On March 7, FLIR Systems (FLIR) had their investor day to recap fiscal year 2012 results and discuss the outlook for the business heading into 2013. As you likely know if you’re reading this, I pitched FLIR as a value contest pick back in May (here), and still like the company despite the nice move higher since then (currently about 15% below the low end of my intrinsic value estimate from that article). Considering that the investor day was quite long, I’m going to break the presentation up into three articles, in this order: Government Systems, Commercial Systems and Corporate/Financial Overview, along with my closing thoughts; with that, let’s get started on the Government Systems business:
As a refresher, the Government Systems division is comprised of three reporting segments: Surveillance, Detection, and Integrated Systems. Government collectively accounted for 45% of FLIR’s $1.4 billion in revenue in 2012 (10-K), with Surveillance reporting $486 million in revenue (35% of company total), Detection reporting $63 million in revenue (5%), and Integrated Systems reporting $69 million in revenue (5%). While Detection and Integrated Systems grew nicely in the past two years (collectively, revenue increased from $38 million to more than $130 million, and would’ve been even higher had the company not purposely chosen to pull out of the contract R&D space), these smaller segments haven’t been able to balance weakness in the larger Surveillance segment: In the past two years, revenues declined from $671 million to $486 million, and earnings from operations have fallen from $256 million to $160 million (as operating margin declined precipitously – from 38% to 33%); with that said, backlog in the segment was increased 6% at year-end, and up for the first time since 2008 – suggesting a turn may be in sight (though the peak is still a long way off, with the 2008 backlog nearly 2x the 2012 backlog).
For fiscal 2012, Government Systems revenues were down 13% overall, with international revenues off 6% and domestic revenues off 17%. The domestic revenue figure continues to show the company’s dependence on the U.S. – and is further fuel to continue stretching the global reach of FLIR’s business, as has been done consistently for years (international sales increased from 39% of revenues in Surveillance for 2011 to 45% in 2012).
In regards to sequestration – and its impact on FLIR, Andrew Teich, the president of Commercial Systems, said the following (rough transcript here):
“What happens with sequestration and this continuing resolution environment to our business is really procurement slowness. It's the hesitation, the trepidation to release orders. And it's my belief that if we can get a continuing resolution approved, we'll have a budget, we'll at least have a budget for two more quarters (government fiscal year ends in October). So, at least if we have a budget, the procurement agencies will start spending. And actually, in the last couple of weeks, we've been hearing from procurement agencies, hey, it's going to pass. Start spending your own damn money, you're behind on that. Start spending O&M as fast as you can. The resolution's going to pass. Congress is not going to stop the government. We're going to have a budget, start spending. So we're hearing that in the last couple of weeks. Stopping the government is probably not going to happen. So if we can actually get to a continuing resolution, we'll have a budget for the second half of the year. By the way, it's at sequestration level of spending and I think that -- the fact that we have a budget is more important than what's going to happen with sequestration in the future now… So to me, the most important thing is get the budgets released, get the procurement officers ready to start spending again and get focused on the areas that we excel in.”
In Detection, management drove higher gross margins and brought the segment to operating profitability in 2012 even as revenue declined; while part of this is due to the decline in contract R&D (CRAD) mentioned above, it was also driven by the company’s efficiency efforts: “In 2012, there was a lot of restructuring that went on, from seven sites down to three. We reduced the headcount by 23%, and caused some pretty good disruption there - we were still able to execute… a lot of work went on with operating expenses - we removed $10 million out of OpEx last year. So this business is getting poised in the right position for us.” Within this segment, the company is focused on explosives, and is in the process of trying to get on the qualified products list (QPL) so that the TSA will consider buying their products in the U.S.; this is a global focus, with FLIR looking to nab the European (ECAC) and Chinese (CAAC) certifications as well in 2013.
Integrated Systems was firing on all cylinders in 2012 – backlog increased about 75% year over year (to $70 million), with revenue, gross margins and operating profit (in dollar terms and as a percentage of sales) all increasingly solidly; management doesn’t mince words when it comes to Integrated Systems, plainly calling it a “rapidly growing business.” Teich sums it up nicely:
“So where are we going? There are 400 nuclear power plants, oil refineries certainly been in the news [700+], a lot of interest in that space. The airport security market is growing rapidly [estimated to increase more than 70%, to a $45 billion market, by 2018]. China is going to add over 100 airports in the next five years. And we're getting approvals for our radars, our infrared equipment into the China space. Prisons, bases, ports, buildings, lots of places for us to go with our integrated systems technology. I really think, two years from now, you're going to see a shift from where Government Systems is.”
As the company notes, military spending isn’t much of a near term opportunity for FLIR – by their estimates, worldwide military spend will likely be unchanged in the coming years (with an obvious footnote being that you’ll never know when that might change). With that said, there’s little doubt that nations are increasingly concerned about their security and their sovereignty: “The markets of border security, critical infrastructure and civil security are continuing to expand worldwide, and we think that we can get a piece of this.”
I’ll be out with an update on the Commercial Systems segment in the coming days.
About the author:
As it relates to portfolio construction, my goal is to make a small number of meaningful decisions. In the words of Charlie Munger, "Patience followed by pretty aggressive conduct."
I run a concentrated portfolio, with a handful of positions accounting for the majority of my equity holdings (currently two). From the perspective of a businessman, I believe this is adequate diversification.