Description

I once watched an interview with Joel Greenblatt in which he explained the advantages of buying the stock of a strong business whose results are widely expected to be weak over the next couple of years.  Such a stock will do okay if results play out as expected because they’re already fully discounted into the price.  If those fears prove unfounded, however, the stock will do extremely well as a higher multiple is assigned to higher earnings.  This is the situation that FLIR finds itself in today, trading at a Net P/FCF of only 13.0x despite its strong leadership position in a technology that is still relatively early in its adoption cycle.  (This multiple is near the bottom of FLIR’s historical Net P/FCF range over the last ten years.)

Background

FLIR Systems is a leading producer of infrared cameras (a.k.a. thermal or infrared imagers) which have proven extremely useful in a plethora of applications.  All matter emits infrared radiation, and infrared cameras can detect this radiation and convert it into an image across a wide range of conditions including total darkness and through obscurants such as smoke, rain or light fog.  This stands in contrast to a more common type night vision called “Image Intensification” which greatly amplifies residual light sources such as starlight to produce a green image.  (Image intensification is thus more vulnerable to the obscurants listed above, and it struggles with scenes that have very low light such as deep shadows or scenes with too much light such as under a street lamp.)  Infrared imagers are also able to see objects over very long distances (i.e. an “unclassified range” of 9 miles).  Lastly, because infrared imagers show an object’s “heat signature,” items of interest tend to be easily recognizable.  For example, an overheating circuit breaker will show up very clearly next to its cooler, properly functioning counterparts.  Another example would be an insurgent burying a roadside bomb at night.  His body heat will show up in high contrast against the landscape which is near the ambient temperature.  This technology originated within the military, but FLIR and its predecessors have been expanding its commercial applications over the last two decades, primarily by reducing its cost and improving its ease of use.  The company has also emerged as a very disruptive player within the military market as their commercial business model has allowed them to develop products that are cheaper and better than those offered by traditional defense contractors.  While this “Commercially Developed, Military Qualified” (CDMQ) model placed FLIR at somewhat of a disadvantage in the past, it is now allowing the company to take marketshare as the military undergoes procurement reform and tightening budgets. 

Both the government and commercial infrared markets are relatively early in their adoption cycles, though the government market is farther along, and the total market is currently split 67% / 33% between government / commercial.  FLIR’s overt government revenue was 46% of 2011 total revenue, but I estimate that the company’s ultimate government exposure is in the 55-60% range as some of its commercial products ultimately find their way to government customers.  For example, FLIR’s commercial division sell camera cores to third party OEM’s, including military contractors who will use these components in military platforms such as UAV’s.  Similarly, FLIR’s commercial division also sells security cameras, some of which are purchased by systems integrators for use in border security projects. 

Commercial Systems

FLIR’s commercial systems division traces its roots to what was once known as the company’s Thermography segment which produced cameras that measured temperatures very precisely (i.e. fractions of a degree) and then converted these measurements into color images.  Thermography cameras were originally used in applications such as preventative maintenance.  Most machinery begins to get hotter as it starts to fail, such as a bearing in a motor that is starting to wear out.  Thermographers could thus do periodic inspections of equipment and compare the current images to prior images in order to detect problems early and avoid unplanned outages or accidents.  I once met a thermographer who had just completed a routine inspection of high voltage electrical equipment at a plant.  He explained that such inspections were so helpful in preventing electrical fires that the plant’s insurance company granted them significant discounts for performing these inspections regularly.  For another interesting example, watch this video: http://www.youtube.com/watch?v=6AtaODO6THU .  As noted in the video, one advantage of using thermal cameras is the speed with which one can quickly survey large areas when looking for potential problems.  Another advantage is the ability to survey objects that are difficult to reach.  For example, faulty electrical components on power lines or in electrical sub-stations can be easily recognized from the ground since they show up very hot on the camera.  While preventative maintenance and factory automation / quality control applications were the primary ones that I saw ten years ago, I always marveled at the range of applications that the technology found its way into.  For example, veterinarians could use thermography to diagnose lameness in horses much faster than with the conventional diagnostic method.  I heard of a rancher who lived in a very remote area and used an entry level camera to determine whether his cows were pregnant and thus avoid calling out the vet unnecessarily.  (A pregnant cow evidently has a different heat signature than a normal cow.)  One researcher discovered that the inner corners of peoples’ eyes heat up very slightly when they lie and that this could be detected with FLIR’s hyper sensitive cameras.  That application found its way into the intelligence agencies.  Building inspectors could use thermography cameras to find air leaks, water leaks, faulty electrical components, and some building defects.  I heard of one instance where a building contractor had used studs that didn’t extend the entire length of the wall, and this was visible on the infrared image since the studs absorbed heat from the sheetrock differently than the air inside the wall.  I spoke to one professional thermographer who used his camera to play hide and seek with his children at home.  When they ran to hide, the friction of their shoes on the carpet would leave thermal footprints, allowing him to simply follow their tracks.  As noted above, FLIR’s cameras can see over long distances which generated some interest among rail roads.  As a train speeds along the tracks, the heat from the wheels travels along the rails faster than the train itself.  This causes the tracks to oscillate which can lead to a derailment if it becomes too pronounced.  Thermal cameras thus offered a means by which to measure this risk over great distances.  Another application involved laying asphalt because the areas that will become vulnerable to pot-holes have a different heat signature than the rest of the asphalt as it is applied.  A few years ago, FLIR introduced a camera called the GasFindIR which was a modified version of a Navy Seals camera that could see Volatile Organic Compounds leaking from pipes and vessels at refineries, pipelines, and oil field processing plants.  Finding these leaks visually was dramatically faster than inspecting every piece of equipment with a “sniffer” probe, and the GasFindIR also showed that some of the largest leaks were coming from equipment that the EPA didn’t require to be inspected.  The GasFindIR also showed that some VOC’s such as propane accumulate in low areas when they leak instead of dispersing as had always been assumed.  For an example of the GasFindIR at work, watch: http://www.youtube.com/watch?v=iXx5tqw1QPk .  The GasFindIR was subsequently modified to be able to see Sulfur Hexafluoride which is a very dangerous gas used by electrical utilities.  For an example of this, watch: http://www.youtube.com/watch?v=9LY925KuR90 .  The applications simply went on and on because everything emits infrared radiation, but the high cost of these cameras limited adoption in many of these applications.

Until the early 2000’s, thermography cameras cost $40,000 or more, so many end users would contract with a professional thermographer to conduct monthly inspections since the plants couldn’t afford to buy their own camera.  Because the technology primarily resided within defense companies, there was not an impetus to reduce costs.  FLIR was the pioneer within commercial infrared, but it purchased its “low cost” detectors from BAE Systems who was not interested in reducing their cost.  Consequently, in 2003, FLIR acquired an emerging competitor called Indigo Systems which allowed it to backwards integrate into detectors.  This allowed the company to lower unit costs and begin to exploit the price elasticity in the market.  Over the last several years, the company has thus reduced their costs and prices, opening up new markets and increasing volumes.  This has also allowed them to improve upon their roughly 40% thermography marketshare in 2004 to around 60% today.  Infrared has high barriers to entry, and they’ve thus been able to achieve this growth without sacrificing operating margins. 

Thermography was FLIR’s original commercial division, but in 2006, the company began reporting results for a separate “Commercial Vision Systems” (CVS) segment.  CVS used technology similar to FLIR’s government business, but it was applying it to commercial applications such as commercial security networks, commercial and personal maritime, and even luxury automobiles.  (Broadly speaking, FLIR’s government cameras provided qualitative measurements whereas its thermography cameras provided precise quantitative measurements.  The government cameras thus produced only black and white images because the users only cared about finding the enemy; they didn’t also need to know if he had a fever.)  Because both CVS and Thermography were pursuing a commercial strategy, they were merged into a single “Thermal Vision & Measurement” Segment in late 2010.

In 2010, FLIR acquired Raymarine which produces electronics such as radar and GPS for the boating market.  Raymarine had just entered bankruptcy when FLIR acquired it as the company suffered from a severely depressed boating market and a high cost structure.  FLIR was interested in the company, however, as a vehicle through which to expand its infrared sales in the boating market.  (In late 2007, FLIR had made a similar acquisition for its low cost thermography cameras, acquiring a firm named Extech which brought a high volume distribution channel, as well as some complimentary products.)  Prior to Raymarine, FLIR sold its cameras as an aftermarket “add-on” through a network of maritime dealers.  Purchasing Raymarine, however, has allowed FLIR to tightly integrate its infrared cameras into a well known maritime product line.  In addition to this integration work, FLIR has also been refreshing Raymarine’s product line with innovative, but lower cost products.  (High product costs were Raymarine’s principal problem.)  The resulting new products have been introduced over the last several months and have won a number of awards. 

Government Systems

As mentioned before, FLIR derives the majority of its revenues from the government segment where its imagers go into a wide range of programs.  The high cost of these systems had historically limited them to airborne and maritime applications, but the wars in Iraq and Afghanistan expanded their use to fixed land applications, and they are increasingly moving into vehicle and soldier-based applications.  Importantly, infrared imagers in the military are often coupled with related technologies.  For example, a radar will continually scan an area and then direct an infrared camera to point at and focus on an object that has been detected by the radar.  In airborne applications, infrared imagers are often mounted in a gimbal alongside laser target designators and rangefinders.  This has led FLIR to forward integrate into an number of these adjacent technologies by acquiring capabilities in lasers, motion control (i.e. pan and tilt), radar, and even systems integration. 

Because of their ability to see across a wide range of conditions and over very long distances, infrared imagers have proven very helpful in the recent wars as the military has needed to adapt to finding one or two insurgents instead of an entire battalion.  I believe that infrared imaging has also been used to locate roadside bombs since recently disturbed earth has a different thermal signature than the dirt around it.  In addition to infrared’s use in recon and targeting applications, it has also become very helpful in force protection applications.  During the wars, bases often mounted gimbals equipped with infrared cameras to aerostats or tall towers to monitor the surrounding area—effectively giving themselves an “eye in the sky.”  (Some of these gimbals included laser rangefinders with which troops could precisely direct ordinance.)  FLIR’s imagers were uniquely positioned for Force Protection applications since the cameras needed to run continually in the harsh and hot environments of Iraq and Afghanistan.  Impressively, FLIR provided the gimbals for many of these programs (i.e. RAID, GBOSS, BETSS-C) even though Raytheon was sometimes the systems integrator, and Raytheon is one of the largest military infrared vendors.  FLIR’s systems, however, were much more reliable which made them the imager of choice for these 24x7 applications.

In the late 1990’s, FLIR was a somewhat marginal government player since its cameras provided 70% of the capability of those offered by defense contractors for 50% of the price.  Through aggressive internally funded R&D, however, FLIR dramatically improved its competitive position, and by the late 2000’s, its products offered 90-120% of the capability of competitors’ for just 75% of the price.  Not only was FLIR offering equal or superior products at much lower prices, but it was doing so at very high operating margins.  FLIR’s government infrared margins have settled in the mid-30%’s—roughly three times that of prime military contractors.  This has all been underpinned by a fundamentally different business model than its competitors. 

Traditional military procurement begins with government funded R&D efforts.  Because the government is funding the R&D, they dictate the direction of the program and control how the resulting technology can be used.  FLIR, by contrast, chose to fund its own R&D efforts.  This allowed it to focus on the product attributes that it thought would be most useful to the war fighter and develop components that could be shared across multiple military and commercial platforms.  This latter point is critical since infrared detectors are exotic semiconductors, and their unit prices thus fall as volumes increase.  Sharing components across platforms thus allowed FLIR to initiate a virtuous cycle of falling costs, which allowed it to lower prices and increase volumes, which further lowered costs, etc.  Another benefit of this approach is that it allows for much faster product development since FLIR can pursue the features that are most likely to be needed instead of being hamstrung by the government’s procurement bureaucracy which can take years to finalize specifications.  The company refers their approach as “Commercially Developed, Military Qualified,” (CDMQ). 

In the past, FLIR was confronted with two political disadvantages.  The first was simply that FLIR lacked the influence of much larger contractors such as Raytheon and Lockheed who had larger lobbying efforts and employees in more congressional districts.  The second, however, was that FLIR’s CDMQ strategy placed it at a disadvantage to contractors who had accepted government R&D funding.  While competitions would ostensibly be fair, it looked bad for the DoD to award business to FLIR after having spent tens of millions of taxpayer money to have another contractor develop a product that turned out to be inferior.  New procurement rules, however, encourage a more commercial approach to bidding military programs, and in 2H11, FLIR announced two instances in which it won a spot along incumbent suppliers who were previously the sole source for the related programs.  The first of these was 3Q11’s Persistent Ground Surveillance System for force protection, and the second was 4Q11’s Vehicle Optical Sensor System which will be mounted on MRAP’s.  The CDMQ model is also very well suited for tightening defense budgets as it allows the DoD to avoid development risks, and it also produces lower cost products. 

FLIR’s government infrared division is expected to shrink modestly in 2012, due to the host of issues that have delayed government procurements.  Over the long term, however, FLIR’s products are well positioned because there is an ongoing trend towards ISR and improving platform capability, including soldier capability.  FLIR produces a component that dramatically improves the productivity of various platforms such as enabling a base to watch its own surrounding instead of requiring a sentry to continually scan the horizon.  Alternately, infrared enables a vehicle or soldier to see for several miles instead of having to physically cover greater distances to perform the same amount of reconnaissance.  I believe that these factors will lead to greater military adoption of infrared and that FLIR will continue to expand its marketshare in this area.  (Over the last five years, FLIR has expanded its global government infrared marketshare from 5% to 9%, making it the fourth largest vendor in this space.)

In late 2010, FLIR acquired ICx which allowed it to forward integrate into radar and systems integration.  Radar was an obvious extension since it is often coupled with an infrared camera, and ICx’s systems integration capabilities reduced FLIR’s dependence on prime contractors such as Raytheon who offered their own line of infrared cameras.  ICx, however, also brought a Detection business which produces sensors for Chemical, Biological, Radiological, Nuclear and Explosive (CBRNE) threats.  FLIR’s management believes that customers are beginning to want integrated systems that organize imaging and CBRNE information into a single, actionable platform.  The company is experiencing some initial success with this approach, and I can certainly understand its appeal over the long term, but I am assigning very little value to these divisions at this time.  I believe that investors have generally viewed both the ICx and Raymarine acquisitions with skepticism, which has further depressed FLIR’s valuation.

As explained above, I see tremendous opportunity for FLIR’s commercial and government divisions as they lower product costs, improve ease of use and expand awareness in order to drive greater adoption of this extremely useful technology.  The greatest risk is that government spending for ISR remains depressed over the next several years, though this expectation appears to be firmly embedded into the stock price.  This can be easily observed in the stock’s multiple:

Long-Term Projections

I have modeled results out to 2016 using both conservative and aggressive scenarios, though I really think both scenarios are pretty conservative and incorporate the drab outlook for defense.  My key assumptions are that:

• TV&M grows 12-13% annually, which is slower than the 16% CAGR it has achieved since 2004.  
• FLIR’s “Surveillance” segment (primarily government infrared) grows at a 3-5% CAGR. 
• Margins don’t expand much, except at Raymarine where management is executing a very credible turnaround.
• An exit P/E multiple of 16-17x.

Even with these assumptions, I’m seeing expected returns of 12-22% over the next three to five years.  In truth, I think we’re still in the early stages of adoption for this technology, and growth could thus come in much better than this which creates an excellent risk / reward proposition.

I have included the following financial tables for those who are interested:

Catalyst