On Tuesday, I sold roughly one-third of my position in FLIR Systems Inc. (NASDAQ:FLIR). As readers may remember, I've owned a position in the company dating back to 2012. Given that I've discussed it publicly on GuruFocus in the past, I thought it would be worthwhile to update my thinking.
The decision to trim ultimately came down to three factors: recent trends in the underlying business, more aggressive uses of capital in the past several years, and the current valuation of the company.
In 2018, FLIR hosted an Investor Day event. As part of the presentation, management outlined the current state of the business, along with thier expectations for the next few years. In terms of forward financial targets, management set the following expectations for investors (through fiscal 2021).
At that time, those targets seemed attainable: In the first half of 2018, the company had reported double-digit organic revenue growth. But as shown below, organic revenue growth at FLIR has trended in the wrong direction over the past 18 months. By the fourth quarter of fiscal 2019, organic sales growth had even turned negative (for the year, organic growth was up 1.1%).
On top of a difficult finish to 2019, the company provided lackluster guidance for 2020.
Here's what CEO Jim Cannon had to say on the company's fourth quarter conference call:
"We expect the financial and operational trends we experienced in 2019 to persist, which is reflected in our 2020 outlook. In fact, we view 2020 as a year of evolution in many respects... While [the Investor Day targets] reflected our best projections at the time, several factors have impacted our ability to achieve them. First, the acceleration of our operating strategy and the influx of recent franchise program wins have resulted in an increase in near-term investments required to prepare for and execute on these programs. And second, external macro factors significantly impacted certain end markets served by the Commercial Business Unit (CBU)."
The net result is FLIR expects both revenue and earnings per share to basically be flat in 2020, along with the suggestion that this could continue into late 2021 as well - and that was the case before the potential macroeconomic impacts from Covid-19 were fully appreciated. I'm still not entirely sure how to think about the impact of the pandemic on the business, but my base case is that it's much more likely to be a negative for FLIR than a positive, with the revenue headwind flowing through to margins and profitability (exposure to government customers and increased demand for infrared imaging solutions in certain safety applications should help, but that should be more than offset by declines elsewhere in Commercial and Industrial).
Under Cannon, who stepped into the leadership role in June 2017, FLIR has been more aggressive with its balance sheet. First, the company has become more acquisitive: it spent $630 million on acquisitions in the past two years, equal to what it spent over the period from 2012 to 2017.
In addition, those acquisitions have targeted early stage companies, most notably Aeryon Labs and Endeavor Robotics (with price tags of $206 million and $386 million, respectively). And while those acquisitions may eventually work out for FLIR, the reality is that it will take longer to determine success or failure on these deals that it would be if they acquired a more established business. Put another way, these deals have actually been a headwind to the income statement in the short term, despite requiring cash outlays of nearly $600 million.
These acquisitions, when combined with more than half a billion dollars of dividends and share repurchases in the past two years (2018 and 2019), have taken a toll on the company's financial position. At the end of 2017, FLIR held roughly $100 in net cash on its balance sheet. At the end of 2019, FLIR held roughly $390 million in net debt. That's a meaningful change, and it has reduced its ability to be opportunistic in the coming quarters and years.
To be clear, I'm not suggesting that these acquisitions or the decision to more aggressively use the balance sheet was misguided. What I am saying is that the nature of these bets, combined with higher financial leverage, had changed the risk profile in my mind. (As a side note, planned divestitures in the Commercial segment will be more difficult to complete in this environment).
This one may seem a bit odd, given what I wrote about FLIR in early March:
"As I wrote in November, I did not think the stock was cheap enough at ~$53 per share. Since then, the stock has come under pressure and now trades at ~$41 per share. This is the kind of price action that I've been waiting for. While 2020 will be a tough year, I think that's accounted for in the valuation. Said differently, this is a reasonable opportunity for long-term investors. That's why, for the first time in years, it's likely I will add to my position in the near future."
Today, at a nearly identical price (approximately $41 per share), I'm trimming my position. Why?
First, the stock has traded well below current levels over the past 60 days, touching a low of $25 per share on March 20. I did my best to take advantage of this volatility, adding at $36 per share and again at $31 per share. With the price returning to $41 per share over the past few days, my position reached a point where I was becoming a bit uncomfortable with its sizing.
Here's the other consideration in terms of valuation: While FLIR was flat from early March to today (unchanged at $41 per share), the S&P 500 fell from 3,130 to 2,736 over the same period - a decline of roughly 13%. Unsurprisingly, many of the companies that I have considered buying for the first time or adding to have seen comparable declines, and some much worse (down more than 20%).
In summary, while I continue to believe that FLIR deserves a place in my portfolio at today's price, I'm starting to see better opportunities elsewhere. For those reasons, I've trimmed my position.
As always, I look forward to your thoughts or questions.
Disclosure: Long FLIR Systems.
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This article first appeared on GuruFocus.