FLIR At CES 2018: Thermal By FLIR Program Introduced

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FLIR Systems, Inc. (NASDAQ:FLIR) Q1 2018 Earnings Call April 25, 2018 9:00 AM ET

Executives

Shane R. Harrison - FLIR Systems, Inc.

James J. Cannon - FLIR Systems, Inc.

Carol P. Lowe - FLIR Systems, Inc.

David Ray - FLIR Systems, Inc.

Travis D. Merrill - FLIR Systems, Inc.

Frank Pennisi - FLIR Systems, Inc.

Analysts

Noah Poponak - Goldman Sachs & Co. LLC

Asher Carey - Robert W. Baird & Co., Inc.

Drew Lipke - Stephens, Inc.

Saliq Jamil Khan - Imperial Capital LLC

James Ricchiuti - Needham & Company, LLC

Jonathan F. Ho - William Blair & Co. LLC

Michael Ciarmoli - SunTrust Robinson Humphrey, Inc.

Josh Ward Sullivan - Seaport Global Securities LLC

Jeffrey Ted Kessler - Imperial Capital LLC

Operator

Greetings and welcome to the FLIR Systems First Quarter 2018 Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded.

It is now my pleasure to turn the call over to your host, Shane Harrison. Please go ahead.

Shane R. Harrison - FLIR Systems, Inc.

Good morning, everyone. Please note that our earnings press release and presentation slides that will be referred to on this call are available under the Events & Presentations section of www.flir.com/investor.

Before we begin this conference call, I need to remind you 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, intends, and believes, and similar words and expressions are intended to identify forward-looking statements. 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 forecasts. The forward-looking statements we make today speak as of today and we do not undertake any obligation to update any such statement to reflect events or circumstances occurring after today.

We will be discussing our results for the quarter primarily on an adjusted non-GAAP basis. We believe that non-GAAP information is useful because it can enhance the understanding of our core ongoing operating results and facilitate consistent comparison of results over time. A full reconciliation between GAAP and these adjusted measures is in our press release this morning.

Let me now turn the call over to Jim Cannon, President and CEO of FLIR Systems. Jim?

James J. Cannon - FLIR Systems, Inc.

Thank you, Shane, and thank you, everyone, for joining FLIR's first quarter 2018 earnings call. With Shane and me today are Carol Lowe, our CFO; Todd DuChene, our General Counsel; Travis Merrill, President of our Commercial Business Unit; Frank Pennisi, the President of our Industrial Business Unit; and David Ray, the President of our Government & Defense Business Unit.

The first quarter was successful on many fronts and was a strong start to the year. We grew our top-line double digits organically, significantly expanded our gross margin, and saw very strong operating leverage down through earnings per share. All three of our business units grew over 10% organically, while business unit level operating margin expanded nearly 300 basis points.

I'll start the review of the first quarter on slide 3 of the presentation. This morning, we reported first quarter revenue of $440 million, which was an increase of 8% over the first quarter of 2017. When you exclude first quarter 2018 and 2017 revenue of the Security businesses that we divested in early-February, organic top-line growth was 13%. Adjusted gross profit and adjusted operating income grew 13% and 26% over the prior year respectively, with adjusted operating margin expanding approximately 290 basis points over the first quarter of 2017. Adjusted earnings per share for the quarter were at $0.48, which represents 33% growth versus last year's adjusted earnings per share of $0.36.

At the bottom of slide 3 is our updated expectations for full-year 2018. We now expect revenue to be in the range of $1.76 billion to $1.79 billion, and full-year adjusted earnings per share to be in the range of $2.11 to $2.16. When you exclude the results of the divested businesses from 2017, these ranges represent expected organic revenue growth of 6% to 8%, and adjusted earnings per share growth of 12% to 15%. These updates incorporate our first quarter performance in comparison to our operating plan as well as our conviction and our ability to execute in what we feel are strong industrial and defense end-markets. We also announced today a quarterly dividend of $0.16 per share, which will be payable on June 8 to shareholders of record as of May 25.

Related to the $15 million charge that we took to GAAP operating income in the quarter, we reached an agreement yesterday with the U.S. Department of State to resolve alleged civil violations related to the International Traffic in Arms Regulations, or ITAR. As a result of this consent agreement, we'll pay a penalty of $30 million over four years with $15 million of that $30 million suspended and credited against past and future remedial compliance expenditures that will enhance our compliance processes. This agreement is the result of a long review process, where we cooperated fully and have devoted considerable time and expense to improve our compliance processes. The bigger picture here is that we're fully aligned with the U.S. Government in achieving its policy objectives, including the most important one and that is protecting the lives of the U.S. war fighter.

Moving to slide 4, I'd like to now touch on some of the new innovations our team has introduced since our last earnings call. In the Commercial Business Unit, the Security division introduced our new F-Series ID line of thermal security cameras. This camera sets the standard for critical infrastructure customers needing threat detection as it features 300% more thermal sensitivity than our previous system, and has onboard video analytics for automated detection low false alarming.

In March, at the Intertraffic show in Europe, the Commercial Business Unit's Intelligent Traffic Systems (sic) [Intelligent Transportation Systems] business announced the ThermiCam V2X. A new thermal traffic detection sensor for Smart Cities and connected vehicle applications that utilizes emerging crash avoidance technology called vehicle-to-everything also referred to as V2X. The ThermiCam V2X enables vehicles and traffic infrastructure to communicate and share data in a system that aims to improve motorists, pedestrians, and bicyclists' safety and efficiency. This sensor personifies the differentiation FLIR delivers to its markets by using thermal technology to improve our roadways and help save lives and livelihoods. In February, the Commercial Business Unit's Raymarine business introduced their newest maritime radar, the Quantum 2. This is Raymarine's most advanced solid state radar featuring doppler target identification technology that color codes both moving and stationary targets to greatly improve a boater's situational awareness. It's also 50% lighter than traditional radars in the market, showcasing our ability to significantly reduce the size, weight and power consumption of our advanced sensing solutions.

Also in February, the Industrial Business Unit introduced two new handheld thermography cameras for use in electrical, mechanical, and building applications. The E53 is the latest in our Exx series of cameras and represents an entry level price point for the popular series of cameras, enabling more professionals access to the benefits of thermal imaging. Also launched was the new T1010, a high-definition thermography camera. This is a new entry level price point for the T1K premium series in our thermography camera lineup. It generates images up to 3.1 megapixels, thanks to our unique UltraMax image enhancement software, and like all T1K series cameras, it uses high-fidelity optics, which FLIR designed specifically to work with HD thermal sensors for greater image clarity and measurement accuracy.

Turning to slide 5, we recently introduced our new Thermal by FLIR cooperative product development and marketing program that supports original equipment manufacturers or OEMs and their product innovators, who use our thermal imaging sensors in their products. At the Mobile World Congress show in Spain this past February, Thermal by FLIR partner, Bullitt Group, a leading maker of highly ruggedized smartphones announced that they've integrated our Lepton microcamera in their latest Android phone, the Cat S61. Building on the success of the Cat S60 that was launched in 2016, the new Cat S61 features an improved temperature range, a better HD visible camera, an updated MyFLIR app and live streaming capability.

Also at Mobile World Congress, Panasonic announced their new fully ruggedized Panasonic Toughpad FZ-M1 thermal imaging tablet. This device utilizes Thermal by FLIR by integrating our Lepton microcamera to enable industrial professionals to realize the benefits of detecting temperature issues, seeing through obscurants, and seeing in the dark. Our Industrial Business Unit announced another collaboration with the world's leading civilian UAS or unmanned aerial systems maker DJI. Under the Thermal by FLIR program, a jointly developed product that is DJI's first dual sensor UAS camera called the Zenmuse XT2, designed for industrial and public safety applications. This UAS payload integrates a 4K visible camera and a high-resolution FLIR thermal camera, as well as features our patented MSX, image enhancement algorithm.

Lastly, I'd like to highlight a strategic minority share investment we made in DroneSense, a young and innovative company that develops software platforms that greatly enhance and optimize public safety and first responder organizations in their use of unmanned aerial systems. As a part of the investment, FLIR and DroneSense will collaborate and share respective expertise and relationships to develop mission-critical solutions that will enhance situational awareness, act as a force multiplier and ultimately save more lives as organizations continue to integrate UAS into their daily missions.

Let me now turn the call over to Carol, and have her review the first quarter financial and operational highlights. Carol?

Carol P. Lowe - FLIR Systems, Inc.

Thank you, Jim. On slide 6, you'll see our first quarter financial results. Please note with the exception of cash flow, all of these financials are on a non-GAAP basis. Reconciliation to GAAP data is included in the filed appendix. Consolidated revenue for the quarter was $440 million, an 8% increase year-over-year and 13% on an organic basis. Geographically, revenue increased 45% in the Middle East, 17% in Europe, 14% in Asia, and 2% in the U.S. The strength in the Middle East region was due to deliveries from the Government & Defense Business Unit.

Revenue to the U.S. government was 27% of total revenues and increased 1% versus the first quarter of 2017. Adjusted gross margin improved 210 basis points year-over-year to 50%, driven by product mix and new products. First quarter adjusted operating margin was 20%, about 290 basis points higher than last year, driven by the improved gross margin and controlled operating expense growth relative to our top-line growth. Adjusted net income for the first quarter of 2018 was up 38% to $68 million, and adjusted earnings per share was $0.48, 33% higher than the prior year.

Quarterly cash flow from operations declined 43% to $43 million and was 63% of adjusted net income, primarily driven by repatriation tax payments and the timing of other tax payments. During the quarter, we repurchased 1.7 million of our shares at an average price of $49.34. With these repurchases and $22 million in dividends paid, we returned a $117 million to shareholders during the first quarter. We finished the first quarter with $452 million of cash.

At the business unit level, we saw meaningful growth in Industrial and Government & Defense and strong growth across all three of our business units on an organic basis. Business unit level operating margins increased 300 basis points over the first quarter of 2017. As Jim mentioned, our guidance for full year revenue is now $1.76 billion to $1.79 billion, and full year adjusted earnings per share is now $2.11 to $2.16, representing organic revenue growth of 6% to 8%, and adjusted earnings per share growth of 12% to 15% when you exclude the divested Security businesses. This guidance reflects our current view of 2018 after seeing how Q1 outperformed our plan, the effects of delivery pull-ins from our second quarter and how our teams see the rest of the year unfolding. We continue to expect higher year-over-year growth in the first half versus the second half of 2018, as we began to lap the strong performance in the second half of 2017.

Detailing the business units a bit more, you will see on the left side of slide 7, a summary of the Industrial Business Unit's first quarter results. First quarter revenue for the Industrial Business was $171 million, up 10% from the first quarter of 2017. Sales strength was seen in many of the Industrial product lines. The sales volumes in plant predictive maintenance handheld, FLIR ONE mobile accessories, gas imaging cameras, and thermal camera cores were particularly noteworthy compared to the prior year. Operating income for the Industrial Business was $45 million, 6% higher than the prior year. Operating margin declined slightly year-over-year, mainly due to the impact of planned investments and production improvements related to FLIR Method initiatives.

The Government & Defense Business Unit had revenue growth of 15% year-over-year. Deliveries of gimbaled systems for our EO/IR-FP program, high resolution camera border protection to Middle Eastern customers and DR-SKO shipments helped drive this top-line growth. Government & Defense operating profit increased 39% compared to the first quarter of 2017. Healthy product mix and controlled operating expense growth resulted in significant operating leverage in the quarter with operating margin expanding 490 basis points. During the first quarter, Government & Defense received a $26 million DR-SKO order and a $22 million order for BRITE Star gimbals from the U.S. Navy. Year-over-year backlog declined 7% to $357 million due to timing of international bookings into later quarters of 2018 and the wind down of the DR-SKO program.

On the right side of slide 7 is a summary of the Commercial Business Unit. Commercial first quarter revenue was down 4% year over year, due to the comparable to the prior year that included retail and SMB Security business that was divested in early February of 2018. Excluding the divested revenue from both 2018 and 2017, the Commercial Business first quarter revenue grew 12% over last year. Continued market embrace of Raymarine's Axiom line of multifunction displays was the primary driver of the performance, augmented by good growth in maritime thermal cameras, and in our Intelligent Transportation Systems business.

Operating profit for the Commercial Business increased 45%, driven by gross margin improvements across many product lines, but with particular improvement in Raymarine and Enterprise security products. This gross profit performance and low operating expense growth resulted in a 440-basis-point improvement in operating margin.

This concludes my summary of the financials and the business units. I will now pass the call back to Jim.

James J. Cannon - FLIR Systems, Inc.

Thank you, Carol. We're pleased with how we've kicked off 2018. We saw good growth across the portfolio and improvements in profitability. But there remains work to be done to fulfill our objective. Simply said, I'm proud but certainly not satisfied. Timing of various tax related items negatively impacted our cash flow in the quarter and we look to improve our cash generation throughout the balance of the year.

Our working capital turns improved slightly in the quarter, but we have a lot of runway ahead of us. The robust operating leverage we saw in the quarter was the result of high volume, favorable product mix, better margins on new products, and our team's commitment to better utilization of our operating spend. We've just began the rollout of various FLIR Method initiatives across many of our businesses. And while these will take some time to develop into meaningful improvement programs, we're excited about the opportunities to further expand our operating efficiencies, product value propositions, and customer experience.

Deploying our cash effectively and in a value-generating manner is a cornerstone of our long-term strategy. We returned over $100 million back to our shareholders in Q1 and while completing multiple minority share investments. We continue to evaluate several opportunities for further deployment and we build our rationale for such investments around the delivery of strategic and financial value to FLIR and our shareholders. We hope to see you at our Investor Day in New York on May 16. At this event, we'll communicate our strategic priorities and financial objectives for the coming years, as well as provide you an opportunity to interact with our products, technology and some of our leaders. Please RSVP if you've not done so already.

I'll remind everyone of our daily task, our task to consistently exceed our commitments with integrity, and our purpose, which is to innovate The World's Sixth Sense to enhance perception and awareness in order to save lives and livelihood. Within this construct, our focus is on growing our business organically, while maintaining or improving margins and deploying our cash effectively and in shareholder-friendly ways. This task and purpose is reinforced by our be FLIR values to be brave, be bold, be ready and be ambitious and fueled by The FLIR Method.

In closing, I want to thank all FLIR team members past and present, and congratulate them on FLIR's 40th Anniversary, a milestone that we reached this past March. Over the course of four decades, we've worked hard to provide our everyday heroes with technologies to improve their perception and awareness. We're proud to be their sixth sense.

I'll now open up the call for questions and answers. Operator?

Question-and-Answer Session

Operator

Thank you. We'll now be conducting a question-and-answer session. Our first question is coming from Noah Poponak from Goldman Sachs. Your line is now live.

Noah Poponak - Goldman Sachs & Co. LLC

Hey. Good morning, everyone.

James J. Cannon - FLIR Systems, Inc.

Good morning, Noah.

Carol P. Lowe - FLIR Systems, Inc.

Good morning.

Noah Poponak - Goldman Sachs & Co. LLC

So the pace of organic revenue growth clearly shrunk across the entire business. The 15% in Government & Defense, on the one hand, a really nice acceleration, obviously a big number; on the other hand, you've called out the EI/OR (sic) [EO/IR] program, DR-SKO program. So I just want to try to parse out the sort of underlying growth, excluding programs that may be don't last much longer, if that makes sense. So perhaps, you could quantify what those contributed to the quarter, what their growth was excluding this? How much longer those do last? And then I guess, Jim, if you could just speak to the efforts to backfill the backlog to be able to sustain growth beyond those programs?

James J. Cannon - FLIR Systems, Inc.

Sure. I'll give some comments and then David Ray is here, and he can add some color. The majority of our growth in Government & Defense came from outside the United States in the first quarter. And if we look at the EO/IR-FP program, you know that we were awarded last year $74-some-odd-million. We did ship altogether a little under $20 million of that so far. So the bulk of that really is yet to ship in the next two quarters. DR-SKO, as you know, is a program that's winding down last year. In the first quarter, we booked about $50 million of orders. This quarter, we booked about $27 million of orders. But again, the bulk of that revenue growth in Q1 really came from outside the U.S. David, any color you want to add to Noah's question.

David Ray - FLIR Systems, Inc.

I'll add to that. So at the end of Q4 last year, we had a really solid backlog coming into the year. And as Jim mentioned, EO/IR-FP program as well as our DR-SKO program (26:14) for that. Domestically and internationally we had a lot of deliveries there.

I won't go back too far on that. What I'll talk about moving forward is, as we think about our business moving because of our backlog and our ability to execute, it really positions us now to look for larger program of records, and we're in the process of working those this year to create those long-term sustainable programs in DOD and more domestic customers that will fuel long-term growth and predictable growth for the business inside each quarter.

And so the focus from kind of more of the smaller opportunities but a better mix between large programs of record and what we're doing with inside our mid and small programs really give us the strength as we win those programs to drive more predictable growth quarter-in, quarter-out over the next few years.

Noah Poponak - Goldman Sachs & Co. LLC

David, can you actually maybe elaborate on that because your hire is interesting given you've come from Raytheon, which is a large player in military infrared and a defense company that is on large programs of record that are longer cycle in nature. And so the strategy you just articulated resonates and makes a lot of sense. But on the other hand when I think about the implementation, it's sort of like how do you just kind of go out and out of nowhere find those things. So can you may be – I don't know if you can give a few examples or just elaborate on precisely how you can transition the segment in that manner and how long it'll take?

David Ray - FLIR Systems, Inc.

Right. So it won't take long in transition. I think the company already has the DNA to go do that. I will say that with a certain budget that's been approved over the next three years, it really firms up the government's intent to really drive modernization for the existing assets that are in the DOD. What we've been able to do inside of my short time in FLIR is not necessarily have to wholesale make changes inside the company but really it allowed us to focus on fewer bigger deals as opposed to many of the smaller deals we normally go after. And so it's just about allocating resources and really driving the focus and attention on things that really move the needle for the long term.

I'll tell you the investments we make inside of FLIR really position us not only from the technology that we leverage from the commercial side of our business and industrial side, but also our ability to drive scale and that partnership really positions us well for future platforms as we execute against our strategy.

Noah Poponak - Goldman Sachs & Co. LLC

Okay. That's great. And I'll just ask one more just on the gross margin. You've sort of been asked this question before, but I'll try it again, which is it's a good margin. It's up a decent amount year-over-year. It's one of the better quarterly gross margins in a while. And just curious to know how much of that is new management efforts and strategies being implemented and having an effect versus it's actually just that organic revenue growth has accelerated and had a nice drop-through and the FLIR Method and the new operational initiatives have actually yet to flow through and could take margins even higher.

James J. Cannon - FLIR Systems, Inc.

Well, it's a great question. We certainly benefited from leverage that came in the volume growth in the quarter and our business does lever nicely. We also had nice mix in the products that we had across the quarter. We've also made a lot of investments in the FLIR Method and we're self-funding those investments. So when we think about the FLIR Method in the longer term and as we've talked about, we really believe that the pricing and productivity benefits that are going to manifest themselves more in the second half and carry over into 2019, but now in the first half we have to make those investments and do in a way that we maintain or continue to expand margin.

So I do think that we benefited both qualitatively and quantitatively from the business reorganization from six segments to three BUs. I think that some of those benefits have enabled us to self-fund many of these resources for the FLIR Method. And then certainly in the quarter, the volume leverage and the mix, I think I would point to really on top of those things that drove the gross margin improvement year-on-year.

Noah Poponak - Goldman Sachs & Co. LLC

Got it. Thanks so much.

James J. Cannon - FLIR Systems, Inc.

Thank you.

Operator

Thank you. Our next question is coming from Asher Carey from Robert W. Baird. Your line is now live.

Asher Carey - Robert W. Baird & Co., Inc.

Hey good morning, everyone.

James J. Cannon - FLIR Systems, Inc.

Morning, Asher.

Asher Carey - Robert W. Baird & Co., Inc.

You've mentioned the creation of like a pricing analysis function as a priority for 2018. I'm going to ask you a question about that. How much is the pricing strategy beginning to play a role in driving any organic growth, or is it still mainly volume being in the early innings of implementing the standardizing process across the platform? Thanks.

James J. Cannon - FLIR Systems, Inc.

Well, putting together a pricing initiative is a part of the FLIR Method, is a core component. And going out and getting some very talented pricing leader to lead this effort was one of the first steps that we took forward because I do believe, we all believe that we could do a much better job and consistent job, right, in making sure that we extract full value in how we price our products.

Most of that effort right now is focused on data collection. As you implement these kind of pricing initiatives, it's not simply a matter of trying to go raise price on current products or something of that sort. It's much more complex and certainly takes time to mature and develop. So there's a data collection piece and that's really what we've been focused on now. There's a training and education piece with the product management and sales organizations.

And then as we move forward, we're really focused on new product introductions. So many of the new products that I mentioned when I went through the innovations since the last earnings call have benefited from some of this methodology and rationale. And now as they get into the market, we're really kind of getting our first taste of how successful the effort could or couldn't be. But again, it's still very early days. We have a small, relatively small amount of resources dedicated to it but very talented, and the enthusiasm inside the company, the adoption is spreading pretty quickly. But as I stated, with productivity and pricing, I think we're going to really be able to quantify much better in the second half and carry over into 2019 as these new product innovations hit the market their real effect on the business.

Asher Carey - Robert W. Baird & Co., Inc.

That's helpful. Thanks, Jim.

James J. Cannon - FLIR Systems, Inc.

Thank you.

Operator

Thank you. Our next question is coming from Drew Lipke from Stephens. Your line is now live.

Drew Lipke - Stephens, Inc.

Yeah. Good morning. Thank you for taking the question.

James J. Cannon - FLIR Systems, Inc.

Morning, Drew.

Drew Lipke - Stephens, Inc.

You called out a pull-in from the second quarter in terms of deliveries there. I'm curious where did you see this and could you guys maybe quantify the pull forward that you saw?

Carol P. Lowe - FLIR Systems, Inc.

Yeah. So, Drew, we're not going to break out the exact amount. It was largely within our Government & Defense business is where that occurred.

Drew Lipke - Stephens, Inc.

Okay. And then you talked about stronger growth in the first half relative to the second half. Is that prevalent across each segment or is that more pointing to industrial and the tough comps that we've seen there?

Carol P. Lowe - FLIR Systems, Inc.

So it is across all three of the business units because if you look at the growth that the three business units delivered in the last half of 2017, that's when we really started to see the ramp up and the acceleration of that organic growth and we'll start to lap that. And so that makes the comps a little tougher as we move into the second half of the year.

Drew Lipke - Stephens, Inc.

Okay. And then just last one, on the ITAR consent agreement, how long are you under the compliance review? What's the expected incremental cost going forward? And does this impact your defense international sales and your ability to see direct commercial international sales going forward?

James J. Cannon - FLIR Systems, Inc.

Sure. Well, the consent agreement has been in negotiation for some time. This is a multi-year period, in some cases going back 10 years. So we're very pleased to come to an agreement and be able to put it behind us and more importantly focus on our processes from a compliance standpoint. Again, we have the exact same policy (34:41) objective as the U.S. State Department to protect our warfighter. As I mentioned earlier, there is a civil penalty of $30 million. $15 million of that penalty is suspended. $15 million we accrued and it's paid over a four-year period. The term of the agreement is over a four-year period. There'll be two external audits in the course of that and there will be a special compliance official to oversee compliance.

Drew Lipke - Stephens, Inc.

All right. Thanks, guys. Best of luck.

James J. Cannon - FLIR Systems, Inc.

Thank you.

Operator

Thank you. Our next question is coming from Saliq Khan from Imperial Capital. Please proceed with your question.

Saliq Jamil Khan - Imperial Capital LLC

Hi. Good morning, Jim.

James J. Cannon - FLIR Systems, Inc.

Good morning, Saliq.

Saliq Jamil Khan - Imperial Capital LLC

Yes. Just a couple of questions for you. The first one being is over the years there have been a lot of conversation surrounding drones and what that could mean for the camera business as well as the thermal camera manufacturers. So how do you view the FLIR's involvement in this space? And could I expect some material acquisition in the near term?

James J. Cannon - FLIR Systems, Inc.

Well, UAS is an area of emphasis for us on several fronts. First, with the production of sensors and working with the leading UAS civil manufacturer, DJI, we have a very close commercial relationship and provide them with their thermal sensors. As I mentioned earlier in the innovations, we introduced with them the first dual use sensor, the Zenmuse, with DJI. And, again, we're very excited about continued collaboration and growth in that space.

At the same time, as I mentioned in the minority investment DroneSense, we want to bring solutions to first responders in industry so that they can conduct inspections, their missions, whether it's search and rescue, helping firefighters, identify and attack the fire with a holistic solution, not just an airframe with a thermal camera but the software required and the algorithms to deploy the product, to make sure they capture the right information, to go back and also do administrative things to service the products, et cetera.

And on the military side, you know with the acquisition of Prox Dynamics, the Black Hornet product, it is a truly differentiated nano drone for personal reconnaissance and surveillance incorporating both a visible camera and a Lepton camera, fits in the palm of your hand. Again, we're very proud of that product because it is deployed and has been deployed in combat all over the world and has been battle tested.

So when we think about UAS applications going forward, we think about it even more broadly than just UAS but unmanned. And there's a whole host of unmanned vehicles, whether it be sea, air, and land, and all of which need the sort of sensing capabilities that we are developing and we'll continue to put a lot of effort behind. So it's a particular area of focus for us.

Saliq Jamil Khan - Imperial Capital LLC

Thank you. And then one more question on my end. If I take a look at your product profile, you've introduced a number of products that are aimed at the Smart Cities market, and earlier you mentioned the V2X sensor as well. Can you talk a little bit about the growth and the potential margin opportunities or the outlook in this growing market for you guys?

James J. Cannon - FLIR Systems, Inc.

Well, it's something that, again, we're also very focused on. We've talked on calls in the past about ADAS applications, sensors on vehicles themselves. We mentioned on the last earnings call when we launched at CES, an automotive development kit, a kit that we can provide OEMs to examine the capabilities of thermal sensors on their vehicle.

On some high-end vehicles, we have thermal sensors now, but when we think about ADAS, when we think about automation, Smart Cities, et cetera, there are certainly sensors on the vehicle, but there's got to be sensors in the community. We have a small but rapidly growing business, our Intelligent Transportation business that specializes in this. And with this V2X technology, it enables the vehicle to communicate again to the environment around us. If we think about pedestrians and bicyclists in particular, well, they're not going to have sensors on them as they move around communities. So you need to have infrastructure that can speak to the vehicle. But on the call here today is Travis Merrill. He leads that business. Travis, do you want to add some color to that?

Travis D. Merrill - FLIR Systems, Inc.

Sure. Thanks, Jim. Hey, Saliq, how are you doing?

Saliq Jamil Khan - Imperial Capital LLC

(39:39)

Travis D. Merrill - FLIR Systems, Inc.

So in addition to Jim's comments, beyond the ITS business, which was obviously a key part of the safe and Smart City place, where we're seeing it kind of take root early on is on the security side of the house, a lot of municipalities really building out city infrastructure around security. And then when we think more broadly within FLIR, really outside of the Commercial Business Unit, longer-term we feel that we're well positioned to take advantage of this opportunity given the products that we have in technologies like detection or other things that serve law enforcement, firefighters, first responders. That's all going to be part of that safe city ecosystem and Smart City ecosystem. But overall, it's pretty early days in that space and there are a lot of developments kind of constantly coming out, but it's unclear what the platform is going to look like longer-term, but we feel like we're pretty well-positioned there.

Saliq Jamil Khan - Imperial Capital LLC

Awesome. Travis, thank you.

James J. Cannon - FLIR Systems, Inc.

Thank you.

Operator

Thank you. Our next question today is coming from Jim Ricchiuti from Needham & Company. Please proceed with your question.

James Ricchiuti - Needham & Company, LLC

Thanks. Good morning. I was wondering if you could characterize the machine vision industrial camera business in the quarter because I know the comps get much more difficult as you go through the year, but I'm just wondering how you started the year, what you're seeing there?

James J. Cannon - FLIR Systems, Inc.

Well, now as we talk about the business units, I don't want to get into specifics about our IIS business in terms of their numbers growth, et cetera. I'll suffice to say this, you know the business grew organically at a rapid clip through the year last year. We built strong backlog. The business continues to improve. We're very enthusiastic about the machine vision space. We've got a lot of work to do to work down frankly, the backlog that we built. And we've yet to go after some of those synergies introducing like we mentioned in the past, thermal cameras. But again on the call here is Frank who owns that business unit as a part of the Industrial Business Unit. Frank, any color you'd like to add?

Frank Pennisi - FLIR Systems, Inc.

I think Jim made a good point, good strong point that we built a lot of backlog over time. And I'll say that the Industrial Business Unit has been one of the early adopters of The FLIR Method, and we put it into the machine vision space very early on, so we could actually double our production rates over time. And so as a consequence that increased production has been really paying off and gaining fruit for us. So overall, it's been a terrific business for us and we expect that growth to continue.

James Ricchiuti - Needham & Company, LLC

And then just shifting into the Commercial, the CBU, there's clearly been some moving parts in that, but the organic growth rate was impressive. And I'm just wondering, was there anything unusual or are you just seeing now traction in the maritime market that maybe reflects new products as well as I guess just stronger end demand than we've seen in that market in a while. Is that one way to think about what's going on there?

James J. Cannon - FLIR Systems, Inc.

Well, there's an arbitrage I think certainly. You know divesting the retail security piece buoyed the rest of the business certainly. If we think about our Raymarine business, the Axiom, the Quantum, the Axiom Pro products that we've introduced through the course of 2017 are really being well adopted and that business in particular is a driver of the organic growth and margin improvement that we're seeing in that space as they've introduced them. Really differentiated products there.

James Ricchiuti - Needham & Company, LLC

Okay. Thanks very much.

James J. Cannon - FLIR Systems, Inc.

Thank you.

Operator

Thank you. Our next question is coming from Jonathan Ho from William Blair. Your line is now live.

Jonathan F. Ho - William Blair & Co. LLC

Hi. Just wanted to get a sense in terms of the Industrial business, I think you guys called out an improvement in both the Cores as well as the Gas Imaging cameras. Are you starting to see sort of a pickup in demand from that from the end-market or has there been any sort of shift there in terms of that pickup?

James J. Cannon - FLIR Systems, Inc.

Well, that's a great question. We certainly are seeing increased demand from end-markets, in particular with the optical gas foundries. Whether it's regulation, whether it's more awareness around safety, and the kind of applications where those products go, there is a real need for them. I mean, they indeed save lives and livelihood when you look at the capability they bring to the market. So I think there is more awareness, certainly more adoption, and we continue to improve upon its capability.

Jonathan F. Ho - William Blair & Co. LLC

Got it. And then just regarding the DR-SKO program, I don't think I clearly understood this, but when you say that the program is wrapping up, are there additional sort of variants that are expected to come in future years or is there any potential for a gap there in terms of that system?

James J. Cannon - FLIR Systems, Inc.

Well, we got in Q1 a $20-plus-million, I think $26 million booking for DR-SKO in Q1. We expect that there's going to be another tranche later in the year that we're going to receive as well. Now based off the need, based off the threat in the world that we're in now and certainly CBRNE is front and center in that threat environment we're facing, could there be additional DR-SKO orders that we see potentially, but that program formally is winding down. It's going to be replaced with other programs, the next gen chem bio-detector that we're competing on now. So while it winds down, there'll be other programs that replace it and we're certainly working hard to make sure we're well-positioned for those programs now.

Jonathan F. Ho - William Blair & Co. LLC

Thank you.

Operator

Thank you. Our next question is coming from Michael Ciarmoli from SunTrust. Your line is now live.

Michael Ciarmoli - SunTrust Robinson Humphrey, Inc.

Hey. Good morning, guys. Thanks for taking the questions. Nice quarter. Maybe, David, on the Government side, I think you talked about the backlog down year over year. Any color on the sequential change and maybe just a general update, did you have any impact in the quarter from the budget, from the shutdown, continuing resolution, did that have an impact at all on the bookings and has there been any change in, maybe I'll call it, contracting velocity since we've had this budget deal?

David Ray - FLIR Systems, Inc.

Well, I'll just say quickly that we're well into 2018, in the first quarter we didn't see any notable difference in spending habits from Department of Defense. We think that's more going to come towards the end of this year in 2019. And frankly, we're not right now alarmed by the bookings in Government and Defense. I mentioned the biggest driver being DR-SKO, a lot of activity, some timing of international orders. On whole I think we, David, feel strong that we can continue to grow our Government and Defense business and well positioned as we get into the surety of the budget for the next three years.

Michael Ciarmoli - SunTrust Robinson Humphrey, Inc.

Can you maybe give us a sense of, you mentioned trying to get larger programs, programs of record, is there anything else the GBOSS-E is out there, I'm assuming there could be potential content on the next gen combat vehicle Soldier Borne Sensor. Are there any big programs on the radar screen that we should be aware of that you guys are going after?

James J. Cannon - FLIR Systems, Inc.

Well, you mentioned three that we certainly are going after. So I would count all those in the inventory for certain GBOSS-E is extension of the EO/IR-FP program or RAID before that, and it's a product we're very proud of for force protection. With Black Hornet and Soldier Borne Systems again, we have a battle proven solution for personal reconnaissance that have been used by friendly forces around the world for some time now, and we're very proud of its battle record. It's down range as we speak, and if we think about all the modernization efforts; next generation vertical lift, long range precision fires, reconstituting air defense artillery, fighting in a contested air space, CBRNE or NBC battlefield, we know as we focus on near-peer we're going to face the realities of fighting on a nuclear, biological and chemical battlefield and that fits with our detection business and the solutions that they bring. So when you look across all of the key modernization efforts underway and the programs that come with them, whether it be a solution, an intelligent sensor or a sensor integrated under other platforms we are keen to and intend to participate across the board.

Michael Ciarmoli - SunTrust Robinson Humphrey, Inc.

Got it. That's helpful. And then just Carol, I don't want you to kind of sitting there quiet here. Lots of focus on working capital, turns improvement. I think there's been talk about optimizing R&D, other continuous improvement, how should we think about free cash flow for 2018 and maybe conversion. Can you give us any color there?

Carol P. Lowe - FLIR Systems, Inc.

So, we – and everything you referenced is obviously something we're working on, it all falls under the FLIR Method initiatives. We're in very early stages for that, but we have high confidence that we will continue FLIR's record of operating cash conversion, and being well over 100%. The first quarter was impacted largely by timing on tax payments, but very confident that we'll continue to deliver as FLIR always has in the past from a cash flow conversion standpoint.

Michael Ciarmoli - SunTrust Robinson Humphrey, Inc.

Got it. And housekeeping, any change to the full-year tax rate for 2018?

Carol P. Lowe - FLIR Systems, Inc.

No, not compared. It's consistent with what we have, we communicated previously, the 24.5%.

Michael Ciarmoli - SunTrust Robinson Humphrey, Inc.

Got it. Perfect. Thanks, guys.

Carol P. Lowe - FLIR Systems, Inc.

I'm sorry, 21.5%. Yeah.

Michael Ciarmoli - SunTrust Robinson Humphrey, Inc.

Got it.

Carol P. Lowe - FLIR Systems, Inc.

Thanks.

Operator

Thank you. Our next question is coming from Josh Sullivan from Seaport Global. Your line is now live.

Josh Ward Sullivan - Seaport Global Securities LLC

Hi, good morning.

James J. Cannon - FLIR Systems, Inc.

Good morning, Josh.

Josh Ward Sullivan - Seaport Global Securities LLC

Just following up on the FLIR Method, maybe you can dig into where it's executed as expected? And then maybe some things you've seen that you didn't expect. I mean, as far as timing, what do you think that the long-term timing of the rollout of the FLIR Method is at this point?

James J. Cannon - FLIR Systems, Inc.

Well, that – I welcome that question. Again, I could talk about the FLIR Method all day long, I'm so excited about it. We're here in Billerica doing the call; and yesterday, we went down to meet with a team of folks, we've got a new FLIR Method leader, dedicated to facility here. We want this facility to be a showcase, because with these kind of efforts, it's important to kind of get some quick wins and demonstrate to the rest of the organization, the real tangible benefit that you can have. So we got a chance to meet with a dozen folks that are being our first round of champions here, getting trained on the various tools. Now, this is in a manufacturing setting, so they're focused on a lot of the manufacturing tools that you'd see value-stream mapping, et cetera, PQ analysis, spaghetti flow diagrams, you name it.

As Frank mentioned earlier, at our IIS business, they've probably been the earliest adopters. And as we mentioned, they had a very strong backlog and they went in using the FLIR Method and several Kaizen events, reengineered several production lines. And in those production lines, we've seen an exponential improvement in the output that we're able to get weekly, as well as an improvement in yield.

There's another area, I was in Belgium not long ago visiting with a sales operations team that do purely transactional work, right, processing orders, they're a touch point with the customers, and I was thrilled to see that they on their own took the tools, value-stream mapped every process, they identified every touch point, quantified that touch point, and had improvement plans in place.

So those are three early examples of where it's beginning to take root. A lot of work to get it embedded into the entire company, and it's the kind of thing you're never done with, right. You're always working on to get better, but still very, very early days and we're self-funding this effort to dedicate resources to it, as we're seeing some of the savings. But as Carol mentioned, the FLIR Method in terms of continued cash generation, that's a principal driver as we really strive to drive our working capital turns and take what's already historically strong cash generation really to the next level and we're going to talk much more about that at the upcoming Investor Day.

Josh Ward Sullivan - Seaport Global Securities LLC

Great. Yeah. And just as a follow-up to that with the Analyst Day coming up, are there any other themes you can preview for us here, what we should be expecting to see?

James J. Cannon - FLIR Systems, Inc.

You'll get a chance to see yourself in infrared, I can guarantee you that.

Josh Ward Sullivan - Seaport Global Securities LLC

Great. Thanks, Jim, and everyone.

Operator

Thank you. Our next question today is coming from Jeff Kessler from Imperial Capital. Your line is now live.

Jeffrey Ted Kessler - Imperial Capital LLC

I'm sorry that Imperial Capital is doubled up here, but – you folks had an impressive booth at the ISC West Show. I'm wondering if you could update us on what is going on in some of your core technology improvements, what you're doing to get better – smaller, better, more efficient, cameras around those cores. And maybe more importantly, what you think you can do with this core technology going over the next three to five years to essentially leave the competition behind and present a value proposition to basically make you guys – put you guys out there alone when it comes to looking at taking size and cost out of thermal?

James J. Cannon - FLIR Systems, Inc.

Well, that's a great question, Jeff, and it's something that we're heavily focused upon in our Industrial Business Unit that focuses on producing these infrared cores and providing them to the other business units, and the Commercial Business Unit with our Security business where they integrate those cores into broader solutions. You know that we launched the Boson camera, the Tau has been a mainstay camera, uncooled camera core for us for some time, and with the introduction of the Boson, we continue to push that capability in terms of size, weight and power consumption.

So notably smaller, great product with great adoption across many, many applications, security cameras being one. I mentioned our focus earlier and product introduction around critical infrastructure, parameter security, more thermal sensitivity, less false alarming. We're looking also in the ITS business, at how we can introduce thermal more and more in smart cities and in tunnels and in trains to detect fires and do other safety applications like that. And I think you're also going to see as we go forward, we're going to integrate more and more of our sensing technologies together into products in particular looking at critical infrastructure, perimeter security, et cetera.

So, it's a real area of emphasis for us certainly. It's an area where we feel like given the scale of our business and the fact that we provide these cores into so many different applications; we get some real leverage inside the company. And with the shift in our Security business from retail back into enterprise, critical infrastructure, et cetera, there's some real needs to provide at many of these facilities robust sensing capabilities with a whole suite of sensors and intelligent sensors.

Jeffrey Ted Kessler - Imperial Capital LLC

Just one related question, as the security industry moves toward a much more converged model of a lot more analytics and cyber, if you want to call it, merged with the physical aspects of it, how do you envision the sensor technology – the core technology that you just talked about, as part of this – I guess, as part of this growing wave of convergence?

James J. Cannon - FLIR Systems, Inc.

Well, across the entire company, when we think about our technology roadmap and how we've been evolving it, it's moved from sensors to intelligent sensors to solutions, sensing solutions. And you see that more and more with products that we're introducing now, that have onboard video analytics, that have incorporated algorithms for sharper focus and functionality, and you're going to see that – I think, that trend continue certainly. Cyber security is always a concern, right. It's a omnipresent threat that we face all the time.

As a U.S. manufacturer of these products we take it very seriously, and when we think about our customers in U.S. and critical infrastructure around the world and allied nations, ensuring that we can provide them a cyber hardened solution to meet their needs, because of the cyber risks that they face every day is a primary mission of ours and we always have a lot of work to do in that regard.

Jeffrey Ted Kessler - Imperial Capital LLC

Okay. Just quickly there was a room at the security, at this large conference that was full of essentially Asian – small Asian manufacturers, a lot of whom had thermal and infrared capabilities. And the reaction to them was, well, again relative to your company is, there was – I would just say there was some suspicion toward their capabilities and the use of them in critical infrastructure integration. So, it would seem that you have at least here at home a market that you've just talked about if you can develop that market.

James J. Cannon - FLIR Systems, Inc.

That's right. We agree and we're absolutely working hard to develop that market. We're committed to our customers' missions and the kind of places these products go, you know critical infrastructure, our purpose, lives and livelihood can be in the balance.

Jeffrey Ted Kessler - Imperial Capital LLC

Thank you very much.

James J. Cannon - FLIR Systems, Inc.

Thank you, Jeff.

Operator

Thank you. We've reached the end of our question-and-answer session. I'd like to turn the floor back over to Jim for any further or closing comments.

James J. Cannon - FLIR Systems, Inc.

Well, I want to thank everyone again for joining our call today. Again, I want to reiterate, I want to thank all FLIR team members past and present, our customers, our partners for their work over the past 40 years. Marking a 40-year milestone this past March is something we're very, very proud of and remain absolutely committed to our task and purpose. I hope to see many of you at our upcoming Investor Day in May, and I hope you all have a great day.

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.

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