Q3 of last year that were pretty strong in that business that we didn't see in Q3 of this year. And the FLIR ONE is in that business, so it did -- it added to the revenue. And as Andy indicated, it's making money. But on an overall basis, the operating margin you see from that isn't quite what you would see, at least not yet, that you'd see from our cooled and uncooled cores business.

[James Ricchiuti:]

Got it. And then just switching gears, just more broadly to the range of revenues that you're suggesting for Q4 and it's fairly typical wide range. But I wonder if you can comment a little bit more about what areas of the commercial business that there's perhaps more variability from where you sit today relative to your guidance?

[Anthony L. Trunzo:]

I think the variability is not on the commercial side of the business, really at all, Jim.

[James Ricchiuti:]

Okay. So you think it's -- so it's primarily on government? That's...

[Anthony L. Trunzo:]

Yes.

[Andrew C. Teich:]

Yes.

[Anthony L. Trunzo:]

Yes. I think we have a pretty tight range around what we think we're going to see from our commercial businesses.

[James Ricchiuti:]

And can you elaborate on what you're seeing in the government side that -- is there any one particular couple of programs? Or is it just more broadly, just in general, the environment with the U.S. DoD and maybe some international customers?

[Anthony L. Trunzo:]

So a couple of things. Number one, you've seen -- it's interesting, in Q3, I think some of this data is in the deck that we put on the website, which I hope everybody finds to be useful. It's the first time we've done it, and we're anxious to get your feedback because I think it's something we'll do going forward, but there were not a significant number of large orders in the -- particularly in the Surveillance business in Q3. The bookings were -- they were pretty broad based, which is a good thing. But the U.S. Government portion of that business last quarter was only 33%, which is really low. International deliveries in Q3 and in Q4 are going to be substantial. And there are, I would always say, incremental risks with respect to timing in those kinds of businesses. You have acceptance exposure. You have licensing exposure. And even when you have the backlog, there's some variability in terms of establishing exactly what the timing of delivery is going to be. Tom or Andy or...

[Andrew C. Teich:]

That's perfect. Yes, that's exactly the issue that international deliveries have more risk associated with them than U.S. deliveries, and that's what gives us the range of revenue.

[Operator:]

Our next question today is coming from Michael Ciarmoli from KeyBanc.

[Michael F. Ciarmoli:]

Maybe if, Andy, we could stay on the commercial side and maybe look at the performance of some of the international markets. I mean, I guess, your European revenue's flat year-over-year and you've got a pretty tough comp. I think you did $110 million fourth quarter last year. What are the bookings trends telling you? I mean, do you think you can continue to remain flat in that sector or in that region? I mean, just trying to get a sense of what we've seen with the erosion in global growth and how that's going to impact kind of the go-forward business even in 4Q and maybe next year.

[Andrew C. Teich:]

Well, so given what we're seeing going on in Europe right now, it is an area of concern for us in terms of growth. But that said, we saw better growth than we expected in the U.S. market in Q3 and we also saw good growth coming out of APAC. So at this point, we factor that into our plans for Q4. We're not expecting to see growth in the European market in Q4, but we do expect to see continued growth in the U.S. market. We combine -- as we look at the businesses, we combine Middle East together with Europe, so we get a little bit of offset from the Middle East region as we look at EMEA in total, where we are continuing to see growth. But we're being, I think, appropriately cautious about what we expect to see in Europe in Q4.

[Michael F. Ciarmoli:]

Okay. What about APAC as well? I mean, we're certainly seeing slowing there. I mean, what are your bookings trends telling you on a sequential basis?

[Andrew C. Teich:]

APAC had a good quarter in Q3. At this point, coming back from our sales forces, they're a bit more conservative about Q4, and that we've also rolled into our plans at this point.

[Michael F. Ciarmoli:]

Okay, okay. And then just to get back maybe on Jim's line of questioning. Instruments declining on a sequential basis, I mean, was that just more product lumpiness? Or anything jumping out there that caused that deceleration or that decline on a sequential basis?

[Anthony L. Trunzo:]

I think you're looking pretty deeply into the details. It went from $86.3 million -- no hang on. It went $83.9 million to $82.5 million.

[Michael F. Ciarmoli:]

Yes. Well, I mean, even that, Tony, I mean, it hasn't grown. It hasn't grown all year on a sequential basis.

[Anthony L. Trunzo:]

Instruments?

[Michael F. Ciarmoli:]

Yes.

[Anthony L. Trunzo:]

It's up 6% year-to-date.

[Andrew C. Teich:]

Yes, yes.

[Anthony L. Trunzo:]

I mean, Instruments is typically...

[Andrew C. Teich:]

This quarter was...

[Michael F. Ciarmoli:]

Well, on a sequential, I mean, it's basically been running about $83 million, $84 million.

[Anthony L. Trunzo:]

Which is not unusual. I mean, you look at last year, it went $78 million, $80 million, $77 million in the first 3 quarters.

[Michael F. Ciarmoli:]

Okay. Okay. So nothing unusual there? I mean, even with the product introduction, everything performing as you guys expect?

[Anthony L. Trunzo:]

Yes, nothing unusual there.

[Operator:]

Our next question today is coming from Jonathan Ho from William Blair.

[Jonathan Ho:]

I just wanted to start out with sort of the new products that you guys are going be introducing, particularly on the spot thermometer side of things, as well as, I guess, the new industrial types of application. How big of a market do you think that can be? And sort of what's the time frame for the ramp that you're expecting, maybe size of revenue? Just anything that you can give in terms of color around what the opportunity looks like?

[Andrew C. Teich:]

Well, the -- as you mentioned, there are 2 products that we're talking about here. First is the TG165. And the purpose of that product is to fill the gap in, in between a spot temperature gun and a full-featured thermal imager. So this is a new category for us and a new segment that we're addressing. The initial orders for the product have been quite strong. But largely, that's been channel fill. So at this point, I think it's too early for us to really understand what adoption rates are going to be, but the distribution channel really likes the product. So I would say in terms of a ramp of initial volume, it's one of the highest that we've ever seen in the Instruments segment. The second one is the AX8, which is a new low-cost product for automation and pre-emergent fire detection application. And this is an application that we've seen availability in that application for about a decade now, and Lepton really enables the price point that we believe could spark considerable demand in that space. We haven't started shipping that product yet. We'll start shipping it later in Q4. I don't expect that we're going to see strong results from that product in '14. It'll really be a 2015 product. It'll be largely channel fill in some initial market development of that product this year. Given that it is an automation machine vision product and some of the applications in manufacturing, that it'll suit, it'll require a system integrator involved in the loop to develop the complete closed loop solution for it. However, we also see applications for this product in data server rooms, engine-ing room monitoring, other equipment monitoring where it can be used as a stand-alone product with the basic built-in analytics capabilities that are in the product today.

[Jonathan Ho:]

Got it. And then you guys have talked about sort of doubling in unit volumes, pretty substantial increases in sort of the number of products that you've been selling. And yet, we haven't seen the revenue sort of growth rates on the commercial side pick up relative to that. I just want to get a sense of, number one, is this because there's still slowness in the high-end segment of the products? Or have we reached a point where we're going to start to see a bit more of an inflection point and these lower-end products that are presumably higher volume start to drive the growth starting in 2015? I just want to get a sense for how you guys think about that.

[Andrew C. Teich:]

Well, Jonathan, I think you've hit on the 2 points. We haven't seen strong growth in the higher-end products. There's been slow growth there, and we do have some new product introductions that are coming in that space that we feel will stimulate some additional demand, both on the replacement cycle and as those people who have bought the lower-end products upgrade to higher-end capability because we have seen that historically as well. The other issue is, is that we do believe that these markets are still very thinly penetrated and that the overall awareness building that we're doing, both through the deployment of these low-end products directly in the market and through brand building in adjacent markets with products like FLIR ONE and in the security space, that ultimately, that will help drive demand to more of an inflection point in terms of revenue related to the volumes.

[Anthony L. Trunzo:]

And, Jonathan, it's Tony. I mean, we'll see 60%, 65% growth in uncooled units this year, something in that -- no, a little less?

[Andrew C. Teich:]

Just a tad less.

[Anthony L. Trunzo:]

Something in that area. And the -- I think that's in line with what our expectations are going forward as well is to see that kind of unit volume growth. I think it's -- as Andy said, it's pretty early. I mean, if you look at TG165, it's almost a completely new product category for us, and it's Lepton-enabled, the same with AX8. I think the same thing is going to happen in the Security business. The high end is going to -- we're going to have to continue to push there to keep that business where it is and growing. But I don't know, I kind of like where we are in terms of unit volumes and the progress we're making at the lower price points.

[Andrew C. Teich:]

Yes. And I think it's important to keep it in context; that Q4 will really be the first quarter that we'll be shipping Lepton product into our existing segments. Prior to that, Lepton shipments have only been through FLIR ONE, which is a new -- completely new category for us.

[Operator:]

Our next question today is coming from Jeff Kessler from Imperial Capital.

[Jeffrey T. Kessler:]

Even before the -- because you've introduced Lepton before the AZIS [ph] show, there's quite a bit of buzz about what would eventually come into Lorex, which hasn't come in yet, but what was going to go into the high-end -- higher-end cameras in Security. And clearly, what's happened is that there's been a lot of buzz in the security industry now about getting lower-cost thermal imaging into the cameras. Along with that, though, has come your major competitor in the area that you address [ph] as well as a lot of other small companies with a lot of unknown names have been trying to press lower-cost thermal cores when they can get them and imaging products, whatever quality they are. The question is, is to protect your brand, protect your high end and your product, what are you doing to build up an ecosystem and build up sell-through to the integrators to make sure that you're the guys who are chosen and that the other guys who are chosen are not chosen because they're just good enough; that even though your product may be cheaper or -- and it may not be cheaper in 6 months because they're going to just drop the price. And so the question is, is essentially, how do you protect your channel to make sure that the FLIR brand is the one that is continually being chosen going forward? Because it looks as if the security industry is going to -- is taking on this product and taking on for quite a long time and integrate it into visible light cameras as well.

[Andrew C. Teich:]

Sure, Jeff. I'll mention 3 things here. And then I'll pass it over to Tom for some additional commentary. But 3 things come to mind right off the bat. Number one is, is our product breadth. FLIR is the only company out of any of those that you mentioned that offers a complete suite of products using our Control the Corners strategy. So we have everything from entry level to the highest performance, multi-sensor, cool product on the marketplace. So it's a one-stop shopping environment for an integrator. The second issue is, is the features and functionality. We have led the industry in developing features for these products, features like our patented MSX, features like our MPX, digital-over-coax capability, 3-in-1 camera signal capability that Tom alluded to earlier in his comments. And then the third issue is, is the launch of the FLIR cloud, which is part of our ecosystem for that market, where we will have cloud-based analytics, storage and a recurring monthly revenue model for our users that give an enhanced value in terms of both analytics and storage for our systems. Tom, anything else to add to that?

[Thomas A. Surran:]

Yes. So part of the question is the fact of kind of a price war. I guess you were a little bit alluding to that somehow if you look at that marketplace and you say if someone wants to compete on price, how are we positioned? I believe we're positioned extremely well. We have the strength of -- the scale that we have in all of our thermal products. We have the technologies that we've brought to all of our markets, and we've talked about Lepton. We've talked about some of our optics. And then just to echo what Andy was saying about all right, once you go past the price and the cost and our ability to position, we're creating a product and a strategy and a product roadmap that really kind of take the thermal and then leverages what you can then do with that information and how that can be deployed in a situation to create greater awareness for the user, especially in the security market.

[Jeffrey T. Kessler:]

Yes. There hasn't been anybody up until now who's launched any kind of analytics or, let's say, full-blown end-to-end solution around thermal yet. It's all been around the camera itself.

[Thomas A. Surran:]

Correct, yes.

[Jeffrey T. Kessler:]

One quick follow-up, and that is, Andy, can you -- any update on the automotive side, in broadening your value -- your distribution base?

[Andrew C. Teich:]

Sure. So I don't want to talk too much about our customers' customers. But we would expect, this is, again, kind of a stair-step growth that'll be going on. And the next stair step will occur with 2016 models. So for the first part of this next year, we will see relatively stable volumes, and then we would see another step-up on the stairway as we -- not only this piece but then as we look even farther forward for the next generation of technologies that'll be deployed in multiple automobiles.

[Operator:]

Our next question today is coming from William Lee from Oppenheimer.

[William Lee:]

On Raymarine, third quarter's typically the seasonally weakest quarter. And given the strength this quarter, was there any pull forward of sales from fourth quarter into third quarter? How should we think about the cadence going forward?

[Andrew C. Teich:]

It was actually -- it was a very good quarter. And I think that if you look at kind of what drove the growth, it wasn't necessarily a pull forward. And typically, Q3 and Q4 are both pretty soft quarters, typically and they're typically of similar size. It wasn't a pull forward. It was some growth in the products. The MFD product line has done very well. The introduction and the expansion into the freshwater market has done very well for us. We're going to continue to pull on that lever. Our autopilot, which is the Evolution that's won the award recently is -- the awareness of the performance of that product is getting out, and that's a longer sales cycle type product and awareness product. And as that's gained traction, we saw nice growth there as well. So this was not just a pull forward. I can't say that 1 order or 2 orders didn't get pulled one way or the other, but that's not what this was.

[William Lee:]

Right. So it sounds like it was helped by new product launches. And just a quick question. On the Optical Component sale, was there any revenue attached to that?

[Anthony L. Trunzo:]

Yes. There was, William. Year-to-date, it was $3-ish million, kind of in that ZIP code. It was actually -- it might have been a little bit more than that.

[Andrew C. Teich:]

No, it's more like $6 million.

[Andrew C. Teich:]

Couple of million a quarter. Yes, right, it's couple of million a quarter. Sold that business in the middle of the quarter in August. We did have revenue in this most recent quarter. But we won't, obviously, have any revenue in Q4. And probably, I should probably maybe give another highlight on that transaction though because it was one that ended up both strategically and financially pretty solid. Yes, 2014 year-to-date, OCG revenue -- sorry, William, I've got somebody handing me a number, was $8.8 million, so pretty robust, more than I recalled actually. But we acquired a group of assets a little over a year ago, owned them for about a year. We paid $15 million for them. And the critical technology was the wafer-level optics that we were -- that we wanted and the intellectual property around wafer-level optics that we wanted in association with Lepton and to continue with the development of our broad-based optics capabilities. We were able to retain over 100 patents and all of the intellectual property and manufacturing capabilities that we wanted, while selling the part of the business that was not core for $12 million. And in the year that we owned it, the profits that we made on that business nearly made up the gap between the $15 million and the $12 million. So all in all, we feel like that was a pretty good transaction from a financial perspective. But more importantly, we have been able to retain a pretty substantial chunk of very important intellectual property.

[Operator:]

Our next question is coming from Pete Skibitski from Drexel Hamilton.

[Peter J. Skibitski:]

Yes, guys, follow-up. Test and measurement, I think maybe it was Andy that mentioned early on that it sounds like you guys are maybe seeing something in the market there and that you plan to do maybe kind of a meaningful build-out. Can you add some color there on what you guys are seeing?

[Andrew C. Teich:]

Build-out in what particular market?

[Peter J. Skibitski:]

The test and measurement units within -- I think it's within Instruments.

[Andrew C. Teich:]

Oh, so a couple of things that are going on in that segment, Pete. One is, is that relative to the build-out, we launched, about a year ago, our -- the FLIR-branded test and measurement line with -- I think initially we launched 5 products in that space. And during the most recent quarter, I think there were 5 more products that were launched to help expand that line, and that's something that we will continue to do. These are premium-oriented products. It's -- these are products that are very rugged, very well designed, feature rich. And when compared with other products on the market from a sort of high-level specification standpoint, they tend to -- they're very high-performance products. The -- we consider the TG165 to be part of that line as well, so that will bring thermal imaging capability into that line as a new capability. And we just see it as a marketplace that has some opportunity for us, and it's a good extension of our Instruments business to extend to that lower corner. There are other test and measurement tools that would be benefited by the inclusion of thermal imaging that we'll be looking at.

[Peter J. Skibitski:]

Got it. Okay, very good. And then just the last one, you guys talked earlier about the high end of the market. It sounds like there's some high-end products coming out. Should we think -- are you working on a new high-end core as well? Or just taking kind of some of your existing high-end cores and maybe just adding some features to them?

[Andrew C. Teich:]

Well, we've stated, as part of our strategy and one of the 6 pillars of our strategy is this Control the Corners concept, and we've spent a lot of time talking about the low end of the corner, which the Lepton core fulfills. But yes, we're also looking at the higher end as well. There's certainly opportunity there when you get to the higher performance cores. Obviously, we've got opportunity for higher price points, better performance, longer-range performance. And the customer groups that we serve are interested in those features, so you will see introductions in that space in the coming year.

[Operator:]

Our final question today is a follow-up from Noah Poponak from Goldman Sachs.

[Noah Poponak:]

Tony, can you walk us back through why the company is choosing to keep running the balance sheet in a net cash position and not more efficiently utilize the balance sheet, especially given it's a pretty cash-generative company?

[Anthony L. Trunzo:]

Well. So a couple of things. I think if you look back over the last 4, 5 years, the amount of capital that we've returned is a pretty substantial amount of capital. This quarter, we returned $50 million back to shareholders, give back over the last several years. It's a large 9-figure amount. So we've not increased our cash balances recently. We've continued to put money back into the hands of the shareholders, and we're going to continue to do that as part of the strategy. But we -- as I indicated, and it was pretty brief, we continue to believe that there's the opportunity to grow this company through acquisition. Specifically, some of our commercial segments have the real potential to be larger through M&A, and some of that M&A could be substantial. And I think we feel like we want to be in a position to act on that to the extent that it becomes available. I will say that over the last couple of quarters, we've passed on a couple of transactions, but not -- more because of the quality of the assets than it was really the strategic fit. And Andy can speak to this. But I think as a management and leadership team, we would like to find the opportunity to do more M&A, particularly to augment businesses like Instruments and Security, where we see some real opportunities for growth, and frankly, potentially, in emerging markets as well. So I don't think we're being overly conservative. We talked years ago about the fact that when we went out and sold bonds, we didn't want to do that until we got to an investment-grade credit rating and I think we want to run the company with an investment-grade credit profile. We've clearly got some excess capital relative to that profile today. But we'd like to find a way to deploy it strategically, and feel like there are opportunities likely to come up to do that.

[Noah Poponak:]

Okay. And I guess, I was a little surprised the buyback went down sequentially because the stock was down, and you guys have the super-impressive chart of regularly buying the stock low, which a lot of others don't show. Shall we look for that to step up in the fourth quarter? Or is the answer to that similar to what you just said, where you're keeping that lower than maybe otherwise would because you are keeping an eye on M&A?

[Anthony L. Trunzo:]

I guess the answer I would give you that you could interpolate through our thinking is it was painful to watch the stock slide in September, particularly in the latter part of September and not be in a position to buy it back because of our fairly rigorous approach to...

[Noah Poponak:]

I guess, right where you would normally buy it was...

[Anthony L. Trunzo:]

Right. Yes, exactly.

[Noah Poponak:]

And then what's the tax rate we should look for in the fourth quarter?

[Anthony L. Trunzo:]

So our tax rate for the year -- through the first 2 quarters, we had assumed that the effective tax rate, excluding discretes was 23.75%. We ticked it up 50 basis points in Q3 to 23% -- I'm sorry, 24.25%. There was a catch-up associated with that of about $1 million from Q1 and Q2, so the tax rate for the quarter came in right around 25%. You should see it be probably 75 basis points lower than that in Q4.

[Noah Poponak:]

And then should we just run that forward?

[Anthony L. Trunzo:]

I think that's a good ZIP code to be in. Yes, I mean, we'll continue to do some planning work. We are clearly influenced by the mix of our income because there's some pretty significant differences in tax rates in the jurisdictions where we trade. But I think that's a reasonable go-forward number now.

[Andrew C. Teich:]

Great. Well, thank you, everyone. Again, we were pleased with the execution in Q3 and we continue -- we've got some work ahead of us for Q4. But at this point, I'm very pleased with the way the management team has been executing in a way that it's been built out and we'll look forward to talking to you about our results after the New Year. Thank you, everyone.

[Operator:]

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