FLIR SYSTEMS
FLIR
)
: FLIR Systems, which was founded in 1978 and is based out of
Wilsonville, Ore., is the world leader in the design,
manufacturing and marketing of thermal (infrared) imaging
systems. Thermal imaging systems detect the infrared energy
(heat) that is emitted by all people, objects and materials.
Infrared cameras allow the operator to see in total darkness,
adverse weather and through air pollutants as smoke and haze. The
company's products, which include advanced sensors and integrated
sensor systems enable the gathering and analysis of critical
information, with applications in commercial, industrial and
government markets, via both off-the-shelf products (at retail)
and system configurations suited to specific customer
requirements.
INFRARED TECHNOLOGY OVERVIEW
Infrared is a portion of the electro-magnetic spectrum that is
adjacent to the visible spectrum, but is invisible to the human
eye due to longer wavelengths. Unlike visible light, infrared
radiation (or heat) is emitted directly by all objects above
absolute zero in temperature. Thermal imaging systems detect this
infrared radiation and convert it into an electronic signal,
which is then processed into a video signal and displayed on a
video screen.
Thermal imaging systems are different than other types of "low
light" vision systems, such as visible light intensification used
in green/gray sighted night vision goggles. Infrared imaging
systems are not adversely affected by the presence of visible
light (they can be used during the day) and they are not
susceptible to rapid changes in visible light levels. Since
infrared systems are detecting emitted infrared radiation, they
are passive and thus more concealed than "active" or
"illuminated" systems. Additionally, thermal imaging systems can
measure very slight changes/differences in the temperature, a
critical feature for a variety of commercial, industrial and
scientific applications.
An infrared detector, which collects infrared radiation and
converts it into an electronic signal, is the primary component
of thermal imaging systems. The two types of infrared detectors
manufactured and used in FLIR systems are referred to as "cooled"
and "uncooled," with demand for both types expected to increase
substantially in the future.
Cooled detectors utilize a micro-cooler to reduce the operating
temperature of the infrared sensor to -200� C and
offer high sensitivity and resolution for long-range applications
or those applications requiring high measurement precision; these
detectors, while more sensitive and thus able to see farther,
result in a product that is heavier and more complex/expensive.
Uncooled detectors operate at room temperature and don't require
a micro-cooler, resulting in products that are lighter, use less
power and are less expensive to produce than cooled detectors.
While the performance of uncooled detectors is improving,
uncooled detectors are still less sensitive than cooled
detectors. The cost of both types of detectors is declining and
FLIR expects to continue reducing costs as volumes rise and the
technology continues to advance.
For those of us who are scientifically challenged (that's me), it
might be helpful to read through the 10-K and listen to the
company's recent events (particularly the November 2011 Investor
Day) to hear about the breadth of commercial applicability of the
products, ranging from building inspection for pest infiltration
to optical gas imagining systems to detect greenhouse gases; from
my perspective, I think it is safe to assume that the
applicability for this technology will continue to increase in
the future as the cost component becomes increasingly attractive.
CORPORATE DIVISONS AND SEGMENTS
FLIR is organized into two divisions: Commercial Systems and
Government Systems. Within these divisions, the company has five
reporting segments: Thermal Vision & Measurement (TVM) and
Raymarine, which comprise the Commercial Systems division and
Surveillance, Detection and Integrated Systems, which make up our
Government Systems division.
2011 Revenue, by Division & Segment
|
Thermal Vision & Measurement (TVM)
|
43% |
|
Raymarine
|
11% |
|
COMMERCIAL SYSTEMS
|
54%
|
|
Surveillance
|
37% |
|
Detection
|
5% |
|
Integrated Systems
|
4% |
|
GOVERNMENT SYSTEMS
|
46%
|
|
FLIR
|
100%
|
COMMERCIAL SYSTEMS
The vision for the commercial systems side of the business (as
laid out at the Investor Day) is short and sweet: "Infrared
Everywhere." The strategy behind this vision involves controlling
the corners of the market: low volume, high cost products (by
having the best technology) and high volume, low cost products;
as the overall market for infrared grows, the marginal cost to
high volume products continues to decrease rapidly, which results
in a virtuous cycle that drives tipping points for increased
commercial applications as the cost to integrate the technology
becomes less prohibitive (according to Yole
D�veloppement, a French market research company, the
commercial applications in surveillance, automotive and
thermography will reach total volume of over 1 million units in
2016, compared to roughly 300,000 in 2011).
From that base (they are currently the highest producer, by
volume, of commercial infrared sensors in the world and the price
leader in thermal imaging products), FLIR will be able to attack
any opportunity that lies in between, through a mix of
technology, cost and volume leadership. So far, this strategy
appears to be moving along nicely: CS unit volumes have increased
at a CAGR of nearly 50% over the past five years.
TVM
Thermal Vision & Measurement (TVM) products are generally
sold for applications where the customer need is to see at night
or in adverse conditions or to image a scene while gathering
valuable temperature information. Due to continued reductions in
the cost of infrared technology, demand in large untapped
commercial markets such as commercial security (ports, commercial
sites, borders, residential homes, etc), automotive (currently in
certain BMW, Audi and Rolls Royce models), marine (recreational
boating, cruise lines, etc), airborne and first responder markets
has grown rapidly. FLIR's TVM products range from highly
sensitive cameras with extensive analytic capabilities to "value"
cameras for less demanding applications.
Typical TVM customers include OEMs, major integrators of security
systems, security dealers, utility companies, electrical
contractors, maritime dealers, law enforcement agencies, building
inspectors, damage restoration contractors, universities,
numerous commercial enterprises and increasingly, consumers (the
emerging personal vision systems market is becoming accessible as
the price of advanced thermal imaging products is continually
reduced); FLIR believes that this consumer market is a key
strategic area of focus given the vast size of the customer base
and the opportunities it provides to develop brand equity.
As noted in the 10-K, customers in markets like predictive
maintenance and R&D are sensitive to the broad economy
because the company's cameras are viewed as capital expense
items. The sales of high volume cameras and emerging thermal
vision products are somewhat less sensitive to economic cycles
due to lower price points and growing awareness of thermal
technology.
Many of the markets that TVM addresses are emerging from the
early-adopter environments to broader-based demand, which has
attracted competitors. While independent industry research pegs
the company's market share in thermography products at
approximately 61% (up from 56% five years ago), the TVM market is
highly competitive, with large and niche providers of thermal
camera equipment, including divisions of Danaher (Fluke), General
Dynamics (Axsys), L-3 Communications, Sofradir (ULIS), Axis
Communications, NEC, Testo and numerous smaller companies.
Revenue from TVM has grown at a CAGR of 16% over the past five
years and was equal to 43% of company-wide revenues in 2011:
|
Category
|
2011
|
2010
|
2009
|
|
Revenue
|
$660.3M |
$574.9M |
$491.8M |
|
Operating Earnings
|
$194.7M |
$163.7M |
$122.2M |
|
Operating Margin
|
29.5% |
28.5% |
24.9% |
|
Backlog
|
$136M |
$135M |
$111M |
While revenue increased 14.8% in 2011, units increased at a rate
of nearly 50% - as the price per unit continues to decline, the
viable commercial uses for the company's products (for utilities,
in automobiles, personal use, etc) will continue to expand and
drive growth.
Raymarine
Raymarine designs, develops and markets electronics for the
maritime market and is a leading global provider of fully
integrated "stem to stern" networked electronic systems for
boats; the division was acquired by FLIR in May 2010 for $180
million in cash. The business distributes its products through a
large network of independent distributors and retailers as well
as through its relationships with boat builders, providing first
fitment (the electronic "backbone" on new boats) and aftermarket
solutions (due to long life of a recreational boat despite rapid
technological development). During 2011, Raymarine generated
revenue of $172 million (11% of company total) and $12 million of
operating earnings (which includes $3.8M of intangibles
amortization).
Raymarine supplies a global network of approximately 2,500
dealers, retailers, distributors and wholesalers, many of whom
partner on an exclusive basis and only stock Raymarine electronic
boating equipment. Raymarine also has a global network of
approximately 2,000 dealers and service centers which are able to
sell, repair and install Raymarine's products. This global
support and repair service network is very important to boaters
as many of the products offered are critical to the operation of
a boat, making easy access to parts and service essential.
Principal competitors include Furuno, Garmin (outbid by FLIR for
Raymarine), Navico and a number of small companies.
GOVERNMENT SYSTEMS
Surveillance
Surveillance is focused on selling advanced imaging and sensor
systems to government customers (military, law enforcement, etc)
in markets where high performance is required. Typical
applications include intelligence, surveillance and
reconnaissance (
ISR
), force protection, search and rescue, special operations and
target designation. Surveillance products are sold off-the-shelf
or can be customized for specific applications and frequently
incorporate additional sensors, including visible light cameras,
radars, low light cameras and laser rangefinders, among others.
Surveillance products range in price from under $10,000 for
certain hand-held and weapon-mounted systems to over $1 million
for the most advanced stabilized targeting systems.
At 12/31/2011, Surveillance backlog totaled $247 million,
compared with $333 million at year end 2010; the decline is
largely due to reductions in U.S. government procurement. While
the U.S. government is a key customer in Surveillance, it's
important to recognize that they're becoming a smaller percentage
of FLIR's business: sales to U.S. government agencies accounted
for 43%, 34% and 29% of revenues in 2009, 2010 and 2011,
respectively. The company's principal competitors in Surveillance
(highly competitive) include divisions of BAE Systems, General
Dynamics, L-3 Communications, Lockheed Martin and Raytheon, to
name a few.
Over the past five years, Surveillance revenue has grown at a
CAGR of 17%, with 2011 revenue of $578 million equal to 37% of
the company total:
|
Category
|
2011
|
2010
|
2009
|
|
Revenue
|
$577.6M |
$671.3M |
$655.3M |
|
Operating Earnings
|
$208.5M |
$256.2M |
$286.4M |
|
Operating Margin
|
36.1% |
38.2% |
43.7% |
|
Backlog
|
$247M |
$333M |
$433M |
As is clear from these figures, Surveillance is currently an area
of concern; here is what the 10-K says about the year over year
declines: Revenue decreased by 14% in 2011 compared to 2010,
primarily
due to decreases in revenue from U.S. government
agencies
, partially offset by revenue of $8.8 million from ICx business
units, which were acquired on October 4, 2010. Lower revenue and
increased segment operating expenses caused the decline in
earnings from operations and operating margin from 2010 to 2011.
The decline in backlog from 2010 to 2011 was primarily
due to the continued reduction in procurement activity by our
U.S. government customers in 2011...
Revenue increased by 2.4% in 2010 compared to 2009. Higher
deliveries of ground-based products and the revenue from a
business acquired in October 2009 was offset by decreases in
revenue from airborne and maritime products as spending by U.S.
government agencies declined in 2010. The change in product mix
and increased operating expenses of the segment resulted in the
decline in earnings from operations and operating margin from
2009 to 2010. The decline in backlog from 2009 to
2010 was primarily due to deliveries on U.S. government programs
that were booked in prior years and the
reduced procurement activity by our U.S. government
customers in 2010.
"
Detection
Detection primarily produces sensor systems that detect and
identify chemical, biological, radiological, nuclear and
explosives (CBRNE) threats (including the market leading portable
explosives detector); the ICx acquisition of October 2010 ($274M)
is focused on this segment.
Detection has unique strengths in understanding the nature of
sophisticated security threats, the technological potential of
advanced detection instruments and the procurement processes of
U.S. government customers. With a history of entering into
government-funded design and development contracts, Detection has
built relationships with key government customers and has
experience in converting highly specialized technologies into
commercial solutions that are marketable to a global customer
base (today, the Detection business is roughly 80% domestic).
During 2011, Detection generated $80 million of revenue, or 5% of
consolidated 2011 revenue; at the end of the year, the backlog
stood at $25 million.
Integrated Systems
Integrated Systems develops platform solutions for combating
sophisticated security threats and incorporates multiple sensor
systems in order to deliver actionable intelligence for wide area
surveillance, intrusion detection and facility security.
Integrated Systems incorporates advanced sensors from both the
FLIR pipeline (ICx technology is also used in this segment) and
external vendors in order to design and manufacture adaptive and
effective force protection, homeland security and commercial
solutions designed to save lives and protect critical assets.
Like detection, this segment is still relatively small, with 2011
revenues of $55 million equal to just 4% of the company total
(for detection and integrated systems, year over year revenue
comparisons are pointless due to the integration of ICx at the
start of October in 2010). Integrated Systems competes with
well-known companies such as Boeing, Honeywell, L-3
Communications, Lockheed Martin, Raytheon, SAIC and Thales.
GROWTH THROUGH ACQUISITIONS
In the past five years, FLIR has completed a total of thirteen
acquisitions, with the most recent significant ones being
Raymarine Holdings and ICx Technologies, in May and October of
2010, respectively. The company continues to look for additions
that are strategically significant and additive/complementary to
their existing technologies, distribution network, or product
portfolio.
Looking at recent acquisitions (since 2003) shows that the
company has efficiently allocated capital to M&A: the average
revenue CAGR since purchase and the average annual return (EBIT)
on the purchase price have both been 16% over that time period,
showing that the $875 million in capital invested over this time
period wasn't spent frivolously simply for the sake of becoming
larger (many managers willingly destroy value in an attempt to
build an empire).
Raymarine enhanced the distribution capabilities of the company's
thermal marine products business by adding a substantial number
of dealer outlets and marine OEM relationships, in addition to
the opportunity to build integrated product lines (a recurring
theme at FLIR) that offer thermal imaging cameras coupled with
Raymarine's displays, radars, depth sounders, global positioning
systems and autopilots products to create the broadest and most
effective suite of products in the marine electronics industry.
The acquisition of ICx (which was primarily incorporated into the
Detection and Integrated segments) expanded FLIR's capabilities
into advanced sensor technologies that detect chemical,
biological, radiological, nuclear and explosives (CBRNE) threats,
including products that are currently sold to the defense and
homeland security markets. In addition, ICx enhanced FLIR's
existing intelligence, surveillance and reconnaissance product
suite by adding advanced radars, imaging and integrated platforms
solutions.
Besides acquisitions, the company's other key growth initiative
is in house R&D; internally funded research and development
expenses were $147 million, $117 million and $91 million in 2011,
2010 and 2009, respectively. Product development is critically
important to FLIR's continued success, with an average of $125
million spent on research and development annually since 2006;
importantly, R&D has been primarily paid for with internal
funding (85%), leaving FLIR with full ownership of the
intellectual property rights and the end product.
COMPETITIVE ADVANTAGES
FLIR has decades of experience in developing and marketing
infrared sensor products and has built several unique advantages
over competitors that are core to its continued success.
The company's manufacturing capability, which reaches across the
world in both developed and emerging regions, is based on a
vertically integrated model that provides control over certain
key component technologies that increases the effectiveness and
efficiency of meeting customer needs and delivering value
(essentially like Intel's operating model compared to that of
other chip manufacturers). Through acquisitions and internal
development, management has created an internal supply network
that allows for optimized manufacturing throughput, increased
product design flexibility, enhanced product reliability and
independence in designing key components; this integrated
approach enables lower costs and improved functionality of
critical components so that they work together efficiently within
the company's products.
In comparison to competitors that do not possess a similar level
of integration (they rely on third-party suppliers for critical
components), FLIR can deliver products to customers in a more
timely and cost-effective manner; in Government Systems, for
example, where controlling cost has been (and will continue to
be) pushed to the forefront as a result of debt/national budget
concerns, this is a critical advantage to have.
By management's estimation, none of FLIR's competitors have
comparable penetration into as many markets as they do, including
the government, industrial, commercial and consumer sectors. This
leading position allows the company to secure new and continuing
business which results in increased manufacturing economies of
scale. This creates a cycle whereby sensor technologies become
increasingly affordable to an array of end-users while unit costs
decline.
The company's size and history also seeds future growth in
another fashion: product development. With a broad array of
products and key customer ties (thousands of commercial and
government customers for use in a variety of applications and
markets worldwide), the company can utilize field use data and
customer feedback in the development process to add new features
that meet the evolving needs of the end-user. This end-user is a
diverse group, include government agencies and militaries,
aerospace and defense contractors, electricians and tradesmen,
commercial ports, first responders, critical infrastructure
operators, electrical generation and gas processing plants,
heating and air conditioning technicians, building inspectors,
food processors, automobile parts manufacturers, commercial and
residential security providers, research and lab technicians,
manufacturing companies, doctors and veterinarians and
recreational boaters, to name but a few. As noted in the 10-K,
this continual evolution of products has proven successful
through high levels of customer retention, product line expansion
(which has diversified the customer base) and continued revenue
and income growth.
And while this may not be considered a competitive advantage,
intelligent capital allocation is so often overlooked that I
think it should be highlighted in the case of FLIR; for example,
take a look at their share repurchase activity by month in 2011
(key months in bold):
| March 1 - March 31 |
212,879 ($31.83/share) |
| May 1 - May 31 |
177,161 ($35.07/share) |
| June 1 - June 31 |
322,839 ($33.49/share) |
| July 1 - July 31 |
100,000 ($28.38/share) |
| August 1 - August 31 |
2,201,826 ($24.20/share)
|
| Sept 1 - Sept 31 |
1,698,174 ($26.18/share)
|
| Oct 1 - Oct 31 |
284,751 ($26.57/share) |
| November 1 - November 31 |
684,421 ($25.41/share) |
| December 1 - December 31 |
453,194 ($25/share) |
|
Average Price per Share
|
6,135,245 ($26.19/share)
|
It's so nice to see a company actually buy their stock when it
gets cheaper and hold off as it appreciates rather than just pay
lip service to the idea; also, investors should note that they
became increasingly attracted to the stock at around $24/share,
about 9% above Wednesday's close of $22.07 per share.
GROWTH STRATEGIES
Grow Existing and Enter New Markets
A key element of FLIR's success has been addressing the market by
delivering high-value sensor technologies with various specs and
price points to reach an expanding range of customers (see the
breakdown of price/capability across various product lines in the
investor day presentation). This has been realized on the
commercial side by increasing the availability, value and
effectiveness of products, with the growing end-user population
often finding new uses for the technology.
Design and Develop Innovative Sensor Systems
FLIR plans to broaden their product line by developing
next-generation sensor technologies via internal funding and,
when strategically beneficial, customer funds as well.
Critically, they must develop novel features and technologies for
products while also reducing their size, weight and power
consumption (particularly in cooled detectors). From the 10-K:
"By being aware of our changing customers' needs and the trends
within our markets, we expect to bring to market the most
cutting-edge and innovative products that provide critical
information to secure, protect and improve lives and resources."
Continually Reduce Costs
The company's commercial operating model has had past success
developing/manufacturing products that benefit from economies of
scale, a trend that enables the company to expand on their
leading market position while reducing the cost needed to deliver
products to customers. Management expects to further leverage
this model (primarily by continued vertical integration), where
increased unit volume output reduces costs, leading to lower
selling prices and increasing demand and sales volume for FLIR
products.
Expand Global Reach
FLIR has been successful in expanding to new international
markets, most recently in regions of the Middle East; in the
future, they intend to increasingly focus on developing countries
such as India and China. Additionally, as their technologies have
become more affordable and prevalent in consumer markets, FLIR
has continued to strengthen marketing and sales channels to
better communicate and serve the millions of potential customers
in the commercial systems business.
Build Application Awareness
Both thermal imaging and CBRNE detection technologies are still
in the early stages of adoption in many of our markets. As people
understand and recognize the extensive commercial, consumer and
industrial uses for the information provided by FLIR sensors,
business will continue to grow. As such, the company is
communicating the benefits of thermal and detection
sensors to new market participants in order to drive demand for
our products via internet promotion, advertising, direct mail,
press and demonstration tours, technical articles for
publications and sponsorship of and participation in major trade
shows.
RISKS
At 29% of total 2011 revenues, the U.S .government and its
agencies are the company's biggest customer. As expected, the
funding of contracts awarded to FLIR depends on the overall
United States government budget and appropriations process, which
is beyond FLIR's control and likely to be affected by potential
defense cuts; the risk is that any material cut in defense
spending would likely start at the top line and work its way down
(deteriorating operating/profit margins).
Even if this comes to fruition, at some point enough is enough;
as the date for automatic defense cuts draws closer, the stock
continues to fall - in the past year, FLIR has fallen by more
than 37% while the DJIA and the S&P 500 have increased
marginally. At this point, the stock is within spitting distance
of its March 2009 low (by comparison, the S&P has doubled).
On top of that, it's important to look at FLIR as a company,
rather than simply looking at the defense budget as a proxy for
their growth potential; for example, while the U.S. Department of
Defense budget has growth by roughly 8% per annum since 2001,
FLIR's U.S. Government business has growth at a rate of 26% per
annum. In addition, the Surveillance & Reconnaissance portion
is still growing (despite a flat budget overall) and is worth $14
billion, leaving FLIR plenty of opportunity to grab additional
market share.
The same concern with the U.S. government's spending cuts can be
made for international customers looking to shore up their
sovereign balance sheet, though the potential for material
defense spending cuts outside the U.S. appears to be much less
impactful to FLIR (and this doesn't appear to be happening on a
company level anyways: sales to international customers jumped to
48% of total revenues in 2011 from 41% in 2009, due to
international sales growth of 25% annually since 2009).
The dark cloud in the equation will be competitive forces and the
importance that the future development of technology will have in
determining the company's success (particularly when competing
with giants like Lockheed Martin, Raytheon, etc). In answering
that question, I tend to look at historical financials and the
track record the management team has established, which suggests
that investors would be misguided to bet against FLIR. As always,
this comes with the disclaimer that historical results may not be
representative of the company's future performance.
MANAGEMENT
Earl Lewis, 68, has been the CEO at FLIR since November 2000; his
total compensation has averaged $6 million each of the past three
years, with less than 20% coming in the form of cash. He owned
2.6 million shares of common stock as of the proxy filing date,
equal to nearly 2% of the outstanding shares (and nearly 10x his
average annual salary, aligning his interests with shareholders).
Besides one individual, every person on the management team and
the board of directors holds at least $2 million (at the current
price) in stock and collectively hold ownership of 3% of FLIR's
outstanding shares.
Top management has been at FLIR for a number of years; the
President of Government Systems, the President of Commercial
Systems and the CFO joined the company in various roles in 1994,
1999 and 2003, respectively. Again, stock ownership is aligned
with shareholders: each of those three gentlemen holds at least
3x their 2011 salary in common stock.
HISTORICAL OPERATING RESULTS
Over the past decade, FLIR has increased both revenue and
earnings per share at a rate of 22% per annum. Here's a breakdown
of the most recent five year figures:
|
Year
|
2011
|
2010
|
2009
|
2008
|
2007
|
| Revenue |
$1.54B |
$1.39B |
$1.15B |
$1.08B |
$779M |
| Gross Profit |
$828M |
$763M |
$658M |
$606M |
$433M |
| R&D (% sales) |
9.5% |
8.4% |
8.0% |
8.4% |
9.3% |
| Operating Margin |
20.28% |
25.95% |
30.28% |
26.42% |
24.61% |
| Net Earnings |
$221.5M |
$248.1M |
$230.2M |
$200.9M |
$133.6M |
| Profit Margin |
14.3% |
17.9% |
20.06% |
18.65% |
17.14% |
| Diluted EPS |
$1.38 |
$1.54 |
$1.45 |
$1.28 |
$0.89
|
Four Year CAGR, 2007-2011
| Revenue |
18.58% |
| Gross Profit |
17.59% |
| Net Earnings |
13.47% |
| Diluted EPS |
11.59% |
As we can see from these two sets of data, some worrying trends
are appearing in the P&L. While revenue growth has been
strong at a high teens compounded annual rate, the trend as we
move down the income statement is contracting, rather than
leveraging the growth in sales: gross margin, net earnings and
diluted EPS growth have all trailed revenue growth rates. In
2011, this can be attributed to two specific events: first,
Raymarine and ICx have historically had lower gross margins than
the remainder of the company's operations, which has dragged down
margins as those businesses were consolidated; secondly, the
product mix in the surveillance division negatively impacted
gross margins, which was partially offset by operating
efficiencies in TVM.
As we get past the COGS, we see that higher R&D as a
percentage of sales (up 26% year over year on a dollar basis)
also impacted operating margins and the bottom line; how an
investor interprets the way that cost rolls through the P&L
should come with the remainder that despite the accounting
conventions, the proceeds from that work will be applicable well
beyond 2011.
While the absolute results (declining) aren't what investors
would hope for, it's important to step back from a vacuum
approach and see where the company stands in comparison to the
competition; as noted during the Investor Day, the company's
operating margin has consistently been best in class (in
comparison to the peer group) and has stayed in the top quartile
in each of the past five years (due to lower SG&A as a
percentage of sales and higher gross margins).
In addition, we can see that revenue growth has slowed over time;
in 2011, for example, revenue was up 11.2%, but would have been
flat if the acquisitions of Raymarine and ICx were excluded.
As noted in the 10-K, this is directly related to government
spending: while revenue in the Thermal Vision and Measurement
(TVM) segment increased by 14.9% in 2011, revenue in the
Surveillance segment declined by 14%. This becomes more apparent
when we look at pre-tax earnings on a regional basis:
|
Region
|
2009
|
2010
|
2011
|
|
United States
|
$241.47M |
$248.36M |
$192.22M |
|
Foreign
|
$98.92M |
$114.34M |
$118.86M |
As always, investors need to be looking through the windshield
rather than staring into the rear view mirror; with the U.S.
government accounting for less than 30% of the business at the
end of 2011 (compared to over 40% in 2009), it's important to
recognize that FLIR's future is not tied to the defense budget.
With the continued growth in the international and commercial
business, the U.S. government slice of the pie will become
smaller with each passing year.
BALANCE SHEET
At year end, FLIR had $441 million in cash and $1.23 billion in
current assets, compared to $248 million in long term debt and
only $232 million in current liabilities (current ratio of 5.3x).
Goodwill and intangibles are a sizeable piece of total assets
($662 million, or 30.8%, the majority of which is classified
under the Thermal Vision & Measurement segment), which is
what you would expect for a company that has acquired 13
businesses over the past five years.
FREE CASH FLOW
|
Category
|
2011
|
2010
|
2009
|
2008
|
2007
|
|
Cash Flow from Ops
|
$243.9M |
$255.3M |
$271.8M |
$218.3M |
$116.1M |
|
CapEx
|
$42M |
$66M |
$41.9M |
$27.6M |
$44.0M |
|
FCF
|
$202M
|
$189M
|
$230M
|
$191M
|
$72M
|
DU PONT ANALYSIS
|
Account
|
2011
|
2010
|
2009
|
2008
|
2007
|
|
Net Profit Margin
|
14.34% |
17.87% |
20.07% |
18.65% |
17.14% |
|
Total Asset Turn
|
0.77 |
0.83 |
0.84 |
0.95 |
0.86 |
|
Financial Leverage
|
1.29 |
1.23 |
1.34 |
1.53 |
1.74 |
|
ROE
|
14.28%
|
18.20%
|
22.48%
|
27.21%
|
25.64%
|
MISCONCEPTIONS
Often, value investing comes down to buying companies where there
is a misconception about what recent results mean for the
company's future, or even what the company does; FLIR has been
exposed to a bit of both.
On the first point, weakness in government systems has led to the
perception that this company cannot grow without an expanding
defense budget; the reality is that the U.S. government is
becoming an increasingly less important customer (under 30% of
sales) and is being mitigated by strong growth in commercial and
international markets, which can push it under 25% looking
forward (government will come close to 50/50 split between
international and domestic this year, with the split between
government and commercial learning towards commercial).
The second misconception (what the company does) is tied to this:
despite what some people may think, the company is not a DOD
contractor; listen to what Bill Sundermeier, President of
Government Systems, has to say on this topic:
"I suspect there are a few analysts that are out there right now
that [will] comp us against DOD contractors and let me tell you
every time I see one of those reports my stomach turns because
every single day I think about not being a DOD contractor and
being compared to them. We do everything we possibly can to not
be like them, from the way we produce our products, to the way we
deal with our costs, we fight extremely hard to not be a cost
plus contractor. Why? The margins there are terrible; if you take
a development contract, you're lucky if you get 7-8% margin on
that and that turns into a product sale that you might get 13-14%
profit on. We do everything we can to not be a DOD contractor."
For example, look at companies like Raytheon, Northrop Grumman,
L-3, or Lockheed Martin: for every one of them, gross margins in
2010 were materially below 20% (average in the low teens); by
comparison, FLIR's gross margin in 2010 was over 50%. Of course,
that begs the question: why?
Because FLIR will not build a product that does not have the
potential for commercial application: "we will not take a project
that doesn't lead into a product that everybody (meaning police,
FBI, border patrol, etc) can use," and they are pushing this into
ICx by eliminating contract R&D that doesn't lead to
profitable products.
Intuitively, this makes sense: with plenty of DOD contractors
competing on price with limited barriers to entry, the laws of
economics tell us that they will drive down the bids to a point
where the margins are of limited attractiveness (on cost plus
contract, that figure is essentially set in stone prior to
commencement). The issue at that point becomes that most of the
products being developed for the U.S. government have all the
bells and whistles (see expensive) and won't be affordable
commercially, assuming that it even has commercial applications.
FLIR, on the other hand, will specifically turn down projects
that do not have commercial applications, because they know that
they won't make attractive returns otherwise.
With their method, FLIR builds products across a vertically
integrated components and technology company that is funded by
internal R&D (they take the risks) and ultimately owns the
rights to the proceeds of their developments (and the rewards)
with a focus on expanding the reach to commercial applications;
comparing this methodology to the operations of the major DOD
contractors is the equivalent of comparing apples and oranges
(and explains why the Lockheed's, Raytheon's and BAE's of the
world are some of FLIR's best customers - because they get a
better product from FLIR than they can from their own
subsidiaries, not surprising considering that cost plus
contractors have little incentive to drive down expenses).
Of course, this doesn't come without risk: while the Lockheed's,
Raytheon's and Northrop Grumman's spend 1-2% of sales on internal
R&D funding, FLIR spends 8-10% annually; because customers
don't pay FLIR directly to develop products, they can make them
in a way that they can satisfy the needs of multiple customers,
driving economies of scale.
Ironically, this model has helped FLIR to increasingly meet the
needs of the militaries around the world; according to market
researcher Maxtech, the company has increased their share of the
world market for military infrared imaging systems from 5% to 9%
in the past five years, passing BAE, L-3 and Northrop Grumman
along the way (Raytheon and Lockheed are the industry leaders
with roughly 18% share a piece).
Looking to the future, FLIR hopes that some growth will come from
climbing the ladder to compete with Raytheon and Lockheed for
additional share; what Mr. Sundermeier has to say about this
topic is insightful:
"The challenges of fighting against Raytheon, DRS and Lockheed -
one of the things we've consciously done, not being a DOD
company. I have one legislative lobbyist in Washington, DC;
Raytheon has 250. So, there will always be acquisitions that
happen because of the lobbying power, whether or not it's good
for our taxpayers, whether or not it was the right value product
purchased, just the overpowering politics that can happen will
still head things their way.
We continue to fight against that with lower cost products that
have the same technological capabilities. But I can tell you in
Washington, DC it's not a fair fight... The best technology at
the lowest price doesn't necessarily always win because of
politics. And that's not a space we want to spend money in
(growing lobbyists). We're going to stay focused on value and
we're to continue to chug away..."
As he goes on to note, their method to combat that is to stick to
contracts that have application on the commercial side, while DOD
contractors focus on building unique products with limited use
outside of a specific build-set for the U.S. military. According
to Mr. Sundermeier, some people in the military and in Washington
are impressed with the FLIR model and think that it should be an
increasing part of government procurement in the future.
RECENT RESULTS (Q1 2012)
Revenue in Q1 was$349 million, down 7% compared to first quarter
2011. Operating income in the first quarter was$68.3 million,
compared to $76.3 million in the first quarter of 2011. First
quarter 2012 net income was$48.1 million, or$0.31 per diluted
share, compared with net income of$51.3 million, or $0.32 per
diluted share in the first quarter a year ago. During the
quarter, the Company repurchased 1 million shares at an average
price of$25.39 per share.
Revenue from the Company's Commercial Systems division increased
4% from the first quarter of 2011, to$202 million. Within the
Commercial Systems division, revenue from TVM was$156 million, an
increase of 7% over the first quarter results last year.
Commercial Systems' Raymarine segment contributed$46.6 million of
revenue during the first quarter, down 8% from the prior year due
to lower volume from European OEM's.
Revenue from the Company's Government Systems division decreased
19% from the first quarter of 2011 to$146 million. Within the
Government Systems division, revenue from the Surveillance
segment was$115 million, a decrease of 24% from the first quarter
of 2011. Revenue from Government Systems' Detection segment
was$19.4 million, an increase of 8% compared to the first quarter
of 2011. Government Systems' Integrated Systems segment
contributed$12.2 million of revenue during the first quarter, a
decrease of 5% from Q1 2011.
The Company's backlog of firm orders for delivery within the next
twelve months was approximately$457 million as ofMarch 31, 2012,
an increase of$2 million during the quarter. 12-month backlog in
the Government Systems division was$312 million (down $2M) and
the backlog in the Commercial Systems division was$145 million,
up$4 million during the quarter.
Based on financial results for the first three months of
2012,FLIR reaffirmed its outlook for earnings per share for the
full year 2012 of$1.60 to $1.70 per diluted share and revenue for
the full year 2012 to be in the range of$1.55 billion to $1.65
billion.
CONCLUSION
Growth companies often fall into no man's land for value
investors due to the degree of uncertainty in future forecasts
that is necessary to justify the 20-30x multiples seen on current
earnings. At FLIR, government system and commercial system sales
have grown at a compounded annual rate of 18% and 27%
(respectively) since 2002, which has resulted in solid 22% EPS
growth (per annum) over the past decade.
Yet, in the case of FLIR, you're not paying a huge multiple for
the growth opportunities that will continue to surface as the
technology becomes increasing attractive in commercial markets
and in government systems around the globe (FLIR has only
scratched the surface in the BRIC's); on management's 2012
earnings estimate of $1.60 to $1.70 per diluted share, the
company currently sells at a forward multiple of just 12-13x.
On the low end, management estimates that 2012 EPS will increase
16% from the $1.38 earned in FY2011; using that as our proxy for
free cash flow, I estimate that 2012 FCF will come in around
$230M (looking at the four year average FCF, that number is 15%
higher); when those figures are put into a reverse DCF with a
discount rate of 12%, we see that the mispricing of this security
is relatively severe: the implied growth rate in free cash flow
is 7% per annum over the next decade, followed by growth in line
with GDP (3%) in perpetuity.
In the short term, that view may be called into question: growth
may fall short of 12 month expectations as domestic defense cuts
(still material enough to dent near term results) hurts the
government systems business and uptake internationally takes time
to ramp up (as seen in Q1).
While I can't say when, I think that the appropriate conclusion
is that when taking a longer term view, this outlook fails to
consider the company's growth prospects in the international
government business, in addition to opportunities that will
emerge on the industrial and commercial side as a result of
increasingly affordable technology with real world applications.
At $22 per share, I believe that the stock is materially
undervalued, with my estimate of intrinsic value north of $30 per
share (Wally Weitz of the Weitz Funds noted in his Q1 investor
letter that he expects EPS growth to average at least 15% and
pegs intrinsic value at $39). I think that there is a strong case
to be made for initiating a position in FLIR at the current
valuation.
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