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FLIR - Moving Forward

January 09, 2014 | About:
The Science of Hitting

The Science of Hitting

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The Consumer Electronics Show (CES) is an interesting event; as with most things technology related, it is primetime for predictions about how the world as we know it is unquestionably about to change forever (reality has proven to be much less certain as far as I know, not one product from TechCrunch’s “Best of CES 2010” list here has become a commercial success). While some of the innovative new products revealed are worth remembering, many more end falling into the dustbin of history not too shortly thereafter.

For FLIR Systems (FLIR), I don’t think that will be the case. I believe that what they revealed this past Monday at CES could prove to be a real breakthrough for the company.

Let’s start with their first release:

“FLIR Systems, Inc. announces the launch of FLIR ONE, the first consumer-oriented thermal imaging system… FLIR ONE attaches to any Apple (AAPL) iPhone 5 or 5s* smartphone and displays a live thermal image on the phone's screen [model coming for Android (GOOG) later this year], giving users the unprecedented ability to see the world in a way the naked eye cannot, including in complete darkness. With a targeted MSRP of $349, FLIR ONE senses heat rather than light utilizing FLIR's revolutionary new Lepton camera core. This core incorporates the same FLIR thermal imaging technology that has revolutionized the way the world thinks about security, public safety, energy efficiency, nighttime navigation, industrial production, preventive maintenance, and the enjoyment of the outdoors.

FLIR ONE's unique ability to see and measure infrared energy gives consumers a versatile new tool that can be applied in a wide variety of applications. For example, homeowners and contractors with a FLIR ONE can easily identify heat or cooling leaks in buildings, find studs in walls, or locate water damage. An outdoor enthusiast can observe wildlife, day or night, navigate in the dark, determine if the day's catch is fully cooked, or make sure a campfire is out by using FLIR ONE. A family can detect intruders in total darkness, find a lost pet, or see through smoke in an emergency using a FLIR ONE. A worldwide rollout for FLIR ONE is planned for spring 2014, and it will be available in gray, white, or gold colors. FLIR ONE houses its own rechargeable battery that can power the device for two hours of continuous use and can boost iPhone 5 battery life by up to 50 percent.”

If you’re like me, one thing jumped out immediately from the release: What is the Lepton camera core? A second press release reveals what I’m really interested in (bold added for emphasis):

“FLIR Systems, Inc. today announced the release of the new FLIR Lepton thermal imaging camera core. Lepton utilizes innovative technology, high volume manufacturing techniques, and commercial scale to deliver a price point that is an order of magnitude below current thermal camera cores.

Similar in size, weight, and power consumption to a conventional CMOS cell phone camera module, Lepton is the world's smallest microbolometer-based thermal imaging camera core currently available. FLIR will utilize Lepton in new and existing products across many vertical markets. The first commercial use of Lepton is in the new FLIR ONE thermal imaging smartphone accessory introduced today at CES 2014. Lepton has also been designed for easy integration into third party products, such as smartphones, tablets, diagnostic tools, automobiles, toys, building controls, process equipment, security systems, machine vision systems, and advanced gaming devices. OEMs around the world can benefit from the fully-exportable Lepton core, which generates high-quality, fully-processed thermal images through common standard interfaces.

Lepton utilizes multiple proprietary technologies, including wafer level detector packaging, wafer level micro-optics, and a custom integrated circuit that supports all camera functions on a single integrated low power chip. These and other innovations are reflected in more than 100 new patent filings worldwide related to Lepton technologies, processes, and applications. The new Lepton core facilitates accurate temperature measurements and is fully compatible with FLIR's patented Multi-Spectral Dynamic Imaging technology, or MSX, which significantly enhances the thermal image fidelity with data from a visible-light sensor.

“FLIR is committed to the development of lower cost, user friendly thermal sensing technologies to enhance vision and measurement beyond light. Lepton represents our latest, most dramatic step toward our vision of becoming the world's sixth sense,’ said Andy Teich, President and CEO of FLIR. “Not only will Lepton support an array of new imaging applications, but its revolutionary price, size, and low power consumption will open new markets for the useful information and data that thermal technology provides.”

As I’ve noted in the past, FLIR continues to invest a significant percentage of its revenues back into research and development (around 8% to 10% of revenues); much of this expense goes into developing camera cores, like Lepton (as well as other breakthroughs, like MSX). As the leader in infrared detector cores, FLIR is able to spread these R&D costs across the largest number of units, fueling a continual focus on significantly lower price points to expand commercial applications for the technology. The vertically integrated nature of FLIR’s manufacturing operation (less reliance on third party suppliers and control over key component technologies) results in similar advantages for the company – higher volumes and lower unit costs.

I’d recommend you take a look at the individual segments as outlined in the company’s 10-K. Soon enough, something will start to become apparent: FLIR’s competitors are numerous, but are generally competing in only one or two individual market segments. This paragraph from the 10-K captures this perfectly: “We believe that none of our competitors have comparable penetration into as many markets as we do, including the government, industrial, commercial, and consumer sectors. Having a leading position in the markets we serve allows us to secure new and continuing business while also achieving manufacturing economies of scale. Increased unit volumes work to reduce costs throughout our business, which allows us to lower our prices. This creates a virtuous cycle whereby we are able to make advanced sensor technologies more affordable to a wide array of end-users while reducing costs. This established presence across multiple markets enhances our competitive position.”

The results for the TVM segment in the period from 2007 through 2012 shows how this can work mathematically: In a period where average selling prices (ASP’s) fell at a 14% compounded annual growth rate – meaning the price cumulatively fell by more than 50% over the five year period – volumes increased at a CAGR of 27% (by the way, the net result was a 10% CAGR for revenue, with operating profits growing slightly faster at 11% per annum).

A 2009 Seattle Times article that quoted (then) CEO Earl Lewis captures this perfectly: “We really believe that if we can just keep driving the price down, down, down, the number of opportunities will go up.” His commentary continued with the following: “If we can aggregate the (R&D) costs over a big base of different applications, we can push the costs down in any of these markets and we can be the low-cost supplier - and it will be very difficult for anyone to attack FLIR.” I think Lepton is a tangible manifestation of that strategy – and it appears to be working (MSX is an important value driver as well).

It has been true in the past, and I think it will continue to be the case in the future: I believe that there is a bright future ahead for this technology, with volume growth leading to additional declines in ASPs (over time) and fueling a virtuous cycle as additional applications become viable at lower price points. More importantly for investors, I think FLIR is in a position to capitalize and profit from that continued progress (adoption isn’t worth much for investors without a sustainable competitive advantage to capitalize on future growth as it occurs, as the airlines have shown us over the years). In my mind Lepton is a significant step in the right direction for FLIR – a step that will put competitors in a precarious position moving forward.

I wouldn’t feel right in ending this article without one disclaimer (it’s been a bit too optimistic for my blood): As I noted in my last portfolio review, FLIR is not among my four largest positions. When it comes to investing, actions speak louder than words – so let me explain. I attribute that bit of conservatism to two factors: one, the potential to be blindsided by new technologies or competitors, though I’m not entirely sure how that could happen without actively investing in the space as FLIR has done; and two, the relative position of FLIR’s competitors in relation to the company. On the second point, I’ve had a very hard time finding consistent and reliable data on this industry; a look at Danaher’s (DHR) 10-K – the parent company for Fluke – offers another example as to why this is an issue: they mention Fluke all of four times in a 118 page filing (with no real description of the business, recent results, etc., in those four mentions). This is similar for other competitors – many are smaller divisions among larger corporations, and garner little to no mention in SEC filings or the press.

On both of these points, I think I’ve been adequately conservative in my assumptions about the industry in general (largely unfocused on the broader opportunity – namely the DoD contractors) and FLIR in particular, with the long term financials a primary factor in those conclusions – but for the sake of full transparency, readers should know about those two factors.

About the author:

The Science of Hitting
I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.

I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over many years.

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