Value Contest Submission: FLIR Systems

FLIR Systems, which was founded in 1978 in Wilsonville, Ore., is the world leader in the design, manufacturing and marketing of thermal (infrared) imaging systems. Thermal imaging systems detect the infrared energy (heat) that is emitted by all people, objects and materials. Infrared cameras allow the operator to see in total darkness, adverse weather and through air pollutants such as smoke and haze. The company’s products, which include advanced sensors and integrated sensor systems, enable the gathering and analysis of critical information, with applications in commercial, industrial and government markets, via both off-the-shelf product offerings and system configurations suited to specific customer requirements (Government and Military applications).

INFRARED TECHNOLOGY OVERVIEW

Infrared is a portion of the electro-magnetic spectrum that is adjacent to the visible spectrum, but is invisible to the human eye due to longer wavelengths. Unlike visible light, infrared radiation (or heat) is emitted directly by all objects above absolute zero in temperature. Thermal imaging systems detect this infrared radiation and convert it into an electronic signal, which is then processed into a video signal and displayed on a video screen.

Thermal imaging systems are different than other types of “low light” vision systems, such as visible light intensification used in green/gray sighted night vision goggles. Infrared imaging systems are not adversely affected by the presence of visible light (they can be used during the day) and they are not susceptible to rapid changes in visible light levels. Since infrared systems are detecting emitted infrared radiation, they are passive and thus more concealed than “active” or “illuminated” systems. Additionally, thermal imaging systems can measure very slight changes/differences in the temperature, a critical feature for a variety of commercial, industrial and scientific applications.

An infrared detector, which collects infrared radiation and converts it into an electronic signal, is the primary component of thermal imaging systems. The two types of infrared detectors manufactured and used in FLIR systems are referred to as “cooled” and “uncooled,” with demand for both types expected to increase substantially in the future.

Cooled detectors utilize a micro-cooler to reduce the operating temperature of the infrared sensor to -200° C and offer high sensitivity and resolution for long-range applications or those applications requiring high measurement precision; these detectors, while more sensitive and thus able to see farther, result in a product that is heavier and more complex/expensive.

Uncooled detectors operate at room temperature and don’t require a micro-cooler, resulting in products that are lighter, use less power and are less expensive to produce than cooled detectors. While the performance of uncooled detectors is improving, uncooled detectors are still less sensitive than cooled detectors. The cost of both types of detectors is declining and FLIR expects to continue reducing costs as volumes rise and the technology continues to advance.

For those of us who are scientifically challenged (that’s me), it might be helpful to read through the 10-K and listen to the company’s recent events (particularly the November 2011 Investor Day) to hear about the breadth of commercial applicability of the products, ranging from building inspection for pest infiltration to optical gas imagining systems to detect greenhouse gases; from my perspective, I think it is safe to assume that the applicability for this technology will continue to increase in the future as the cost component becomes increasingly attractive.

CORPORATE DIVISONS AND SEGMENTS

FLIR is organized into two divisions: Commercial Systems and Government Systems. Within these divisions, the company has five reporting segments: Thermal Vision & Measurement (TVM) and Raymarine, which comprise the Commercial Systems division and Surveillance, Detection and Integrated Systems, which make up our Government Systems division.

2011 Revenue, by Division & Segment

COMMERCIAL SYSTEMS

The vision for the commercial systems side of the business (as laid out at the Investor Day) is short and sweet: “Infrared Everywhere.” The strategy behind this vision involves controlling the corners of the market: low volume, high cost products (by having the best technology) and high volume, low cost products; as the overall market for infrared grows, the marginal cost to high volume products continues to decrease rapidly, which results in a virtuous cycle that drives tipping points for increased commercial applications as the cost to integrate the technology becomes less prohibitive (according to Yole Développement, a French market research company, the commercial applications in surveillance, automotive and thermography will reach total volume of over 1 million units in 2016, compared to roughly 300,000 in 2011).

From that base (they are currently the highest producer, by volume, of commercial infrared sensors in the world and the price leader in thermal imaging products), FLIR will be able to attack any opportunity that lies in between, through a mix of technology, cost and volume leadership. So far, this strategy appears to be moving along nicely: CS unit volumes have increased at a CAGR of nearly 50% over the past five years.

TVM

Thermal Vision & Measurement (TVM) products are generally sold for applications where the customer need is to see at night or in adverse conditions or to image a scene while gathering valuable temperature information. Due to continued reductions in the cost of infrared technology, demand in large untapped commercial markets such as commercial security (ports, commercial sites, borders, residential homes, etc), automotive (currently in certain BMW, Audi and Rolls Royce models), marine (recreational boating, cruise lines, etc), airborne and first responder markets has grown rapidly. FLIR’s TVM products range from highly sensitive cameras with extensive analytic capabilities to “value” cameras for less demanding applications.

Typical TVM customers include OEMs, major integrators of security systems, security dealers, utility companies, electrical contractors, maritime dealers, law enforcement agencies, building inspectors, damage restoration contractors, universities, numerous commercial enterprises and increasingly, consumers (the emerging personal vision systems market is becoming accessible as the price of advanced thermal imaging products is continually reduced); FLIR believes that this consumer market is a key strategic area of focus given the vast size of the customer base and the opportunities it provides to develop brand equity.

As noted in the 10-K, customers in markets like predictive maintenance and R&D are sensitive to the broad economy because the company’s cameras are viewed as capital expense items. The sales of high volume cameras and emerging thermal vision products are somewhat less sensitive to economic cycles due to lower price points and growing awareness of thermal technology.

Many of the markets that TVM addresses are emerging from the early-adopter environments to broader-based demand, which has attracted competitors. While independent industry research pegs the company’s market share in thermography products at approximately 61% (up from 56% five years ago), the TVM market is highly competitive, with large and niche providers of thermal camera equipment, including divisions of Danaher (Fluke), General Dynamics (Axsys), L-3 Communications, Sofradir (ULIS), Axis Communications, NEC, Testo and numerous smaller companies.

Revenue from TVM has grown at a CAGR of 16% over the past five years and was equal to 43% of company-wide revenues in 2011:

While revenue increased 14.8% in 2011, units increased at a rate of nearly 50% - as the price per unit continues to decline, the viable commercial uses for the company’s products (for utilities, in automobiles, personal use, etc) will continue to expand and drive growth.

Raymarine

Raymarine designs, develops and markets electronics for the maritime market and is a leading global provider of fully integrated “stem to stern” networked electronic systems for boats; the division was acquired by FLIR in May 2010 for $180 million in cash. The business distributes its products through a large network of independent distributors and retailers as well as through its relationships with boat builders, providing first fitment (the electronic “backbone” on new boats) and aftermarket solutions (due to long life of a recreational boat despite rapid technological development). During 2011, Raymarine generated revenue of $172 million (11% of company total) and $12 million of operating earnings (which includes $3.8M of intangibles amortization).

Raymarine supplies a global network of approximately 2,500 dealers, retailers, distributors and wholesalers, many of whom partner on an exclusive basis and only stock Raymarine electronic boating equipment. Raymarine also has a global network of approximately 2,000 dealers and service centers which are able to sell, repair and install Raymarine’s products. This global support and repair service network is very important to boaters as many of the products offered are critical to the operation of a boat, making easy access to parts and service essential. Principal competitors include Furuno, Garmin (outbid by FLIR for Raymarine), Navico and a number of small companies.

GOVERNMENT SYSTEMS

Surveillance

Surveillance is focused on selling advanced imaging and sensor systems to government customers (military, law enforcement, etc) in markets where high performance is required. Typical applications include intelligence, surveillance and reconnaissance (ISR), force protection, search and rescue, special operations and target designation. Surveillance products are sold off-the-shelf or can be customized for specific applications and frequently incorporate additional sensors, including visible light cameras, radars, low light cameras and laser rangefinders, among others. Surveillance products range in price from under $10,000 for certain hand-held and weapon-mounted systems to over $1 million for the most advanced stabilized targeting systems.

At 12/31/2011, Surveillance backlog totaled $247 million, compared with $333 million at year end 2010; the decline is largely due to reductions in U.S. government procurement. While the U.S. government is a key customer in Surveillance, it’s important to recognize that they’re becoming a smaller percentage of FLIR’s business: sales to U.S. government agencies accounted for 43%, 34% and 29% of revenues in 2009, 2010 and 2011, respectively. The company’s principal competitors in Surveillance (highly competitive) include divisions of BAE Systems, General Dynamics, L-3 Communications, Lockheed Martin and Raytheon, to name a few.

Over the past five years, Surveillance revenue has grown at a CAGR of 17%, with 2011 revenue of $578 million equal to 37% of the company total:

As is clear from these figures, Surveillance is currently an area of concern; here is what the 10-K says about the year over year declines: Revenue decreased by 14% in 2011 compared to 2010, primarily due to decreases in revenue from U.S. government agencies, partially offset by revenue of $8.8 million from ICx business units, which were acquired on October 4, 2010. Lower revenue and increased segment operating expenses caused the decline in earnings from operations and operating margin from 2010 to 2011. The decline in backlog from 2010 to 2011 was primarily due to the continued reduction in procurement activity by our U.S. government customers in 2011…

Revenue increased by 2.4% in 2010 compared to 2009. Higher deliveries of ground-based products and the revenue from a business acquired in October 2009 was offset by decreases in revenue from airborne and maritime products as spending by U.S. government agencies declined in 2010. The change in product mix and increased operating expenses of the segment resulted in the decline in earnings from operations and operating margin from 2009 to 2010. The decline in backlog from 2009 to2010 was primarily due to deliveries on U.S. government programs that were booked in prior years and the reduced procurement activity by our U.S. government customers in 2010.”

Detection

Detection primarily produces sensor systems that detect and identify chemical, biological, radiological, nuclear and explosives (CBRNE) threats (including the market leading portable explosives detector); the ICx acquisition of October 2010 ($274M) is focused on this segment.

Detection has unique strengths in understanding the nature of sophisticated security threats, the technological potential of advanced detection instruments and the procurement processes of U.S. government customers. With a history of entering into government-funded design and development contracts, Detection has built relationships with key government customers and has experience in converting highly specialized technologies into commercial solutions that are marketable to a global customer base (today, the Detection business is roughly 80% domestic). During 2011, Detection generated $80 million of revenue, or 5% of consolidated 2011 revenue; at the end of the year, the backlog stood at $25 million.

Integrated Systems

Integrated Systems develops platform solutions for combating sophisticated security threats and incorporates multiple sensor systems in order to deliver actionable intelligence for wide area surveillance, intrusion detection and facility security. Integrated Systems incorporates advanced sensors from both the FLIR pipeline (ICx technology is also used in this segment) and external vendors in order to design and manufacture adaptive and effective force protection, homeland security and commercial solutions designed to save lives and protect critical assets.

Like detection, this segment is still relatively small, with 2011 revenues of $55 million equal to just 4% of the company total (for detection and integrated systems, year over year revenue comparisons are pointless due to the integration of ICx at the start of October in 2010). Integrated Systems competes with well-known companies such as Boeing, Honeywell, L-3 Communications, Lockheed Martin, Raytheon, SAIC and Thales.

GROWTH THROUGH ACQUISITIONS

In the past five years, FLIR has completed a total of thirteen acquisitions, with the most recent significant ones being Raymarine Holdings and ICx Technologies, in May and October of 2010, respectively. The company continues to look for additions that are strategically significant and additive/complementary to their existing technologies, distribution network, or product portfolio.

Looking at recent acquisitions (since 2003) shows that the company has efficiently allocated capital to M&A: the average revenue CAGR since purchase and the average annual return (EBIT) on the purchase price have both been 16% over that time period, showing that the $875 million in capital invested over this time period wasn’t spent frivolously simply for the sake of becoming larger (many managers willingly destroy value in an attempt to build an empire).

Raymarine enhanced the distribution capabilities of the company’s thermal marine products business by adding a substantial number of dealer outlets and marine OEM relationships, in addition to the opportunity to build integrated product lines (a recurring theme at FLIR) that offer thermal imaging cameras coupled with Raymarine’s displays, radars, depth sounders, global positioning systems and autopilots products to create the broadest and most effective suite of products in the marine electronics industry.

The acquisition of ICx (which was primarily incorporated into the Detection and Integrated segments) expanded FLIR’s capabilities into advanced sensor technologies that detect chemical, biological, radiological, nuclear and explosives (CBRNE) threats, including products that are currently sold to the defense and homeland security markets. In addition, ICx enhanced FLIR’s existing intelligence, surveillance and reconnaissance product suite by adding advanced radars, imaging and integrated platforms solutions.

Besides acquisitions, the company’s other key growth initiative is in house R&D; internally funded research and development expenses were $147 million, $117 million and $91 million in 2011, 2010 and 2009, respectively. Product development is critically important to FLIR’s continued success, with an average of $125 million spent on research and development annually since 2006; importantly, R&D has been primarily paid for with internal funding (85%), leaving FLIR with full ownership of the intellectual property rights and the end product.

COMPETITIVE ADVANTAGES

FLIR has decades of experience in developing and marketing infrared sensor products and has built several unique advantages over competitors that are core to its continued success.

The company’s manufacturing capability, which reaches across the world in both developed and emerging regions, is based on a vertically integrated model that provides control over certain key component technologies that increases the effectiveness and efficiency of meeting customer needs and delivering value (essentially like Intel’s operating model compared to that of other chip manufacturers). Through acquisitions and internal development, management has created an internal supply network that allows for optimized manufacturing throughput, increased product design flexibility, enhanced product reliability and independence in designing key components; this integrated approach enables lower costs and improved functionality of critical components so that they work together efficiently within the company’s products.

In comparison to competitors that do not possess a similar level of integration (they rely on third-party suppliers for critical components), FLIR can deliver products to customers in a more timely and cost-effective manner; in Government Systems, for example, where controlling cost has been (and will continue to be) pushed to the forefront as a result of debt/national budget concerns, this is a critical advantage to have.

By management’s estimation, none of FLIR’s competitors have comparable penetration into as many markets as they do, including the government, industrial, commercial and consumer sectors. This leading position allows the company to secure new and continuing business which results in increased manufacturing economies of scale. This creates a cycle whereby sensor technologies become increasingly affordable to an array of end-users while unit costs decline.

The company’s size and history also seeds future growth in another fashion: product development. With a broad array of products and key customer ties (thousands of commercial and government customers for use in a variety of applications and markets worldwide), the company can utilize field use data and customer feedback in the development process to add new features that meet the evolving needs of the end-user. This end-user is a diverse group, include government agencies and militaries, aerospace and defense contractors, electricians and tradesmen, commercial ports, first responders, critical infrastructure operators, electrical generation and gas processing plants, heating and air conditioning technicians, building inspectors, food processors, automobile parts manufacturers, commercial and residential security providers, research and lab technicians, manufacturing companies, doctors and veterinarians and recreational boaters, to name but a few. As noted in the 10-K, this continual evolution of products has proven successful through high levels of customer retention, product line expansion (which has diversified the customer base) and continued revenue and income growth.

And while this may not be considered a competitive advantage, intelligent capital allocation is so often overlooked that I think it should be highlighted in the case of FLIR; for example, take a look at their share repurchase activity by month in 2011 (key months in bold):

It’s so nice to see a company actually buy their stock when it gets cheaper and hold off as it appreciates rather than just pay lip service to the idea; also, investors should note that they became increasingly attracted to the stock at around $24/share, about 9% above Wednesday’s close of $22.07 per share.

GROWTH STRATEGIES

Grow Existing and Enter New Markets

A key element of FLIR’s success has been addressing the market by delivering high-value sensor technologies with various specs and price points to reach an expanding range of customers (see the breakdown of price/capability across various product lines in the investor day presentation). This has been realized on the commercial side by increasing the availability, value and effectiveness of products, with the growing end-user population often finding new uses for the technology.

Design and Develop Innovative Sensor Systems

FLIR plans to broaden their product line by developing next-generation sensor technologies via internal funding and, when strategically beneficial, customer funds as well. Critically, they must develop novel features and technologies for products while also reducing their size, weight and power consumption (particularly in cooled detectors). From the 10-K: “By being aware of our changing customers' needs and the trends within our markets, we expect to bring to market the most cutting-edge and innovative products that provide critical information to secure, protect and improve lives and resources.”

Continually Reduce Costs

The company’s commercial operating model has had past success developing/manufacturing products that benefit from economies of scale, a trend that enables the company to expand on their leading market position while reducing the cost needed to deliver products to customers. Management expects to further leverage this model (primarily by continued vertical integration), where increased unit volume output reduces costs, leading to lower selling prices and increasing demand and sales volume for FLIR products.

Expand Global Reach

FLIR has been successful in expanding to new international markets, most recently in regions of the Middle East; in the future, they intend to increasingly focus on developing countries such as India and China. Additionally, as their technologies have become more affordable and prevalent in consumer markets, FLIR has continued to strengthen marketing and sales channels to better communicate and serve the millions of potential customers in the commercial systems business.

Build Application Awareness

Both thermal imaging and CBRNE detection technologies are still in the early stages of adoption in many of our markets. As people understand and recognize the extensive commercial, consumer and industrial uses for the information provided by FLIR sensors, business will continue to grow. As such, the company is communicating the benefits of thermal and detection

sensors to new market participants in order to drive demand for our products via internet promotion, advertising, direct mail, press and demonstration tours, technical articles for publications and sponsorship of and participation in major trade shows.

RISKS

At 29% of total 2011 revenues, the U.S .government and its agencies are the company’s biggest customer. As expected, the funding of contracts awarded to FLIR depends on the overall United States government budget and appropriations process, which is beyond FLIR’s control and likely to be affected by potential defense cuts; the risk is that any material cut in defense spending would likely start at the top line and work its way down (deteriorating operating/profit margins).

Even if this comes to fruition, at some point enough is enough; as the date for automatic defense cuts draws closer, the stock continues to fall - in the past year, FLIR has fallen by more than 37% while the DJIA and the S&P 500 have increased marginally. At this point, the stock is within spitting distance of its March 2009 low (by comparison, the S&P has doubled).

On top of that, it’s important to look at FLIR as a company, rather than simply looking at the defense budget as a proxy for their growth potential; for example, while the U.S. Department of Defense budget has growth by roughly 8% per annum since 2001, FLIR’s U.S. Government business has growth at a rate of 26% per annum. In addition, the Surveillance & Reconnaissance portion is still growing (despite a flat budget overall) and is worth $14 billion, leaving FLIR plenty of opportunity to grab additional market share.

The same concern with the U.S. government’s spending cuts can be made for international customers looking to shore up their sovereign balance sheet, though the potential for material defense spending cuts outside the U.S. appears to be much less impactful to FLIR (and this doesn’t appear to be happening on a company level anyways: sales to international customers jumped to 48% of total revenues in 2011 from 41% in 2009, due to international sales growth of 25% annually since 2009).

The dark cloud in the equation will be competitive forces and the importance that the future development of technology will have in determining the company’s success (particularly when competing with giants like Lockheed Martin, Raytheon, etc). In answering that question, I tend to look at historical financials and the track record the management team has established, which suggests that investors would be misguided to bet against FLIR. As always, this comes with the disclaimer that historical results may not be representative of the company’s future performance.

MANAGEMENT

Earl Lewis, 68, has been the CEO at FLIR since November 2000; his total compensation has averaged $6 million each of the past three years, with less than 20% coming in the form of cash. He owned 2.6 million shares of common stock as of the proxy filing date, equal to nearly 2% of the outstanding shares (and nearly 10x his average annual salary, aligning his interests with shareholders).

Besides one individual, every person on the management team and the board of directors holds at least $2 million (at the current price) in stock and collectively hold ownership of 3% of FLIR’s outstanding shares.

Top management has been at FLIR for a number of years; the President of Government Systems, the President of Commercial Systems and the CFO joined the company in various roles in 1994, 1999 and 2003, respectively. Again, stock ownership is aligned with shareholders: each of those three gentlemen holds at least 3x their 2011 salary in common stock.

HISTORICAL OPERATING RESULTS

Over the past decade, FLIR has increased both revenue and earnings per share at a rate of 22% per annum. Here’s a breakdown of the most recent five year figures:

Four Year CAGR, 2007-2011

As we can see from these two sets of data, some worrying trends are appearing in the P&L. While revenue growth has been strong at a high teens compounded annual rate, the trend as we move down the income statement is contracting, rather than leveraging the growth in sales: gross margin, net earnings and diluted EPS growth have all trailed revenue growth rates. In 2011, this can be attributed to two specific events: first, Raymarine and ICx have historically had lower gross margins than the remainder of the company’s operations, which has dragged down margins as those businesses were consolidated; secondly, the product mix in the surveillance division negatively impacted gross margins, which was partially offset by operating efficiencies in TVM.

As we get past the COGS, we see that higher R&D as a percentage of sales (up 26% year over year on a dollar basis) also impacted operating margins and the bottom line; how an investor interprets the way that cost rolls through the P&L should come with the remainder that despite the accounting conventions, the proceeds from that work will be applicable well beyond 2011.

While the absolute results (declining) aren’t what investors would hope for, it’s important to step back from a vacuum approach and see where the company stands in comparison to the competition; as noted during the Investor Day, the company’s operating margin has consistently been best in class (in comparison to the peer group) and has stayed in the top quartile in each of the past five years (due to lower SG&A as a percentage of sales and higher gross margins).

In addition, we can see that revenue growth has slowed over time; in 2011, for example, revenue was up 11.2%, but would have been flat if the acquisitions of Raymarine and ICx were excluded.

As noted in the 10-K, this is directly related to government spending: while revenue in the Thermal Vision and Measurement (TVM) segment increased by 14.9% in 2011, revenue in the Surveillance segment declined by 14%. This becomes more apparent when we look at pre-tax earnings on a regional basis:

As always, investors need to be looking through the windshield rather than staring into the rear view mirror; with the U.S. government accounting for less than 30% of the business at the end of 2011 (compared to over 40% in 2009), it’s important to recognize that FLIR’s future is not tied to the defense budget. With the continued growth in the international and commercial business, the U.S. government slice of the pie will become smaller with each passing year.

BALANCE SHEET

At year end, FLIR had $441 million in cash and $1.23 billion in current assets, compared to $248 million in long term debt and only $232 million in current liabilities (current ratio of 5.3x). Goodwill and intangibles are a sizeable piece of total assets ($662 million, or 30.8%, the majority of which is classified under the Thermal Vision & Measurement segment), which is what you would expect for a company that has acquired 13 businesses over the past five years.

FREE CASH FLOW

DU PONT ANALYSIS

MISCONCEPTIONS

Often, value investing comes down to buying companies where there is a misconception about what recent results mean for the company’s future, or even what the company does; FLIR has been exposed to a bit of both.

On the first point, weakness in government systems has led to the perception that this company cannot grow without an expanding defense budget; the reality is that the U.S. government is becoming an increasingly less important customer (under 30% of sales) and is being mitigated by strong growth in commercial and international markets, which can push it under 25% looking forward (government will come close to 50/50 split between international and domestic this year, with the split between government and commercial learning towards commercial).

The second misconception (what the company does) is tied to this: despite what some people may think, the company is not a DOD contractor; listen to what Bill Sundermeier, President of Government Systems, has to say on this topic:

“I suspect there are a few analysts that are out there right now that [will] comp us against DOD contractors and let me tell you every time I see one of those reports my stomach turns because every single day I think about not being a DOD contractor and being compared to them. We do everything we possibly can to not be like them, from the way we produce our products, to the way we deal with our costs, we fight extremely hard to not be a cost plus contractor. Why? The margins there are terrible; if you take a development contract, you’re lucky if you get 7-8% margin on that and that turns into a product sale that you might get 13-14% profit on. We do everything we can to not be a DOD contractor.”

For example, look at companies like Raytheon, Northrop Grumman, L-3, or Lockheed Martin: for every one of them, gross margins in 2010 were materially below 20% (average in the low teens); by comparison, FLIR’s gross margin in 2010 was over 50%. Of course, that begs the question: why?

Because FLIR will not build a product that does not have the potential for commercial application: “we will not take a project that doesn’t lead into a product that everybody (meaning police, FBI, border patrol, etc) can use,” and they are pushing this into ICx by eliminating contract R&D that doesn’t lead to profitable products.

Intuitively, this makes sense: with plenty of DOD contractors competing on price with limited barriers to entry, the laws of economics tell us that they will drive down the bids to a point where the margins are of limited attractiveness (on cost plus contract, that figure is essentially set in stone prior to commencement). The issue at that point becomes that most of the products being developed for the U.S. government have all the bells and whistles (see expensive) and won’t be affordable commercially, assuming that it even has commercial applications. FLIR, on the other hand, will specifically turn down projects that do not have commercial applications, because they know that they won’t make attractive returns otherwise.

With their method, FLIR builds products across a vertically integrated components and technology company that is funded by internal R&D (they take the risks) and ultimately owns the rights to the proceeds of their developments (and the rewards) with a focus on expanding the reach to commercial applications; comparing this methodology to the operations of the major DOD contractors is the equivalent of comparing apples and oranges (and explains why the Lockheed’s, Raytheon’s and BAE’s of the world are some of FLIR’s best customers – because they get a better product from FLIR than they can from their own subsidiaries, not surprising considering that cost plus contractors have little incentive to drive down expenses).

Of course, this doesn’t come without risk: while the Lockheed’s, Raytheon’s and Northrop Grumman’s spend 1-2% of sales on internal R&D funding, FLIR spends 8-10% annually; because customers don’t pay FLIR directly to develop products, they can make them in a way that they can satisfy the needs of multiple customers, driving economies of scale.

Ironically, this model has helped FLIR to increasingly meet the needs of the militaries around the world; according to market researcher Maxtech, the company has increased their share of the world market for military infrared imaging systems from 5% to 9% in the past five years, passing BAE, L-3 and Northrop Grumman along the way (Raytheon and Lockheed are the industry leaders with roughly 18% share a piece).

Looking to the future, FLIR hopes that some growth will come from climbing the ladder to compete with Raytheon and Lockheed for additional share; what Mr. Sundermeier has to say about this topic is insightful:

“The challenges of fighting against Raytheon, DRS and Lockheed – one of the things we’ve consciously done, not being a DOD company. I have one legislative lobbyist in Washington, DC; Raytheon has 250. So, there will always be acquisitions that happen because of the lobbying power, whether or not it’s good for our taxpayers, whether or not it was the right value product purchased, just the overpowering politics that can happen will still head things their way.

We continue to fight against that with lower cost products that have the same technological capabilities. But I can tell you in Washington, DC it’s not a fair fight… The best technology at the lowest price doesn’t necessarily always win because of politics. And that’s not a space we want to spend money in (growing lobbyists). We’re going to stay focused on value and we’re to continue to chug away…”

As he goes on to note, their method to combat that is to stick to contracts that have application on the commercial side, while DOD contractors focus on building unique products with limited use outside of a specific build-set for the U.S. military. According to Mr. Sundermeier, some people in the military and in Washington are impressed with the FLIR model and think that it should be an increasing part of government procurement in the future.

RECENT RESULTS (Q1 2012)

Revenue in Q1 was$349 million, down 7% compared to first quarter 2011. Operating income in the first quarter was$68.3 million, compared to $76.3 million in the first quarter of 2011. First quarter 2012 net income was$48.1 million, or$0.31 per diluted share, compared with net income of$51.3 million, or $0.32 per diluted share in the first quarter a year ago. During the quarter, the Company repurchased 1 million shares at an average price of$25.39 per share.

Revenue from the Company's Commercial Systems division increased 4% from the first quarter of 2011, to$202 million. Within the Commercial Systems division, revenue from TVM was$156 million, an increase of 7% over the first quarter results last year. Commercial Systems' Raymarine segment contributed$46.6 million of revenue during the first quarter, down 8% from the prior year due to lower volume from European OEM’s.

Revenue from the Company's Government Systems division decreased 19% from the first quarter of 2011 to$146 million. Within the Government Systems division, revenue from the Surveillance segment was$115 million, a decrease of 24% from the first quarter of 2011. Revenue from Government Systems' Detection segment was$19.4 million, an increase of 8% compared to the first quarter of 2011. Government Systems' Integrated Systems segment contributed$12.2 million of revenue during the first quarter, a decrease of 5% from Q1 2011.

The Company's backlog of firm orders for delivery within the next twelve months was approximately$457 million as ofMarch 31, 2012, an increase of$2 million during the quarter. 12-month backlog in the Government Systems division was$312 million (down $2M) and the backlog in the Commercial Systems division was$145 million, up$4 million during the quarter.

Based on financial results for the first three months of 2012,FLIR reaffirmed its outlook for earnings per share for the full year 2012 of$1.60 to $1.70 per diluted share and revenue for the full year 2012 to be in the range of$1.55 billion to $1.65 billion.

CONCLUSION

Growth companies often fall into no man’s land for value investors due to the degree of uncertainty in future forecasts that is necessary to justify the 20-30x multiples seen on current earnings. At FLIR, government system and commercial system sales have grown at a compounded annual rate of 18% and 27% (respectively) since 2002, which has resulted in solid 22% EPS growth (per annum) over the past decade.

Yet, in the case of FLIR, you’re not paying a huge multiple for the growth opportunities that will continue to surface as the technology becomes increasing attractive in commercial markets and in government systems around the globe (FLIR has only scratched the surface in the BRIC’s); on management’s 2012 earnings estimate of $1.60 to $1.70 per diluted share, the company currently sells at a forward multiple of just 12-13x.

On the low end, management estimates that 2012 EPS will increase 16% from the $1.38 earned in FY2011; using that as our proxy for free cash flow, I estimate that 2012 FCF will come in around $230M (looking at the four year average FCF, that number is 15% higher); when those figures are put into a reverse DCF with a discount rate of 12%, we see that the mispricing of this security is relatively severe: the implied growth rate in free cash flow is 7% per annum over the next decade, followed by growth in line with GDP (3%) in perpetuity.

In the short term, that view may be called into question: growth may fall short of 12 month expectations as domestic defense cuts (still material enough to dent near term results) hurts the government systems business and uptake internationally takes time to ramp up (as seen in Q1).

While I can’t say when, I think that the appropriate conclusion is that when taking a longer term view, this outlook fails to consider the company’s growth prospects in the international government business, in addition to opportunities that will emerge on the industrial and commercial side as a result of increasingly affordable technology with real world applications.

At $22 per share, I believe that the stock is materially undervalued, with my estimate of intrinsic value north of $30 per share (Wally Weitz of the Weitz Funds noted in his Q1 investor letter that he expects EPS growth to average at least 15% and pegs intrinsic value at $39). I think that there is a strong case to be made for initiating a position in FLIR at the current valuation.