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Edited Transcript of FLIR earnings conference call or presentation 25-Oct-17 1:00pm GMT

Q3 2017 FLIR Systems Inc Earnings Call

WILSONVILLE Oct 31, 2017 (Thomson StreetEvents) -- Edited Transcript of FLIR Systems Inc earnings conference call or presentation Wednesday, October 25, 2017 at 1:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* James J. Cannon

FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director

* Shane R. Harrison

FLIR Systems, Inc. - Interim CFO & Senior VP of Corporate Development & Strategy

* Todd M. DuChene

FLIR Systems, Inc. - Chief Ethics & Compliance Officer, SVP, General Counsel and Secretary

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Conference Call Participants

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* Andrew Jay Lipke

Stephens Inc., Research Division - Research Analyst

* Asher Burton Carey

Robert W. Baird & Co. Incorporated, Research Division - Research Associate

* James Andrew Ricchiuti

Needham & Company, LLC, Research Division - Senior Analyst

* Jeffrey Ted Kessler

Imperial Capital, LLC, Research Division - MD

* Jonathan Frank Ho

William Blair & Company L.L.C., Research Division - Technology Analyst

* Joshua Ward Sullivan

Seaport Global Securities LLC, Research Division - Director & Senior Industrials Analyst

* Michael Frank Ciarmoli

SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst

* Noah Poponak

Goldman Sachs Group Inc., Research Division - Equity Analyst

* Saliq Jamil Khan

Imperial Capital, LLC, Research Division - VP

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Presentation

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Operator [1]

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Greetings, and welcome to the FLIR Systems Third Quarter 2017 Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Todd DuChene. Please go ahead.

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Todd M. DuChene, FLIR Systems, Inc. - Chief Ethics & Compliance Officer, SVP, General Counsel and Secretary [2]

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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 & Presentation section of flir.com/investor.

Before we begin this conference call, I need to remind you that statements made on this call, other than historical facts, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and are based on our current expectations. Words such as anticipates, estimates, expects, 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 forecast.

The forward-looking statements we make today speak as of today, and we do not undertake any obligation to update such statements to reflect 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 adjusted measures is in our press release this morning.

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

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [3]

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Thank you, Todd, and thank you, everyone, for joining us for FLIR's Third Quarter 2017 Earnings Call. With Todd and me today are Shane Harrison, our Acting CFO and SVP of Corporate Development and Strategy; Travis Merrill, the President of our Commercial Business Unit; and Frank Pennisi, the President of our Industrial Business Unit.

Overall, Q3 was a strong quarter, with 15% revenue growth, gross margin improvement and 17% growth in operating cash flow versus prior year. All 6 of our segments grew their revenue and operating income over the prior year. Bookings in the quarter led to a finishing backlog of $709 million, the highest level in FLIR's history. I'll start the review of the third quarter on Slide 3 of the presentation.

This morning, we reported third quarter revenue of $465 million, which was an increase of 15% over the third quarter of 2016, and 8% on an organic basis. Our commercial products revenue grew 20% over the prior year, and our government products revenue grew 8%. Adjusted gross profit and adjusted operating income grew 16% and 14% over the third quarter of 2016, respectively.

Segment growth was broad, and segment level operating margin expanded approximately 30 basis points. Now this growth was offset slightly by increased corporate expenses and a higher tax rate. Adjusted earnings per share for the quarter were $0.52, which represents 8% growth versus last year's adjusted EPS of $0.48. Total company 12-month backlog finished the quarter at $709 million, up $63 million or 10% over the end of the second quarter.

Our performance in Q3 was ahead of our expectations, due partially to revenue that was pulled in from Q4, as shipments in some of our businesses were accelerated by customer requirements. Consequently, we continue to expect full year 2017 revenues to be in the range of $1.775 billion to $1.825 billion, and if narrowed, our expectations for adjusted EPS to be in the range of $1.83 to $1.88. We also announced today a quarterly dividend of $0.15 per share, which will be payable on December 8 to shareholders of record as of November 24.

I want to remind everyone of our operational realignment. As we discussed in September, and as shown on Slide 4, beginning on January 1, we will begin reporting in 3 business units rather than 6 segments. Streamlining the operations in this way is expected to reduce our complexity, improve our agility, unlock synergies, increase team collaboration and enhance management focus. It will also better enable our strategy to fuel, to feed and to focus on our businesses. It's my goal that this leads to improved ability to grow and create sustained shareholder value.

This leads me to the next slide that shows our operational task and purpose. Our task is to consistently exceed shareholder commitments with integrity, and our purpose as an entity is to innovate The World's Sixth Sense in order to save lives and livelihood. We will operate with these in mind at all time, and we will drive our strategies with the intention to succeed in the eyes of our customers, our employees and our shareholders. One of my primary goals in my first month at FLIR was to develop a better articulation of our core values, so that they're more actionable, more aspirational and can be better owned by our employees.

On Slide 6, you'll see the results of this effort, which are the following core values: be ready, be bold, be brave and be ambitious.

First is be ready, which speaks to prioritizing speed and agility and reacting to an ever-changing technology landscape. We will be bold, and that we will pioneer and innovate to continue pushing the boundaries of what's possible, both in our technology, as well in our daily operations. We need to be brave in our actions to exhibit the utmost integrity and ethics in our daily decision making, not usually, but always. And lastly, we will be ambitious.

With the will to win, a tenacity to find the best ways to accomplish our tasks and collaborate with the utmost respect for our teammates and our customers. These core values will serve as the standards by which our people operate and behave at FLIR. We expect our teams to feel accountable for upholding these values each and every day, and by doing so, we expect to see tangible results in our business performance.

On Slide 7, you'll find an overview of our continuous business improvement initiative that we're calling The FLIR Method. While implementation will begin this quarter, this is a long-term investment that we expect will better enable organic growth, increase our profitability and generate excess cash to utilize in ways that enhance shareholder returns.

Each of our business units will have dedicated FLIR Method leaders at various facilities globally, who will lead the focus on enhancing our productivity, refining our product pricing strategy, standardizing our core business terminology to better share best practices globally, implement expanded talent development programs, boost our acquisition and integration processes, and continue to develop world-class products that exceed our customers' expectations.

During my first few months as CEO, I've seen firsthand the strength of our technology, the power of our innovation engine, and most importantly, the quality of our people. The FLIR Method will become the way we strengthen all functions of our business through a persistent journey that will be a key component of our culture. I'm confident that a global focus on continuous improvement in all aspects of our business will fuel the innovation engine for future growth, continue to raise employee job satisfaction and increase shareholder return.

And on the subject of innovation, let me now talk briefly about some of our new products that we've announced since our last earnings call. First, turning to Slide 8. Our Security segment introduced a new thermal bullet camera, called the FLIR FB-Series O, which is specified for perimeter security applications to detect potential intruders in total darkness, and for sun glare, smoke, dust and light fog. In August, our Outdoor and Tactical Systems business within Surveillance launched a line of Thermal Rifle Scopes that are based on our new Boson camera core, called the ThermoSight Pro Series.

The OEM and Emerging segment announced a new drone camera for use in commercial applications, called the FLIR Duo Pro R. This is a hybrid sensor system that allows the operator switch between visible and thermal inflight and features onboard GPS, motion, environmental sensors to enable high-fidelity geo-tagging for mapping purposes. In Maritime, we introduced the latest version of our LightHouse software, which enhances numerous mapping, data logging, data streaming and image display functionality to this already well-received operating system that's used in our multifunction displays.

And this month, our Instruments segment released our newest lineup of Infrared Guided Measurement or IGM test and measurement meters, the DM166, the DM285 and the CM275. Each of these tools used by electricians and trade people have the unique addition of thermal imaging, which allows for more efficient scoping and detecting of problems, making their jobs easier.

And this week, our Detection segment announced their latest radiation detector, the identiFINDER R440. The R440 is a revolutionary small radioisotope identification device or an RIID that offers unmatched combination of sensitivity and accuracy that allows responders to detect and identify radiation from long distances and with high accuracy.

I'll now ask Shane to review the third quarter financial and operational highlights. Shane?

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Shane R. Harrison, FLIR Systems, Inc. - Interim CFO & Senior VP of Corporate Development & Strategy [4]

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Thanks, Jim. On Slide 9, you'll see our third quarter financial results. Please note with the exception of cash flow, all these financials are on a non-GAAP basis. Reconciliation to GAAP data is included in the filed appendix. Consolidated revenue for the quarter was $465 million, a 15% increase compared to the third quarter of 2016, and as Jim mentioned, an 8% organic growth rate.

Adjusted gross margin was 49%, about 70 basis points higher than last year, driven by acquisitions and improved manufacturing cost. Our adjusted operating margin for the quarter was 22%, about 20 basis points lower than last year, mainly due to higher R&D spend relative to the prior year. Adjusted net income for the third quarter of 2017 was up 11% to $72.7 million, and adjusted EPS was $0.52 per share, 8% higher than last year.

Net income was negatively impacted by a 370 basis point increase in our effective tax rate versus last year to 26.2%. Due to our current expectations of geographic mix in taxable income, we now expect our full year adjusted tax rate to be approximately 25.5%. Quarterly cash flow from operations was 143% of adjusted net income or $104 million, which was $15 million higher than the prior year. Through 9 months of 2017, operating cash flow was 116% of adjusted net income.

During the third quarter, we fully repaid the outstanding $86 million in borrowings under our revolving credit facility, and returned $21 million to shareholders in the form of dividends. Despite these uses of cash, we increased our cash balance by $33 million to $437 million at the end of the quarter. Geographically, revenue increased 9% in the U.S. and 27% in Europe. We saw weakness in the Middle East region due to slower activity in our Surveillance segment. Revenue in the U.S. government was 25% of total revenue, and it increased 4% versus the prior year.

Moving to the segment details on the right side of Slide 9. Revenue and operating income increased across the board. We did experience reduced operating leverage in the form of higher corporate spend, the result of increased legal costs and increased compensation accruals.

Digging in on the segment a bit more, you will see on the left side of Slide 10 a summary of Surveillance's third quarter results. Third quarter revenue for Surveillance was $146.8 million, up 8% from the third quarter of 2016. Airborne and man portable products were particularly strong compared to the prior year and the addition of the UAS business added inorganic revenue growth, all partially offset by a decline in our land products due to a difficult comparison in the prior year.

Operating income for Surveillance was $44.9 million, up 8% over the prior year with consistent operating margins. Surveillance bookings grew 33% during the year due to a $75 million order we received from the U.S. Army for gimbals to support their EO/IR Force Protection program, a variance of the RAID program. This helped drive Surveillance's book-to-bill ratio of 1.45x, and increased backlog 21% quarter-over-quarter to $395 million. Not included in this backlog, but notable none the less, in October, our UAS business received a $7 million order from the Australian Army for our Black Hornet nano UAS solution, a key-stone win for this next-generation personal surveillance and reconnaissance solution.

On the right side of Slide 10 is a summary of the Detection segment, which saw third quarter revenue grow 19% year-over-year to $31.4 million. Timing of deliveries under the DR-SKO program and increases in our radiation and chem bio products drove the increase, which was partially offset by softness in our explosives detection products. Operating margin improved 180 basis points to 28%, a result of higher revenue on the operating expense base.

Detection finished the third quarter with $78 million of backlog, which was down $8 million from the end of Q2, due primarily to shipments of DR-SKO under the previous order. Partially offsetting the backlog decline was another large order from the United States Department of Homeland Security's Domestic Nuclear Detection Office for our R300 compact spectroscopic personal radiation detectors.

Moving to Slide 11. Instruments revenue of $91.4 million was up 11% over the third quarter of 2016. Broad product line growth drove this increase, with particular strength in both volume and premium handheld plant predictive maintenance cameras, as well as growth in our automation cameras. Instruments' operating profit in the third quarter increased 7% from the third quarter of 2016 to $29.6 million or 32% of revenue.

The results for the OEM and Emerging segment are shown on Slide 11 as well. OEM and Emerging third quarter revenue was $87.2 million, increasing 39% over last year. The acquired Integrated Imaging Solutions line of business was the driver of this growth. Organic revenue was slightly up due to higher sales of UAS cameras, mobile accessories and Lepton cores, offset by slower cooled cores revenue.

OEM and Emerging operating profit grew 30% year-over-year to reach an all-time quarterly high of $26.9 million. Operating margin of 31% did decline 200 basis points versus the prior year due to higher operating expenses primarily related to product development and yield improvement initiatives. Order backlog in OEM and Emerging increased 2% during the third quarter to $162 million.

Moving to Slide 12 on the left side, you'll see Security segment revenue of $65.7 million, was up 16% compared to last year's third quarter. Security's Lorex business grew significantly due to sell-ins of our new 4K Ultra HD bundle and our wire-free camera system to 2 major retailers, some of which was revenue pushed in from Q2. We saw a significant growth in Lorex web channel as well. FLIR-branded professional visible security solutions grew 12% year-over-year, while thermal security products were flat to the prior year.

Security operating income grew 36% to $6.5 million year-over-year due to the strong top line and a reduction in operating expenses. In the quarter, we restructured the Security segment to improve their selling function, their R&D strategy and to reduce SG&A by approximately $1 million annually. A portion of these savings were realized in the third quarter. Maritime segment revenue was $42.3 million, up 4% versus the prior year, despite the negative impact of hurricanes in the U.S. market. New products drove DoD growth across the Raymarine business, which was partially offset by weakness in thermal cameras due to increased customer vetting processes.

Maritime operating income grew 42% to $4.5 million or 11% of revenue. Stronger gross margins, mixed with controlled operation spending, resulted in another quarter of operating margin improvement, this time by 280 basis points compared to Q3 of 2016.

That concludes my summary of the financials and the segments. I'll now pass it back over to Jim.

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [5]

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Thank you, Shane. This was a very favorable third quarter, with strong top line results, good organic growth, gross margin improvement, cash flow well ahead of net income and the largest backlog in our history.

I'm proud of the team's ability to post results like we did in the quarter, especially in light of the change of leadership and the reorganization of the business. But I'm not satisfied, and will not be satisfied unless we keep this momentum going. We expect to be able to deliver the revenue and EPS results that we've guided throughout the year with this quarter's performance. The fourth quarter poses some challenges, as we saw some revenue pulled out of our plans in Q4 and into Q3, and we also expect pressure in our retail security business. But we're up to the task of growing this company, while creating meaningful shareholder value as we do so.

Please note that we're planning an Investor Event in the second quarter in New York, so that we can meet face-to-face to present our vision and longer-term strategies in this regard. Details on the event will follow in the coming weeks. And as we announced on Monday, after a thorough search, we've hired a new Chief Financial Officer. Carol Lowe will be joining us on November 27 as the Executive Vice President and Chief Financial Officer, coming from the multinational industrial company, Sealed Air, where she was their Chief Financial Officer. We're excited to have Carol join the team, as she brings a solid skill set and deep experience in corporate finance, accounting and operations.

I want to thank Shane Harrison for his ongoing leadership, hard work and dedication to our business. Shane took on the added responsibility as the acting CFO in addition to his duties, leading IR our M&A, while onboarding a new Chief Executive Officer. Thank you, Shane.

As I started off the call saying we're in the midst of implementing new methods, procedures and thinking at FLIR that I believe will make this great company even more efficient, even more focused, better able to exceed customer expectations, and at the end of the day, more valuable to our shareholders. I'm excited to continue to work with our over 3,500 team members to bring these to life so that we can even more effectively innovate The World's Sixth Sense to enhance perception and awareness, so our customers can save lives and livelihood.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question today is coming from Jim Ricchiuti from Needham & Company.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [2]

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The question I have, first question is on the OEM and Emerging segment. I think you mentioned that the organic revenues were up slightly. I don't know if you could maybe give us a little bit more, specific about what that growth was. And then the question I have is this, I believe you're coming up on the anniversary of the Point Grey acquisition, and wondering how we should think about this business over the next couple of quarters. And I'm wondering if you're anticipating perhaps some seasonal weakness also in the industrial machine vision business, which is, by all accounts, been pretty strong throughout the industry anyway. So maybe we'll just start there.

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [3]

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Yes, sure, absolutely. So our OEM and Emerging business did grow modestly organically. Now you got to remember, last year, there was a really big comp because they got a large Northrop Grumman order last year. So to be able to meet and comp that was quite an accomplishment for the team. And as you know, our IIS business or Point Grey will lap itself in November. We'll mark the 1 year anniversary of that acquisition being complete, and we have to say, we're absolutely thrilled with the performance of that team and the growth that we've seen in that business.

Now we think that some of that growth will slow a bit. In the past 2 quarters, in particular, they've had some really strong performance, but we're very bullish about the machine vision space, the addition to Point Grey, its synergies with thermal, the development of new products that, that team has underway, again, encourage us a lot about the OEM and Emerging sector, as we go forward, as well as continued efforts in that core business.

Automotive, for example, a lot of work and effort underway and enthusiasm and opportunity in that part of the segment as well, and the team is working hard on it. And we continue to see strong work out of the core customers we've had there for some time. But I can't say enough positive things about the team at Point Grey, IIS, as we call it now. And as we mentioned in November, we'll mark the 1 year anniversary. We continue to see or expect pretty strong growth from that team.

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James Andrew Ricchiuti, Needham & Company, LLC, Research Division - Senior Analyst [4]

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Okay. Jim, just on the Instruments business, is my last question and I'll jump back in the queue. You had a couple of good quarters of solid growth there. And I'm wondering just -- it looks like you're benefiting from a stronger lineup of products, but I'm also wondering if you're seeing stronger market demand in general. Is this a case where you're getting better market conditions, maybe taking some market share back and just getting the benefit of the new products?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [5]

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I would principally say it's the benefit of a lot of the work that the team's done around new products. Now the markets are strong, but the teams worked very hard for the better part of the year to introduce a whole series of products, gas finder, the IGM instruments that I mentioned earlier, some volume products as well. And you're going to continue to see the team in Instruments on their front foot with product innovation. There's a lot more to come in the future.

So we're really seeing the benefit of these products beginning to hit the market. Now we've had sort of a strong sell-in to begin with. That might taper a bit as we go forward. But the feedback that we're getting from users is that the products really are introducing some great new capabilities.

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Operator [6]

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Our next question today is coming from Asher Carey from Baird.

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Asher Burton Carey, Robert W. Baird & Co. Incorporated, Research Division - Research Associate [7]

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I was wondering if you could describe, back to the organic side, some of the drivers and what you're seeing in that part of the business. Is there any way to parse out that 8% organic growth, particularly, in how you're viewing it being driven by government versus commercial?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [8]

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Well, we don't walk in detail our organic growth and exactly the drivers of where it's coming from. As I mentioned earlier, our overall growth, our commercial products grew about 20%. Our government products grew 8%. We are seeing, as we mentioned, growth across all the segments this quarter, which is the first time in recent history we've had all segments demonstrating growth and fueled by a whole host of things in many of our businesses, like Instruments, as I mentioned, or Maritime.

We've got new products hitting the market. Axiom Pro for Maritime hit, we mentioned LightHouse. We've got great 3D fishfinders for the Maritime team. It's got a bevy of products coming to the market. Instruments, we mentioned. Detection and Surveillance really had great orders quarter. We had a book-to-bill of about 1.45 for our Surveillance business, the largest of which, and you may have seen the announcement, was for the EO/IR-FP program, which is a very -- or extension of the RAID program for $74 million. Now we ship just a tiny bit of that. We've got some lead time issues in the supply chain that we've got to get primed, if you will. You're really going to see the benefit of that begin to come, really, in the first quarter and first half of 2018.

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Operator [9]

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

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Jonathan Frank Ho, William Blair & Company L.L.C., Research Division - Technology Analyst [10]

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I just wanted to see if you could give us a little bit more color in terms of the magnitude of orders that you received early from the first -- fourth quarter, and maybe what segments those sell into.

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [11]

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Yes. There was probably about $15 million of revenue that came into the third quarter that we expected would go in the fourth, and the bulk of that, more than half of it was DR-SKO in our Detection business. You know that DR-SKO business is lumpy. We can't always predict when the customer needs those products. It's a critical product, obviously. It faces a very real threat in a world that we operate in.

And -- but I will say, with DR-SKO, we actually added to the backlog in the third quarter. In the second quarter, we had ending backlog for DR-SKO around $40 million. Now it's about $50 million. That's got to be delivered over the next 18 months or so. But of the $15 million, the lion's share by far was the DR-SKO that got pulled into the third quarter.

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Jonathan Frank Ho, William Blair & Company L.L.C., Research Division - Technology Analyst [12]

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Got it. And then as a follow-up, can you maybe talk a little bit about the pressure that you're seeing in the retail security business just given the new product launch? Was the benefit this quarter largely just channel stocking and that maybe dissipates a little bit? Just wanted to get a little bit more sense around what's happening there.

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [13]

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Well, Q4 is typically a stronger quarter for our retail business, but we mentioned the pressure, because in the third quarter, it was artificially high. If you remember, back in the second quarter, we highlighted timing of a load in to retail customers for our Security businesses that came out of the second quarter that we expected to get in the third quarter. And indeed, that happened. In July, we had a fantastic month for our retail security business. So now as we go into the fourth quarter, we -- if we look at run rate, that will fall out.

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Operator [14]

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Our next question today is coming from Saliq Khan from Imperial Capital.

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Saliq Jamil Khan, Imperial Capital, LLC, Research Division - VP [15]

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Jim, for the Surveillance sector, first of all, talking about the $75 million contract that you guys received back in September from the U.S army. Can you give us some more details on the timing of the realization of the entire revenue stream and also the margin profile?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [16]

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Yes, absolutely. So again, it was about a $74 million order, I think $74 million and some change, if you will. A few units have shipped. We did have materials to get I think about $4 million of that out in the quarter. As we look at the fourth quarter now, we've got to kind of reprime our supply chain. There are couple of long lead time items that we've got to get that's really going to be our governor for the fourth quarter. So there's a bit of a bubble there, but that should be fully primed as we go into the first quarter of 2018. The delivery is expected to happen by the end of 2018.

So it's a -- an 18-month or by the end of 2018, we expect to have all those units delivered. And it's a real testament to the quality of our products and it's something we're really proud of. It's something we're very passionate about. Again, I've only been with the business for, I guess, 4 months now. But at AUSA, just recently, got a lot of really unsolicited feedback from commanders in the field and soldiers that recounted experiences at Ford operating bases or cops, where they had that RAID program or EO/IR-FP towers to really help them detect threats at great distance. So it's a product and capability we're very proud of. But to answer your question, really, through 2018 is the future delivery cycle.

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Saliq Jamil Khan, Imperial Capital, LLC, Research Division - VP [17]

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It's good to see that Security was back up again this quarter. And Shane had mentioned something about the selling strategy being improved. Can you highlight what happened in the selling strategy that led you to a 15% incline year-over-year?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [18]

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Well, the biggest thing in the third quarter that drove the growth, as I mentioned, was the orders that we expected in Q2 that fell into Q3 that drove that retail business. But we reorganized the business, as you know, into government, defense and industrial and commercial business. Travis Merrill, who's the President of that Commercial Business Unit now, that also has our Intelligent Traffic Systems business in it and others, is highlighting synergies that we have among the team, and some of those are commercial synergies, where our business development teams can work together more closely, can collaborate on unique projects with customers.

And there's a lot of work happening around product innovation back in the core thermal side of the house. I mentioned the Series O product that we've launched that really is great for perimeter security, can see through obscuration at distance, et cetera. And you're going to see continued innovation across the board for Security, as well as thinking about different ways to go to market and partner with various channel partners.

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Saliq Jamil Khan, Imperial Capital, LLC, Research Division - VP [19]

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Great. One last question on my end, which is you mentioned the word innovation and FLIR continues to be very innovative across all different product lines. However, you also mentioned earlier was -- you've seen ongoing pressure when it comes to the retail portion of Security. So if I think about the future and as you go into '18, you go from 6 segments down to about 3 units. How do I think about the retail portion of Security within your overall portfolio, going forward? Is it still going to become relevant? Is it becoming less relevant? What would your strategy be?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [20]

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That's a good question. Well, here's how we're approaching that. As I mentioned on the last earnings call, my focus has been coming onboard, identifying value, figuring out how we organize around it, and then putting the right operating rhythms in place to make sure we execute to it. So I've been moving down that road map, and most notably, the reorganization of the business, the establishment of the 3 business units is doing just that.

We've implemented new rhythms across the company, business cadences, to make sure that we execute. And our next goal post or objective is by the next earnings call, we will clarify exactly what that strategy is. Travis Merrill, who's been in the role for about a month now, has that right at the center of his road map of things to do to articulate a very concise strategy for not just the retail security business, but our Security business on whole.

Now I do believe FLIR in the long term has a right to play and has compelling technologies in the security space. Even though there are a lot of lower-cost thermal cameras that come on to the market, when you think about critical infrastructure, when you think about power plants or airports or data centers, et cetera, the kind of technology that we can bring together is absolutely compelling in that space to differentiate. We're going to continue to do it. We are working hard in the retail space, and have introduced new bundles and products there as well, but the question you bring up is a question we absolutely intend to answer by or on the next earnings call. Travis and his team are working on that right now.

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Operator [21]

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(Operator Instructions) Our next question is coming from Drew Lipke from Stephens Inc.

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Andrew Jay Lipke, Stephens Inc., Research Division - Research Analyst [22]

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Jim, you talked about putting a dedicated FLIR Method employee at each segment and then you mentioned refining your product pricing strategy. I was curious if you can maybe elaborate on that a little bit more.

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [23]

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Absolutely. The FLIR Method is something I'm really excited about, really passionate about. It's going to be our way to drive continuous improvement in the future, and there's always room to improve. The outputs of The FLIR Method, I mean, obviously, our task, our purpose, et cetera, but we want to drive organic growth. We want to improve margins and we want to improve capital efficiency. So if we look at the levers or the tools that are going to be a part of The FLIR Method, better pricing is a part of that.

There are a few ways that we can affect gross margin, working on continuous improvement, driving productivity programs, engineering or designing to value. Our product certainly is one but another is making sure that we have very effective pricing strategies that win in the market, win for our customers and maximize shareholder value. So introducing professional pricing disciplines across the company and pricing tools will be a part of The FLIR Method, along with dozens and dozens of other tools, like Lean Six Sigma, et cetera, et cetera, with the intent that the measurable output is driving that continuous organic growth, improving margins and capital efficiencies.

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Andrew Jay Lipke, Stephens Inc., Research Division - Research Analyst [24]

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Okay, that's helpful. And maybe sticking on that capital efficiency theme, and this could, perhaps, be a better question for the incoming CFO. But FLIR, historically, is operating with a pretty under levered balance sheet. You're essentially net debt free today. I'm just curious what's your stance and approach to maybe optimal debt levels, as it relates to both M&A opportunities and returning cash to shareholders.

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [25]

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Sure. As I mentioned on the last call, I believe in a balanced capital allocation strategy. So you're going to see us always considering dividends, making sure we have the right amount of debt and conservative in that regard, acquisitions, and we are an acquisitive company. I see acquisitions as a central part of our growth portfolio, going forward, and we're very active in that regard as I come onboard, and we're forming the strategy, as well as buying back shares, et cetera.

So you're going to see us continue to be balanced. Now last year, I think, at this time, we repurchased some shares. We then work for several quarters to build up the capital that we had available for an acquisition that didn't come to fruition. You saw us pay down some debt, of course, pay dividends consistently. But you'll see us have a balanced approach, but I'll ask Shane to maybe elaborate a bit on that question.

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Shane R. Harrison, FLIR Systems, Inc. - Interim CFO & Senior VP of Corporate Development & Strategy [26]

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Sure. Drew, we've been a fairly acquisitive company. We intend to be -- continue to be acquisitive. So we want to have that firepower, let's say, on the ready for when we want to do deals. We -- how far can we take it? It's basically we're investment-grade rated. We like being investment-grade rated. We can leverage that in a lot of different ways across our company. But if the right deal comes along, there's a chance that we could take it above 2.5x, but we just haven't seen deals like that.

So where we sit today is still looking, and I've been spending a lot of my time trying to rebuild our pipeline from M&A. And by rebuilding, I mean, we've kind of processed through a lot of the deals, especially in 2016, we did 4 of those deals. So we intend to be doing some more acquisitions. So we want to make sure we have the bandwidth to do that, and that's part of the reason we did pay down that revolver. There was a couple of other reasons like a swap gain that we realized and a couple of other reasons. But yes, we like having that bandwidth, and that hasn't changed over these last, let's say, 6 months.

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Operator [27]

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

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [28]

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Jim, maybe this might be kind of 2 questions rolled into one. But can you give us the puts and takes on the revenue guidance for the fourth quarter? I mean, we've got just about 2 months left here, $50 million is a pretty wide range. And maybe does that range tie into what's going on with the Defense budget with the continuing resolution? Maybe just bridge us the puts and takes to the low end to the high end of that guidance range.

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [29]

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Sure. Well, as I stated with third quarter performance, we think that we've secured what we've guided throughout the year. Now we didn't narrow the revenue range. We narrowed the EPS range, and we've got some big lumpy pieces of the business that could come in the fourth quarter, and that's why we didn't do it. We mentioned DR-SKO. Now some of that came into Q3, but we've built the backlog actually. Again, it's at $50 million as opposed to $40 million. How much of that happens in the quarter? Right now, it's a bit of unknown.

As well as I mentioned the EO/IR-FP program. We're working on some supply chain issues to be able to drive as much of that as possible. But again, some uncertainty in that, and those are pretty big numbers that does lead us to that wider range. Now as I mentioned, I'm proud of our Q3 performance, but not satisfied. We want to do all as a team to make sure we maximize our efforts here in the fourth quarter. And also, I think I've got 1 quarter now into it, so I can still use the new guy card. 4 months on the job, I wanted to be a bit conservative about how much we sharpen that guidance because I have all of one quarter's experience. That said, Q4 typically is a bigger quarter for us, and we've got everything pushing as hard as we can obviously to maximize our result for our shareholders.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [30]

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Got it. No, that's good. That's helpful. I can appreciate the conservative. And maybe just one more on margins, down year-over-year, and certainly, I'm not going to ask for an outlook on 2018 on margins or anything else. But I heard higher legal, some R&D, restructuring, yield savings, some accruals. It sounds like there's a lot weighing on that margin. How should we expect the operating margins to trend, going forward? And obviously, your -- you guys are sharpening the pencil, looking at the strategy, trying to grow organically. Just any more color on what to expect for margins?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [31]

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Sure. If we look at our adjusted operating income, that 20 bps of pressure that we had, really, as we mentioned, came from corporate, and it came from R&D and legal expenses, or I'll say, legal investments. Now the R&D piece, we've got some things we're really excited about, some technologies that are going to take some time to incubate, and I mentioned sort of the concept of the business, as I approach this: fuel, feed, focus. I mean, that's one part of the business that we're going to continue to feed, as we have some technologies we want to develop over time, and more to come on that.

With the legal expenses, a lot of it was around compliance and training, and making sure that we have the best processes people in place to ensure that we're always compliant, and we have and are recognized as being world class in that regard with export controls, et cetera. So I really look at that as an investment in the business, and something that's necessary in the kind of work that we do. I mentioned our purpose is to help our customers save lives and livelihood, and a part of that is not just our compliance, but our moral obligation to be the best company in the world that's safeguarding this technology to make sure it doesn't go into the wrong places.

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Operator [32]

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Our next question is coming from Josh Sullivan from Seaport Global.

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Joshua Ward Sullivan, Seaport Global Securities LLC, Research Division - Director & Senior Industrials Analyst [33]

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Can you just expand on some of the opportunities for the Black Hornet just as we come up on annualizing that acquisition as well? I know the Australians plan to equip almost every combat platoon with the Hornet. I think here, domestically, the Marines just completed a big UAS exercise. But can you talk about how that maybe performed in the Marine exercise, and maybe how that may matriculate into contract dollars at some point?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [34]

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Josh, the problem we've got is we've -- I don't know if we have enough time of the day for me to talk about my enthusiasm and opportunity for the Black Hornet. It's an acquisition that, as I mentioned, is about 1 year old. I think it annualizes itself in November. We've seen obviously a lot of interest with soldier-born systems, with big army, special operations command, the Marines, as you mentioned, and foreign militaries, Royal Marines, the French Army, the Norwegian Army, various units of use. It's been fielded pretty extensively in combat environments.

And so we've gotten a lot of feedback from users in the field about things that they want, features that they want to add, et cetera. Now we're already on Black Hornet 3. From the original Black Hornet now, it's got even more capability. It's got kind of modularity to it where you can change between cameras, EO/IR. The battery is detachable, et cetera, et cetera. We're really excited because this is something that will change the tactics and techniques and procedures at the individual fire team or squad level. And we're keen now and are already developing road maps for what's next.

We're not satisfied just with its current capability, and I don't want to go into great detail about what that capability is on this call for obvious reasons. But as we think about what next generations, and when we think about the needs of the soldiers, our teams are racing to develop additional capabilities because this is a product that increases situational awareness. It saves lives on the battlefield full stop, and we can point to a lot of examples of how that happens.

The biggest opportunity, though, that we can highlight is Soldier Borne systems. This has been used by small units for some time, by special operations forces that initially sort of adopted it. Soldier Borne systems would be a large fielding to conventional maneuver forces, and we're in the throes of working through that opportunity. There have been some fly offs already.

We're really proud of how Black Hornet performed, but we won't satisfied with Black Hornet until it reaches -- I'll say we'll never be satisfied because it can always push the envelopes of what's possible. The fundamental premise of land warfares make contact with your small as possible element, and right now, that's a soldier, and we'd rather it be a Black Hornet. I could go on and on about this, but I'm afraid we'd take up everybody else's time, Josh.

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Joshua Ward Sullivan, Seaport Global Securities LLC, Research Division - Director & Senior Industrials Analyst [35]

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Okay. I'd let you wax poetic all day on it. But I'll move to the next question over to the IIS. How is the penetration of FLIR products into Point Grey's offering progressing? And then, I guess, secondly, do you see any areas of technology holes that you want to fill in machine vision maybe into the future?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [36]

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The IIS business has grown a lot, but really, what's growing is its core technology. Now it's introducing new products around its core technologies new and improved. But the adoption of thermal at IIS, I'd say it's been sort of mediocre. There's been some opportunities they've developed for certain. We do think that there's future potential for that. That's a synergy that we stated with the acquisition and we're continuing to focus on, but their growth principally came from their core technologies and their own organic innovation.

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Operator [37]

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Our next question today is coming from Noah Poponak from Goldman Sachs.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [38]

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Jim, recognizing you've announced a segment -- a resegmentation of the business. In the current segment form, which of the 6 operating segments do you think is unlikely to have its pace of organic revenue growth accelerate in 2018 versus '17?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [39]

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Well, right now, we're in the midst of going through our 2018 operating plan. We've went through sort of the first iteration of that, where we're getting the bottoms-up view by the businesses, looking at their backlog, their sales forecast, et cetera. The second round of that happens actually in 2 weeks. So I think it'd be a bit premature for me to state that at the segment level or even a BU level right now, because frankly, we're just now going through that diligence as a part of the 2018 operating plan.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [40]

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Okay. Yes, I guess I was looking less for a forecast by segment or anything like that and more top-down if I'm crazy and my model telling me that there's at least a scenario. It's in the scenario analysis that actually every segment could have its pace of revenue growth accelerate next year either because of the end market tailwinds or because of the -- just the way the year-over-year comparison shake out?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [41]

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Well, that's certainly our intent. And the biggest thing that would point to that is our backlog. It's $709 million. We went back as far as 2007 when the company, again, was much smaller on whole, and this is all-time record backlog. And we made that same statement in the second quarter, but we increased the backlog significantly from the second quarter into the third quarter.

And the backlog items that are in the, the biggest pieces, like I mentioned, the EO/IR-FP program, we know what that delivers in 2018, as well as several others also in 2018. The work that's been done in Instruments, the work that's been done in Maritime, and it's not done yet, the work that's been done on IIS and Security, to develop a bevy of new products, they'll kind of get into a full year run rate in 2018, where we didn't have that full year run rate in 2017. So certainly, organic growth is a principal objective for the company.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [42]

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Great. The Middle East weakness you called out in Surveillance, do you have a view based on actual order input or just based on the lapping the -- annualizing the start of that decline. Do you have a view of when that stops, and that geography within Surveillance, can at least flatten out, if not, start growing again?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [43]

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I think in 2018, we had a really big comp. The Middle East was a strong region for our Surveillance business last year. Timing of orders, et cetera, can be difficult to forecast in that region for certain. But if I look at the business development activities there, if I look at the quoting activities, the universe of potential opportunities we're going after, that's actually increasing.

Now the timing of when those opportunities really realize and become an order, that's difficult, certainly, for us to predict. We hope that, that begins to happen as we close the year and go in, and through 2018. But the softness principally right now is again lapping a pretty tough comp. We see a lot of activity in that region, but the timing of which is difficult to predict.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [44]

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Can you remind me, the first quarter that you faced that level of comp -- that level of tough comp?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [45]

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You know when that would be, Shane? That's something we might have to get you an answer after the call.

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Shane R. Harrison, FLIR Systems, Inc. - Interim CFO & Senior VP of Corporate Development & Strategy [46]

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Q1 was a really tough comp. Q3 also was a tough comp. It's choppy, as you know. It's big orders that we get. Deliveries get choppy. But if you look at the -- on a trailing 12-month basis, yes, it's been a very difficult comp, and it's a couple of big orders that we got last year.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [47]

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So as you move into '18, that sort of reset?

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Shane R. Harrison, FLIR Systems, Inc. - Interim CFO & Senior VP of Corporate Development & Strategy [48]

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Right.

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Noah Poponak, Goldman Sachs Group Inc., Research Division - Equity Analyst [49]

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Got it. If I could sneak in one more just on the Surveillance margin, a supercritical input into the model, given it's the largest segment. And if that business can grow with defense getting better, you just naturally mix up. Nice to see it back in the 30s. Jim, I'm sure you've studied the history of that margin at much different volume levels. So I guess with it now kind of poking up above 30 again, I'm curious if you have a view on what the right long run 3- to 5-year sustainable Surveillance segment operating margin is.

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [50]

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Well, as you mentioned, I mean, it levers and delevers nicely with volume. Right now, we've got this Q3 inning backlog of almost $400 million, $395 million. That is about a 21% increase, and the book-to-bill in the quarter was 1.45. I think that where it is now is probably where it's going to continue to maintain itself. We also need to make some investments in that business, and are making investments in that business to ensure that our technology stays on its front foot. So there's a lot of work that we are doing there now that you'll hear throughout 2018 the result of. But I think where -- again, where it's at now in the 30, low-30 range, if we grow, is probably where it's going to kind of hold itself.

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Operator [51]

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Our next question is a follow-up from Michael Ciarmoli from SunTrust.

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Michael Frank Ciarmoli, SunTrust Robinson Humphrey, Inc., Research Division - Research Analyst [52]

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Jim, just more on the Army EO/IR contract. I heard you guys mentioned RAID a couple of times. Is this -- are these products satisfying incrementally new demand? I would have thought there's so many of those gimbals out there in the field that there would have been more repair or are these just simply replacing or upgrading? Can you just give us color on what's sort of going on from a demand perspective?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [53]

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Sure. This is the continuation of -- or you can think of it as a continuation of the RAID program. It's been renamed the EO/IR-FP, the Electro-Optical Infrared Force Protection program. And it's not replacing and it may in certain discrete circumstances replace a unit that's out there, et cetera, but it's really additional need that they have for this product.

It's got great capability, what it enables our war fighters to do to detect threats, identify threats at great distances all over the world in some very, very harsh conditions is a testament of the hard work of the team that put it together. So this is additional demand that the military has for force protection.

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Operator [54]

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

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Jeffrey Ted Kessler, Imperial Capital, LLC, Research Division - MD [55]

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I want to just quickly ask a question about technology and the application technology. That is you've had the -- obviously, the Lepton core out there for some time, where we supplanted, or let's just say, complemented by other core like the Boson core, which has become obviously a staple. What in terms of core development are you doing right now? And what markets are specifically going to -- or in general going to be impacted by new core development that you're doing? What types of product and in which segments -- we should be watching to see some of these new core developments?

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [56]

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Well, as you mentioned, Lepton has enabled so many products and applications across all the segments. Black Hornet, for example, as we mentioned earlier, has Lepton. A host of Instruments products have Lepton. Boson is really important across all of our business, as you know, as well. Smaller, more capable and always that size, weight and power matter.

Jeff, you'll forgive me if I don't go into a lot of detail about what we're doing about future core technology development. Suffice to say, no pun intended at our core, is the development of the best IR cores in the world. And so our team in Santa Barbara is working very hard always on improving the capability, the fidelity, the size, weight, power, et cetera. And as they do that, as you stated across all of our segments, that has application.

If we think about UAS, for example, and I mentioned the new dual product with visible light and IR that we introduced for commercial UAS applications is we can continue to increase the fidelity, as well as the size, weight, power. That has countless applications for firefighters, for first responders, for critical infrastructure inspection, et cetera, et cetera. But I'll stop short of giving frankly any real detail about the effort underway there, if you'll forgive me.

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Jeffrey Ted Kessler, Imperial Capital, LLC, Research Division - MD [57]

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Okay. But my assumption is, is that you will in the next couple of shows, maybe 1/2 year out to 1 year out, we will be seeing some new products from these core development you're doing right now.

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [58]

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We are constantly innovating our core, so yes.

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Operator [59]

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

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James J. Cannon, FLIR Systems, Inc. - President, CEO, President of Government & Defense Business Unit and Director [60]

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Again, I want to thank you all for joining the call. I especially want to thank the FLIR team, over 3,500 teammates that worked so hard to accomplish our task, to exceed shareholder commitments with integrity and that are so very proud of our purpose to innovate The World's Sixth Sense, so that our customers can save lives and livelihood. Thank you, all, so much, and have a great day.

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Operator [61]

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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.