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Flir Systems Inc. (NASDAQ:FLIR)

Q3 FY08 Earnings Call

October 23, 2008, 11:00 AM ET

Executives

William W. Davis - Sr. VP, Secretary and General Counsel

Earl R. Lewis - Chairman, President and CEO

Arne Almerfors - EVP and President, Thermography

Andrew C. Teich - President, Commercial Vision Systems

William A. Sundermeier - President, Government Systems

Stephen M. Bailey - Sr. VP, Finance and CFO

Analysts

Timothy Quillin - Stephens Inc.

Brian Gesuale - Raymond James and Associates

Paul Coster - JPMorgan

Peter Arment - American Technology Research

James Ricchiuti - Needham & Company

Chris Donaghey - SunTrust Robinson Humphrey

Brian Ruttenbur - Morgan Keegan

Jonathan Ho - William Blair

Michael Ciarmoli - Boenning & Scattergood

Jeremy Devaney - BB&T Capital Markets

Randy Gwirtzman - Baron Capital

Operator

Good morning. My name is Mandy, and I will be your conference operator today. At this time I would like to welcome everyone to the FLIR Systems Third Quarter 2008 Financial Results Conference Call. I will now turn the call over to Mr. Wit Davis, Senior Vice President, General Counsel and Secretary of FLIR Systems.

Sir, you may begin.

William W. Davis - Senior Vice President, Secretary and General Counsel

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

Words such as expects, anticipates, intends, believes, estimates and variations of such words and similar expressions are intended to identify such forward-looking statements. All of 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 do not undertake any obligation to update any such statements to reflect events or circumstances occurring after today.

Let me now turn the call over to Earl Lewis, Chairman and CEO of FLIR Systems. Earl?

Earl R. Lewis - Chairman, President and Chief Executive Officer

Thanks Wit, and thank you all for joining us this morning. We are, of course, delighted with our third quarter financial results. We've established new records for orders, for revenue, for operating profit, for net income, for earnings per share, for cash flow and for ending backlog. Our Government Systems Division performed exceptionally well during the quarter, continuing its outstanding execution, while our Thermography and Commercial Vision businesses continued to report solid revenue growth and improved profitability.

Third quarter earnings per share increased by 59% over Q3 last year, to $0.35 a share, on a 45% increase in revenue, to 277 million. Operating margin for the quarter was 27.7%, up almost 3 points from Q2 last year… Q2 this year. All three divisions improved margins in Q3 compared with the last quarter, due to operating leverage and better spending controls.

Orders were strong, resulting in backlog at quarter end with 650 million, up 78 million during the quarter. Compared to the end of last year, our backlog is up 257 million or 65%. Cash flow from operations for the quarter was a record $66 million. During Q3 we repurchased 681,000 shares of stock at an average price of 33.71 and year-to-date we've purchased almost 1.4 million shares at an average price of 29.51.

Each of our three division presidents are here and will comment in greater detail on the results of their businesses. We'll start with Arne Almerfors, President of our Thermography Division. Arne?

Arne Almerfors - Executive Vice President and President, Thermography

Thank you, Earl. Thermography revenue increased 32% to the third quarter of year 2007. Excluding the Extech and Cedip acquisitions, traditional Thermography revenue grew by 7%. Our mid- and high volume products, including the T, and new I-family product lines, continued to grow rapidly and total units grew over 50% from last Q3. But our high-end, including the P and S Series and our GasFindIR were soft during the quarter. Overall Thermography margins improved by more than two points from Q2 due to improved cost control. Growth in the US slowed somewhat during the quarter as a result of the weakening economy, while growth internationally remained healthy.

In the entry-level market, our new i5 Camera did very well, as unit volumes increased 35% over the second quarter. The revolutionary price point of the i5 has opened the full-featured thermography camera market to an entirely new group of users and we are working aggressively to reach them by expanding such high volume channels as catalog and web-based distributors.

During the quarter we announced an agreement with Grainger Industrial Supply to include FLIR's thermography cameras in its catalog and for distribution throughout North America. We also expect to sign several additional high volume distributors throughout the world over the next year and believe these channels will drive rapid volume growth in year 2009 and beyond.

We also launched our new our new i40. i50, and i60 Thermal Imaging Cameras during Q3. This new affordable family of cameras offers best in class infrared diagnostic capabilities for commercial applications and will occupy the market segment of the market between the new high volume i5 and the higher performance T Series line. Leveraging our strategy of developing low-cost, high performance products for price elastic markets, the new iSeries delivers several features not previously found at these price points. The initial response to these cameras has been outstanding and we expect solid growth for this product line in coming quarters.

The mid-market T Series continued its excellent performance in Q3, with revenue growth of nearly 200% over last year and continued excellent modules [ph]. Since its introduction a year ago, the T Series has completely redefined the mid-level Thermography market and become a critical part of our product line.

In the Advanced Technology and Specialty markets, which include the P Series, R&D cameras and the GasFindIR, demand was less than we planned during the quarter, as customers delayed purchases. However, based on current customer activity, we expect a healthy fourth quarter from this market, with the exception of GasFindIR where volumes have fallen significantly. The return on investment offered by these cameras in crucial tentative setting and technical applications is excellent and customer interest remains strong.

During the quarter we also introduced the P620, the most affordable high definition infrared camera on the market. With a superior thermal and visual image quality, spot size resolution, best in class temperature measurement accuracy, and a host of advanced features. The P620 delivers the best engineered infrared camera on the market today at very attractive price points. Our products for the high end and specialty markets are the best in the world and we see continued growth in these segments over time.

At Extech we are seeing strength in the in the traditional instrumentation business as new products and expanded distribution contributed to strong sequential revenue growth. Sales of our Thermography cameras through Extech's channels are also growing nicely, a trend that should continue in year 2009.

Looking to the remainder of year 2008 and into 2009, we foresee continued growth driven by the best, broadest, price… most up to date product line in the industry and expansion into new distribution channels. We are planning for a weak economic environment, but FLIR's positioning in the Thermography market is stronger than ever and we will continue to expand the market by driving down the cost of infrared technology.

That concludes my comments and let me now turn the call over to Andy Teich, President of our Commercial Vision Systems Division.

Andrew C. Teich - President, Commercial Vision Systems

Thanks, Arne. Commercial Vision Systems' Q3 revenue was $45.8 million, an increase of 34% compared to a year ago. Orders remained strong during the quarter and our quarter end backlog was 81 million. Similar to the Thermography business, we also saw strong order activity internationally, while US order volumes grew modestly. From a segment perspective, orders were particularly strong in the Security and Surveillance market, as business doubled from the prior year.

CVS operating margin for the third quarter was 22%, up 6 points from the third quarter of last year and 2.5 points sequentially from Q2. Revenue in the Security and Surveillance market was up nearly 26% over the prior year.

During the quarter, we shipped several HRC-U, long-range, multisensor systems to key integrators worldwide for evaluation and integration into major border programs. The HRC-U features an industry leading 12.5x continuous IR zoom, proprietary digital detail enhancement algorithms and extensive use of our embedded Nexus technology for networking, electronic stabilization, and video analytics.

We also saw strong order activity during the quarter for our medium-range uncooled PTZ-35x140 System, which has a unique combination of two uncooled thermal cameras, a color zoom camera, and a low light TV camera. Users include nuclear power plants, petrochemical facilities and maritime port locations around the world. As with the HRC systems, virtually all of these customers will be using the systems' extensive built-in networking and analytics capabilities, enabled by the onboard integration of our new Nexus technology.

The pipeline for Security Products looks excellent, with strong demand coming from critical infrastructure, nuclear, and petrochemical markets, in addition to borders. We are very well positioned for this business with a broad product offering, strong brand and the increased adoption of our Nexus networking technology.

In Maritime, revenue growth over the last year was strong, but bookings were only up slightly. Of all the commercial markets, Maritime has been impacted the most by the weak economy. As a result, we are actively investing in alternate markets to include channels for maritime law enforcement and commercial shipping, which have been relatively unaffected by the economy.

Overall awareness in this market is rising, customer sentiment remains extremely positive and we believe that ultimately thermal cameras will emerge as the second most popular maritime electronics purchase, just behind GPS systems and ahead of radar. We are making good progress to that end, as we celebrated the shipment of our 2,000th system into this market during the quarter.

In the Cores and Components market, demand remains strong, although we have seen the affect of economic conditions on certain customers and markets. This broad segment includes our cooled and uncooled camera module sales to a wide variety of customers and industries including automotive, firefighting, UAVs and sophisticated defense systems.

For example, we provide a 1kx1k cooled [inaudible] infrared camera core to Northrop Grumman for their third generation LITENING System. With our sensor, Northrop now leads this segment of the targeting Pod business with the only 1kx1k system on the market today. We believe this market breadth can significantly mitigate the effect of economic weakness on this segment of our business.

We recently began shipping parts out of the ON Semi facility. This was a facility formally known as AMI Semiconductor. Both quality and yields are exceeding our initial expectations. These initial parts are 25 micron, low-cost, uncooled sensors for the automotive segment and thermography's iSeries product line. We plan to utilize these sensors in several additional products in 2009.

We expect continued solid growth in CVS for the remainder of 2008 and into 2009. As a result of the R&D investments over the past year, we are planning to launch new products in every sector early in 2009. We look forward to these product introductions and their contribution to our successful strategy of growing commercial markets for infrared technology.

And with that, I'll now pass the call on to Bill Sundermeier, President of the Government Systems Division.

William A. Sundermeier - President, Government Systems

Thanks, Andy. The third quarter was another outstanding quarter for the Government Systems Division. Revenue was a record 151.7 million, up 57% over last year and up 20 million from the previous record set just last quarter. Orders were also a record and backlog increased by 83 million, to an all time high of 547 million, including an 18 million reduction to reflect the cancellation of the US Army Armed Reconnaissance Helicopter, ARH program that happened last week.

We are obviously disappointed by the Army's decision to cancel the ARH program, because we still believe that the ARH aircraft, the BRITE Star II, is the right solution for the Army. FLIR's BRITE Star II proved the superior EO/IR sensor system on multiple occasions throughout ARH's development phase, and would have provided outstanding situational awareness, designation and imaging capabilities for the Army aviators and war fighters. The Army cited cost overruns as the main reason for termination. Despite program changes caused by a variety of factors, FLIR's pricing structure for the BRITE Star II never changed. We remain proud that we maintained our commercial, off-the-shelf and commercially developed, military qualified business philosophy through the entire effort.

Third quarter demand was strong around the world and we once again added to our long-term program business. We ended the third quarter with an unordered IDIQ contract base, nodding [ph] backlog of over 500 million and a significant increase in non-current backlog related to the acquisition of BRITE Star II Systems by the US Marine Corp. We again saw significant operating leverage in Q3, with operating profit reaching a record 64.2 million and operating margin of 42%, also a record.

During Q3, we received delivery orders totaling 127 million from the US Army Space and Missile Defense Command under a previously received 358 million IDIQ contract for force protection applications. Including orders received last quarter, we have now received orders totaling 239 million under this IDIQ. We are extremely proud of the life saving mission of these systems and look forward to continued leadership in force protection applications in the future.

We also received a $67 million delivery order under a 125 million Requirements Contract from the Naval Surface Warfare Center for our BRITE Star II Multisensor Target Designation Systems. These systems will be installed on UH1 Yankees, US Marine Corp. helicopters, as upgraded and will be used for various missions including search and rescue, reconnaissance, and attack. Given the planned timing of deliveries, only 13 million from this initial order is included in our 12 month backlog as of September 30th.

Market acceptance of the BRITE Star II has been strong and we expect this product to be a key driver to growth in the future. In addition to the Yankee upgrades, the BRITE Star II also completed its initial flight test on Northrop Grumman's Fire Scout VTUAV. These flight tests represent a major milestone for the VTUAV program. A current expectation is for the Fire Scout to reach initial operating capability in late 2009.

Internationally, we've received orders from customers in over 20 different countries for a wide variety of systems, with particular emphasis on Star SAFIRE III and Star SAFIRE HD systems.

An important aspect of our strategy is to constantly increase the quality and diversity of our products, applications, and customers. We continue to expand markets for maritime, airborne, and ground-based applications, with a suite of best-in-class products and our unique commercially developed military-qualified model. Our product and application breadth has enabled us to build a substantial customer base within the US, Department of Defense, the Department of Homeland Security and many international governments, and several top prime contractors.

As we conclude 2008 and look to 2009, we see significant opportunities to grow market share by continuing to invest in new products, in our new applications, and further expand our customer base.

While we are targeting large programs, including the DVE and MRTB programs, where we are awaiting the selection decision, the success of our business model does not rely solely upon them. In fact, our recent growth demonstrates the value of our commercially developed military qualified model to our customers and we intend to further leverage this model into new areas of opportunity with our government customers worldwide.

Confirmed by the enthusiastic reception we received at the recent AUSA Conference where our booth traffic, lead generation, and press interest were at an all-time record, we believe the future continues to look bright.

That concludes my comments, and I'll turn it back over to Earl.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Well, thank you all. Like all of you on the call, we are paying very close attention to the economic situation worldwide and the state of the financial markets. I believe that FLIR is not immune from this market turmoil or the risk of the recession. However, we are well positioned for a difficult economic climate, both next year and beyond. We are currently profitable. We have a strong balance sheet, excellent cash flow and substantial untapped liquidity. We'll continue our conservative approach to capital structures and we believe we're insulated from the current uncertainty in the financial markets.

We are in the early stages of our 2009 budget cycle and we do not intend to provide a formal outlook for '09 until our February conference call. However, at this point, we are generally comfortable with the middle range estimate for 2009 EPS.

Our plan assumes there will be an economic impact on our CVS and Thermography business in '09, in the form of slightly slower growth than we saw in '08. These businesses are well diversified geographically, across many markets, many customers and many applications and our overriding strategy of expanding in the price elastic market should continue to drive that growth for many years. We are planning for the possibility of a slowdown effect in these growth rates, and will manage our costs accordingly.

Our Government Systems Division has seen tremendous growth over the past two years and our record backlog gives us very good visibility towards additional strong growth in '09. We believe our longstanding strategy of growing our share of the overall government market with our commercially developed, military qualified model will drive continued long-term growth. Our current operating objective for Government Systems is to achieve another year of strong growth in '09.

We also announced today that we are tightening our full year '08 revenue and earnings per share outlook to the high end of our previously announced range. We now expect '08 revenue to be in the range of 175 billion to 1.1 billion and earnings per share between $1.21 and $1.25. This compares with our previous outlook for revenue of $15 billion to $1.1 billion and earnings per share in the range of $1.18 to $1.25.

Finally, most important, I want to thank FLIR's employees for their dedicated effort to the continued success of our business.

And we'll turn now to Steve, who will go through the financials in more detail.

Stephen M. Bailey - Senior Vice President, Finance and Chief Financial Officer

Thank you, Earl. The financial information to be discussed today includes the operating results of Cedip Infrared Systems, which was acquired in early Q1 2008 and Extech Instruments, which was acquired for 2007. Extech's results are included in the Thermography financial division results. The Cedip financial results are primarily included in Thermography, but a portion of their product sales are reported through Commercial Vision Systems and Government Systems as well.

For 2008, we'll provide appropriate disclosure and material impacts from Cedip and Extech to assist in understanding the comparison to FLIR 2007 pre acquisition results. References to FLIR beyond 2008 will be on a fully consolidated and integrated basis with FLIR operations.

Revenue for the third quarter 2008 totaled $276.7 million, an increase of 45% compared in the same quarter last year. Revenue from Government Systems amounted to $151.7 million, a 57% increase as compared with third quarter 2007. Revenue from Thermography was $79.2 million, an increase of 32% over the third quarter of 2007 and a 7% organic increase, excluding Cedip and Extech revenue. Revenue from our Commercial Vision Systems Division of $45.8 million increased 34% as compared to the third quarter 2007. For the quarter, revenue was distributed at 55% to Government Systems, 29% to Thermography and 16% to Commercial Vision Systems. Our international revenues for the quarter were $86.2 million and were 31% of our total revenue, while revenues from the US Government sales of $118.5 million accounted for 43% of consolidated revenue during the period.

For the first nine months of 2008, revenues totaled $774.6 million, an increase of $237.8 million or 44% from the same nine-month period of 2007. Year-to-date revenue from Government Systems of $397 million, an increase of 48%, Thermography revenue of $239.4 million, an increase of 40% and 13% organically, and revenue from Commercial Vision Systems was $138.2 million, increase of 42% over the first nine months of 2007.

Year-to-date Government Systems revenue is 51% of our total revenues, while Thermography and Commercial Vision Systems represent 31% and 18%, respectively, of total revenue. For the first nine month of 2008, international revenues were $279.2 million and was 36% of our total revenue, while revenues from the US Government sales were $308.8 million or 40% of consolidated revenue during that period.

We closed the quarter with a backlog, and a reminder here, our backlog is for orders in-hand for delivery within the next 12 months, of $650 million. A net increase of $78 million or 14% during the quarter after de-booking $18 million of backlog due to the cancellation of the ARH program. Our backlog has increased 65% or $257 million over the backlog at year-end 2007.

At quarter-end, division backlog amounted to Government Systems $547 million, an increase of $83 million during the quarter, and an increase of $242 million or 79% over year-end 2007. Thermography backlog was unchanged during the quarter at $22 million, which is a 16% increase over year-end 2007. Commercial Vision System's backlog of $81 million, a 6% decrease during the quarter, and represents a 19% increase over year end 2007.

Gross margins for the current quarter were 56% of revenue, the same margin rate as the third quarter of last year. For the first nine months of 2008, gross margins were 56% of revenue, as compared to 55% for the same nine-month period of 2007.

Research and development expense of $21.6 million were 8% of revenue for the quarter, as compared to $15.7 million or 8% of revenue for the third quarter of 2007. For the first nine months of 2008, the company has incurred research and development expense of $68.3 million or 9% of revenue, as compared to $51.6 million or 10% of revenue during the same period of 2007.

Selling, general and administrative expense for the third quarter of 2008 of $57 million were 21% of revenue, as compared to $39.5 million or 21% of revenue for the same period of 2007. The increase in costs includes the addition of Cedip and Extech operating expenses, when compared to 2007. In addition to the general costs increases incurred in support of ongoing business activity. For the first nine months, selling, general, and administrative expenses were $167.9 million or 22% of revenue, as compared to $115.4 million or 21% of revenue in 2007.

Earnings from operations for the third quarter totaled $76.7 million or 28% of revenue, as compared to 51.8 million or 27% of revenue in the third quarter 2007. The 48% or $24.9 million improvement of operating profit, as compared to the third quarter 2007, is a result of our 45% increase in revenues and gross margins, while incurring the 42% operating cost increase for the same period. For the first nine months of 2008, earnings from operations were $196.4 million or 25% of revenue, an increase of $67.4 million or 52% of revenue over 2007.

Interest expense for the quarter totaled $2.1 million, as compared to $2.2 million for the same period last year. Interest expense of $1.8 million relates to the interest costs and amortization transaction costs of the $210 million convertible notes. Year-to-date interest expense amounted to $6.9 million, of which $1.5 million is related to credit line and other debt borrowings.

During the quarter, the company earned $5 million of other income, which included $3.3 million of currency gains and $1.7 million of interest and other income. Year-to-date, other income amounts to $8.6 million, including currency gains of $2.7 million, and interest and other income of $5.9 million.

Based on the anticipated mix of foreign and domestic income for the full year, the effective tax rate for the quarter was approximately 30% and we expect the annual rate to approximately 30% to 31% for the year.

For the third quarter, net earnings were $55.6 million or $0.35 per diluted share; 60% or $20.8 million increase in net earnings compares to net earnings of $34.8 million or $0.22 per diluted share for the same quarter 2007. For the nine months of 2008, net earnings are $138.4 million or $0.87 per diluted share, a $48.3 million or 54% increase over the same period of 2007.

We finished the quarter with cash of $206.1 million, as compared to a second quarter ending balance of $177 million and a year end 2007 cash balance of $203.7 million. Our cash provided from operating activities during the quarter totaled $66.4 million, while increased in working capital by $22 million in accounts receivable and $8 million in inventory.

Cash used in investing activities for the quarter of $6.1 million was related to capital expenditures of $5 million and $1.1 million of other investments. Cash used by the financing activities of $16.4 million during the quarter included the repurchase of approximately 681,000 common shares for $22.9 million, or $33.71 per share and the receipt of $3.7 million from the exercise of stock options.

Year-to-date cash provided from operating activities was $129.8 million. Cash used in investing activities for the first nine months of 2008 of $108.7 million includes cash used for the acquisition of Cedip and Ifara of $79.3 million, $21.1 million of capital expenditures and $8.3 million of other investments.

Cash used by financing activities of $12.4 million year-to-date includes the repayment of debt of $21.4 million and the receipt of $30.6 million from the exercise of stock options and employee purchase plans, coupled with a cash use of $40.7 million to repurchase approximately 1.4 million common shares at an average price of $29.51 per share.

This concludes the summary of third quarter and year-to-date 2008 financial results. I'll turn the call back to Earl.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Well, thanks, Steve. And operator, we're ready to take some questions.

Question and Answer

Operator

Yes sir. [Operator Instructions]. Your first question comes from the line of Tim Quillin with Stephens Inc.

Timothy Quillin - Stephens Inc.

Good morning.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Good morning, Tim.

Timothy Quillin - Stephens Inc.

Nice results.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Thank you.

Timothy Quillin - Stephens Inc.

Your prepared comments covered this quite a bit, but of course everybody's mostly interested in the economic sensitivity right now. And it sounded to me like both in the CVS and Thermography business, the international held up well, and while US saw some weakness, but it just seems like the rest of the world is catching the cold right now. So the question is, do you think that things get worse in both those businesses before they get better?

Earl R. Lewis - Chairman, President and Chief Executive Officer

One of the great things about this company is, one of the things we've talked about for years, is that we're in multiple markets, with multiple products, with multiple applications, with multiple distribution channels and strategies, etcetera. So to go your question and try to make too fine a point on it, I think what Arne said is important. Because, yes, the US was a little weaker than we expected it to be. Europe and the Far East were not particularly weak. But the issue for us more was our high end cameras that didn't sell in total as much as we thought they would in Q3. Our unit volumes were up substantially, Tim, in everywhere across the board. So this is our strategy, playing out relative to selling more and more units at more and more lower prices continually growing.

Where we got hit a little bit across the board was in the very high-end product line and that's what slowed that growth to 7%. It certainly wasn't in the low or medium range anywhere in the world. So we expect those products will continue to grow. I also think that Q3 is usually a little lax in those high end products. We expect Q4 spending on R&D and spending on things like GasFindIRs, etc, will probably be a little stronger. And our indications early on are that it will. No good hard-and-fast rules, I don't think, Tim.

Timothy Quillin - Stephens Inc.

That's helpful, thank you. And then in terms of the Government business, what is the outlook for bookings in the fourth quarter? And maybe on an unrelated note, when… or if do you expect to realize the remaining contract value on your $358 million Space and Missile and Defense Command contract, which I think there's $120 million left there? Thank you.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Yes. I don't want to speculate on the $120 million that's left. We think there's a deployment that needs to be done with a bunch of them we supplied and will supply. So I don't know when that would happen, nor do I want to speculate on when that'll happen.

The other part of your question, though, was what?

Timothy Quillin - Stephens Inc.

Bookings for Q4.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Say it again… oh, Q4. Yes, in our Government business we would expect to take down backlog a little bit in Q4. That's a fairly traditional effect. Q3 is a very strong order entry quarter and Q4 is not as strong.

Operator

Your next question is from the line of Brian Gesuale with Raymond James.

Brian Gesuale - Raymond James and Associates

Nice job today.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Thanks Brian.

Brian Gesuale - Raymond James and Associates

So I'm wondering in the Government business, if you could talk about it? It seems like we've had this trend where operational tempo in the Middle East has been very high. But really, over the last 18 months or so, your installed base of product out there has grown so significantly. Can you talk about an emerging service business, maybe where its at today, how fast that could grow and how meaningful that could be two, three, four years down the road for you in the Government business?

Earl R. Lewis - Chairman, President and Chief Executive Officer

Yes. I'm going to let Bill do that, but clearly we've a great deal on that part of the business and as you know, these systems do have a sort of a natural life to them, because the coolers don't… they have, what, 10,000 hours average or something like that? And these are being used continuously. So we will expect service revenue. But Bill, do you want to comment?

William A. Sundermeier - President, Government Systems

Sure. Certainly the up tempo hasn't been really the high demand for our products. Although, when it comes to, for example the BETSCC and the RAID program, all the systems still haven't been fielded in. In fact, when it comes to BETSCC, those are just getting fielded over there. So we see a central tidal wave of long-term service coming, because those systems haven't been deployed and they haven't made it to their MTBF or beyond. So we do see service for all those products in particular being something that we're focused on. We're growing service here in Portland very rapidly to meet that demand and… we did announce a service contract earlier. So that's an open-ended… not open-ended, as there's a cap to it and we're seeing that… we're watching that service revenue grow. To what extent, don't know. Our policy is to always try and improve our quality and all these systems have helped us improve our quality and extend our MTBF. So we're trying to project on to the future as best we can.

Earl R. Lewis - Chairman, President and Chief Executive Officer

That service revenue, though, is not… those orders are not in our backlog.

William A. Sundermeier - President, Government Systems

That's correct.

Earl R. Lewis - Chairman, President and Chief Executive Officer

We only report an order for service when we actually receive the goods to service them. Even though we have a fairly major contract for how much was it, Bill, 60 million?

William A. Sundermeier - President, Government Systems

57 million.

Earl R. Lewis - Chairman, President and Chief Executive Officer

57 million, I think it was, fairly significant. We did announce it.

Brian Gesuale - Raymond James and Associates

Okay, terrific. That's helpful. Maybe on CVS, could you maybe walk us through? It sounds like you're expecting to see very good growth in that business. Could you maybe walk us through maybe the question of cyclicality versus just penetration and adoption rates? And it seems like maybe the short-term outlook in that business is a little bit muted over the long-term or maybe that's not correct, but maybe just clarify those points for us?

Earl R. Lewis - Chairman, President and Chief Executive Officer

Andrew, do you want [inaudible]?

Andrew C. Teich - President, Commercial Vision Systems

Sure. So, Brian, there is some cyclicality, particularly in the Maritime segment. Q3 is well known to be a low quarter for Maritime Electronics and we did see that effect, although there was still growth in that market in Q3 of this year, just less on the other segments. All of the segments actually grew in Q3. So we expect to continue to see that cyclicality.

I think that we are seeing some softening in the consumer or the pleasure boating piece of the Maritime segment. But that's not that big in the segment for us, and as I mentioned in the prepared comments, we've shifted our effort over to focus more on law enforcement and commercial shipping and it actually had very good initial success in that area. And the nice thing about both of those markets is they tend to be more interested in our higher end units, whereas the consumer tends to be most interested in the least expensive thing that we sell. Moving over to the Security and Surveillance segment, there's less cyclicality there. That's a business that's been growing very nicely.

And as I mentioned, on the order side, it doubled again in Q3 of '07 and we've got a good forecast for Q4 as well and it seems to be relatively unaffected by economic conditions thus far.

Stephen M. Bailey - Senior Vice President, Finance and Chief Financial Officer

Yes, you asked about penetration. There isn't any. I think, based on the size of these markets, CVS is just at the beginning of penetrating Maritime, Security, most of these businesses that we really are just beginning.

Operator

Your next question is from the line of Paul Coster with JPMorgan.

Paul Coster - JPMorgan

Hi, good morning.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Good morning, Paul.

Paul Coster - JPMorgan

I just really only have one question. It's really of on the end, Andy, and it's going back to the comments around international growth offsetting some of the weakness in North America. Where are the pockets of international growth and what is sort of driving that growth in those particular regions or countries?

Arne Almerfors - Executive Vice President and President, Thermography

Should I start and say that the growth will come both from our European activity as well as the Asian-Pacific activity. But the growth is actually more to be… I should say coming forward in Asia-Pacific in even more positive ways, since it's a later start for us. Our product, our setup, our sales organization, everything is coming through. So that is a combination of establishing a structure for Asia-Pacific that is going to pay off long-term. And in Europe we have that structure already. But still at the market impact of the economy in Europe and Asia-Pacific has not been… the negative market impact, let's say, has not been that strong so far.

Andrew C. Teich - President, Commercial Vision Systems

Yes Paul, I'll add to that from a CVS perspective. We actually have… on the order side, we had the largest growth in what we call regions [inaudible] Asia-Pacific. But that was the largest growth from a percentage standpoint. But the more meaningful growth, from a dollar value standpoint, was in region one, which for us is Europe, and I would attribute it to the fact that we have been very aggressive in developing distribution channels there. The manager we have running that area is quite experienced in doing that and has increased the number of distribution outlets that we have there, both for the Maritime, Security and Surveillance, and the cores and components pieces of our business very aggressively, and we're seeing a positive return from that.

Paul Coster - JPMorgan

So there's a follow-up question there. It sounds like you're building out infrastructure in certain regions and are we just seeing the benefit of first-time channel fill or is there a real demand pull-through in those regions as well?

Andrew C. Teich - President, Commercial Vision Systems

The latter.

Paul Coster - JPMorgan

The latter, okay and Steve…

Andrew C. Teich - President, Commercial Vision Systems

Paul, let me just… I want to interject one more thought. Traditionally… we probably didn't state this as well as we should. Traditionally you sell more higher-end products in the US than we do in the rest of the world. And I think that's a fair statement. And so when we said we saw the high-end products with less growth, I think that part of that is historical, in that we tend to have sold, for example, more GasFindIRs in the US. We tend to have sold more high-end R&D products in the US than we would in the Far East or in Europe.

Operator

Your next question is from the line of Peter Arment with American Technology.

Peter Arment - American Technology Research

Good morning. I'll echo everyone else's comments, congratulations on the results. This may be just more on the Government Systems side. Could you… and we know you've mentioned DVE and MRTB? Can you give us any more color on what you're seeing our RFI opportunities or either whether through SOCOM or just either domestically or internationally, what you're seeing on the horizon outside of the two that you mentioned? Thanks.

Stephen M. Bailey - Senior Vice President, Finance and Chief Financial Officer

Sure. I think the significant one that I think we should talk about at this point is where looking forward to an RFI on the LUH program for the Army. And that's something that we think will be an RFI here this fall and perhaps and RFP with an RFP conclusion this winter and that's a fairly significant program, the Army. And that's one we'll be tracking here closely.

Earl R. Lewis - Chairman, President and Chief Executive Officer

One of the things I think we've learned is not to talk about these too much.

Peter Arment - American Technology Research

I know that. That's why I asked, but thanks, Earl.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Yes.

Stephen M. Bailey - Senior Vice President, Finance and Chief Financial Officer

That one was just talking.

Earl R. Lewis - Chairman, President and Chief Executive Officer

That's right. But then clearly those three are sort of on the top of our list, let's put it that way. But it's still a list.

Peter Arment - American Technology Research

Yes and then just in international you're seeing… I mean, you're still seeing the opportunities there? Any color there would be great.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Yes. Our growth rate in Government, in [inaudible] businesses was almost equal, I think, internationally to domestically on a percent basis in Q3 compared to Q3 a year ago.

Operator

Your next question is from the line of Jim Ricchiuti with Needham & Company

Earl R. Lewis - Chairman, President and Chief Executive Officer

Hi Jim.

James Ricchiuti - Needham & Company

Thank you. Arne, a question for you. I mean, again, it relates back to the economic environment. If we look back at the last recession, back 01/02, you guys had some choppy quarters in Thermography. It sounds like what you see now is… let's put it this way. How would you contrast the company, the Thermography business, now versus where it was back then in terms of the markets you're going after? Is that what you think provides some insulation?

Arne Almerfors - Executive Vice President and President, Thermography

Let me first comment on your comment. That is not what I recall, actually, that we were having some sloppy quarters during year 2000. I mean, historically we have not been exposed, to a great extent, to the changes in economy. Of course, the fact that we get bigger, will perhaps give us more sensitivity to the changes in the world economy. So that is my recollection.

Going forward, the way we build Thermography is, actually we build it through setting up a better structure in countries and territories where we haven't been before, which is touching untouched markets, should say, before. So the growth will come even though you have a tough economic environment. At the same time that we introduce broader, more products, another broader product line than we ever have had before, which will in the end support our activity.

James Ricchiuti - Needham & Company

But if you went back to 2000-2001…

Stephen M. Bailey - Senior Vice President, Finance and Chief Financial Officer

Actually, yes the '01-'02 timeframe, there were a couple of bumpy quarters. That's all.

James Ricchiuti - Needham & Company

Okay.

Stephen M. Bailey - Senior Vice President, Finance and Chief Financial Officer

You know, just then we had a product range that might have ranged from $20,000 or the lowest price, or maybe $40,000. Now we're talking about $5,000 to $120,000. That is a significant broadening, and that broadening really ends up capturing lots more applications. I think that the key for us right now is that we've seen this low end continuing to grow at unit volumes that are just fantastic. But that does, with lower price, convert to a little bit lower growth rate than we might have liked to have seen on the top end, if you will, in dollars. But the number of applications are so much broader now than it was in 2000, 2001 and the number of price points that we have and the number of things that we could do with these systems in our distribution channels, doesn't mean we're immune to overall markets. We certainly aren't, but we have a lot broader base than we ever did back then.

James Ricchiuti - Needham & Company

If you think about how much product in Thermography going through distribution channels right now, can you give us a sense as to what it is right now? And it sounds like, Arne, you're looking at continuing to open more channels, including internationally, what it could be, say a year from now?

Arne Almerfors - Executive Vice President and President, Thermography

I can only say that as an effect of the introduction of this high volume i5 product, yes we are also looking for new distribution channels, as we mentioned, catalog and web and even, as we say, sometime wholesalers. I mean, these new distributions, they are new distribution channels to us and they are just on its buildup and that's what we're going to see so much more of in the year 2009. To answer on the relation, I'm not prepared to do.

Earl R. Lewis - Chairman, President and Chief Executive Officer

A very big deal, frankly, was getting in the Grainger catalog with our products. This was a very, very important step for FLIR. They are the premier catalog. We tend to think that other catalogs will look at the fact we're there and be more inclined to have our product lines and that's an entire new distribution methodology, even for the United States. So we have broadened out that distribution, even domestically, in a big way.

Operator

Your next question is from the line of Chris Donaghey with SunTrust Robinson.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Hi, Chris.

Chris Donaghey - SunTrust Robinson Humphrey

Hey, good morning. Good morning, sorry about that. First of all, Earl, I just want to kind of go back to what you were saying, your qualitative remarks about next year. Did you say that middle of the range of 2009 that you're comfortable with?

Earl R. Lewis - Chairman, President and Chief Executive Officer

Yes. I think… forgot what the numbers were, but a $1.5 or so, I think, is the average out there and at this point, we're saying we're comfortable with that.

Chris Donaghey - SunTrust Robinson Humphrey

Okay. But…

Earl R. Lewis - Chairman, President and Chief Executive Officer

We'll give more guidance in February.

Chris Donaghey - SunTrust Robinson Humphrey

Sure. And then just a few questions on backlog. First of all, IDIQ backlog number and then going back to one of Bill's comments about the Yankee upgrade. I think, Bill, you said only $13 million of that is in backlog currently. So how are you thinking… because of timing, does that mean that Portland's capacity is pretty much at full bore [ph] right now? How are you thinking about capacity there, especially assuming the G-BOSS program and/or BETSCC eventually, at some point, begin to slow down?

William A. Sundermeier - President, Government Systems

Well, actually, that's $13 million is what's been negotiated between us and the Marine Corp and kind of their uptick rate. They certainly do want to ramp to a much faster uptick rate as we go into 2010. So I suspect the remainder of the order that we have, which is $67 million will be delivered that year and then the remainder of the contract in the following years. As far as capacity is concerned, we've done a very good job here expanding into another 20,000 plus square feet, making dedicated lines and have already started ramping up the headcount for those lines.

So I am not worried, really, about how the G-BOSS is going to affect the BRITE Star line, because they are independent lines and really, we have an independent line for our COTS customers. We have a RAID line and we have a BRITE Star line now and so those deal with their… each one of those capacity issues on their own, and ramping well there. That answers the question.

Operator

Your next question is from the line of Brian Ruttenbur with Morgan Keegan.

Brian Ruttenbur - Morgan Keegan

Mine's very brief. In the fourth quarter, what kind of gross margins are you looking for? I think revenue should be, according to your guidance, $300, $330 million, $325 million, something like that. Do you anticipate gross margins to dip from third quarter levels given the mix of business?

Earl R. Lewis - Chairman, President and Chief Executive Officer

From memory, our gross margins are a little less, but I'm not sure I could point to exactly why. That's our preliminary look at the quarter. But our revenue, I'll give you our thinking in just a second as soon as I know what it is.

Stephen M. Bailey - Senior Vice President, Finance and Chief Financial Officer

And Brian, what was the number you gave?

Earl R. Lewis - Chairman, President and Chief Executive Officer

$330 million, I think he said, that's…

Brian Ruttenbur - Morgan Keegan

Yes. I mean, your revenue guidance is $300 to $330 million, something like that.

Stephen M. Bailey - Senior Vice President, Finance and Chief Financial Officer

Yes. That was softly up [ph].

Earl R. Lewis - Chairman, President and Chief Executive Officer

Yes. That's approximately right, that's correct.

Brian Ruttenbur - Morgan Keegan

Okay. And I didn't know if there was anything that you were taking to account in the quarter like lower Thermography or the mix of business was going to be different because of the economic environment.

Stephen M. Bailey - Senior Vice President, Finance and Chief Financial Officer

No.

Earl R. Lewis - Chairman, President and Chief Executive Officer

No, not in Q4. Keep in mind Q3 we have fairly lower expenses, in total in the company because of the way you book vacations and those… the way that comes through. So we expect our expenses will be up in Q4 on the operating side. Just traditionally, the way it works.

Operator

Your next question is from the line of Jonathan Ho with William Blair.

Jonathan Ho - William Blair

Good morning, guys. Just in terms of MRTB and DVE-FOS, can you give us your latest thoughts in terms of timing for those programs?

Earl R. Lewis - Chairman, President and Chief Executive Officer

Well we hope to hear by the end of this year.

Stephen M. Bailey - Senior Vice President, Finance and Chief Financial Officer

That's what the program officers have said.

Jonathan Ho - William Blair

Okay. By the end of the year and any shift in the thinking there, any additional feedback that they provided?

William A. Sundermeier - President, Government Systems

Zero.

Jonathan Ho - William Blair

Zero, okay. With regard to the LUH program, what percentage of the helicopters do you expect to have sensors or will this be more of an optional package for that program?

William A. Sundermeier - President, Government Systems

We're going to wait for the RFI to come out and find out what the requirements are.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Hey, Bill, you shouldn't have mentioned it.

William A. Sundermeier - President, Government Systems

Yes.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Jasmine, we're sorry. You got someone else?

Operator

Your next question is from the line of Michael Ciarmoli with Boenning & Scattergood.

Michael Ciarmoli - Boenning & Scattergood

Thanks for taking my call. Congratulations on the quarter.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Thank you, Michael.

Michael Ciarmoli - Boenning & Scattergood

I guess, Earl and Bill, the Government Systems business is really performing at a very high level. It looks like the operating margin is about 42% for that segment. Is this sort of the peak for that segment? Can you go higher from here? Or how can we think about the margins going forward in the Government Systems business?

Earl R. Lewis - Chairman, President and Chief Executive Officer

It all depends on some of these major programs [inaudible] I think. We hopefully will win one or two or at some percentage of one or two or three different programs in the next year. If that happens, I think we'll be able to continue with high margins in that business. If we can't continue the growth, then we'll see those margins decline.

Michael Ciarmoli - Boenning & Scattergood

So just basically a function of volumes? I mean, then if you guys have a very good win rate and keep driving volumes higher…?

Earl R. Lewis - Chairman, President and Chief Executive Officer

It's not added expense, essentially to as a company with the orders that we've received, with G-BOSS and these others. So, effectively what he has done is he has kept his costs low and we have taken it to margin. So if we don't… if we're unsuccessful and continue to grow the business, those margins will shrink.

Operator

Your next question is from the line of Jeremy Devaney with BB&T Capital Markets.

Jeremy Devaney - BB&T Capital Markets

Thanks for taking the call today. I'm on for Mike Lewis. Just a couple questions here. Looking at the CVS and Therm business, what percentage of the revenue is government-related purchases versus commercial?

Earl R. Lewis - Chairman, President and Chief Executive Officer

Yes, I kind of thought that I like about. Andy, do you want to answer this?

Andrew C. Teich - President, Commercial Vision Systems

So we've taken a look at that, Jeremy, as we did anticipate this question and if you trace back to users that are military or government funded, it's probably something on the order of between 60 to 70% of current CVS revenue.

Earl R. Lewis - Chairman, President and Chief Executive Officer

It's a higher percent than we thought it was, particularly due to a number of the OEMs that Andy has with the repackage of our products.

Andrew C. Teich - President, Commercial Vision Systems

Most of the cores and components business, for example, are stuck in that category and certainly as we grow this market, we pursue some of the more consumer-oriented markets, that ratio will change.

Jeremy Devaney - BB&T Capital Markets

Great, thanks. That helps a lot. And then also looking at your Government Services business, what percentage of Government Systems, rather… what percentage of Government Systems is UAV-related and how do you think that end market could be for you guys? How big do you think that could be over the next few years?

William A. Sundermeier - President, Government Systems

Right now it's very small. We're in the VTUAV program. Of course CVS is selling cores to the hand-launched systems that are out there. And this is an area that we are focused on and especially when it comes to tier-two and several other opportunities and we think that we're well positioned and have the right sensors for those platforms. Right now the focus is on fielding the existing platforms that are already out there, because of what's going on in theater [ph]. But as the new systems become a priority, I think we have a very good shot of getting on those new systems.

Operator

Your next question is from the line of Chris Donaghey with SunTrust Robinson.

Chris Donaghey - SunTrust Robinson Humphrey

Hi Earl, just a quick follow-up. I wanted to ask a little bit about the sequential decline in R&D spending, you know, how should we think about R&D going forward?

Earl R. Lewis - Chairman, President and Chief Executive Officer

On an absolute basis, I believe it was up. This is a trailing number, frankly, and always will be a little bit of a trailing number. Our objective hasn't changed to have R&D expense to be close to 10% of our turnover, but we don't necessarily just spend it to make 10% number, so it will lag a little bit, whether it'll be 8 or 9 or 10 next year is still to be determined.

Chris Donaghey - SunTrust Robinson Humphrey

Okay, great. Thanks.

Operator

Your next question is from the line of Randy Gwirtzman with Baron Capital.

Randy Gwirtzman - Baron Capital

Hey, good morning guys, good quarter. A quick question regarding auto OEMs. Obviously the auto market is softer, but because there's really minimal penetration in the market and this is a long lead-time product. I'm just curious as to where OEMs are in terms of incorporating into future model years?

Earl R. Lewis - Chairman, President and Chief Executive Officer

Well, we've announced, what, three [ph] now, the plan to introduce Night Vision Systems into their cars. You're right. Clearly the automotive industry is not robust right now and I think in the short run we're probably not going see a lot of high growth there. I think in the long run, it will be significant. The difference is I don't know what short and long are at this point.

Yes, Andy, do you want to comment?

Andrew C. Teich - President, Commercial Vision Systems

And Randy, one other thing to add and its really an unknown for us right now is that these other manufactures and BMW's latest introduction of 2009 7 Series, which is a new generation 7 Series for them, incorporates the second generation of our Night Vision System, together with Autoliv and that's a system that incorporates automated pedestrian detection. And it's a very powerful addition to the systems in terms of making the function really usable for the driver instead of requiring the driver to glance at the screen. There is an alarming function that's based on a very sophisticated set of video analytics, which we worked together with Autoliv to develop. So I think that's the issue. You mentioned there's pretty low take rate right now. So even though the overall automotive business is down, if we can increase that take rate that'll have a more meaningful impact for us. And we're hoping that the addition of this feature is going to do that for us and we'll just have to wait and see.

Randy Gwirtzman - Baron Capital

Yes that's what I was getting at because last quarter you commented that you'd picked up a couple of… they were smaller, but more exotic, maybe, OEMs. And the question is because these things take a couple years to design in, even though auto volumes will be down, presumably car manufacturers, for the most part, will still be around and are designing automobiles for the 2010, 2011 model years. And I thought maybe you'd have some…?

Earl R. Lewis - Chairman, President and Chief Executive Officer

Yes. The front end of the business, Randy, is looking good in that respect. We're having an increasing number of auto manufactures express some interest in the feature and particularly, as mentioned, the feature becomes more sophisticated and user friendly. So we're just going to have to wait and let that play out but I'm pretty optimistic. I've driven cars with the feature in it and it's very useful. I'm impressed with it. We do have additional OEMs that we're working with too. So it's just one of the things that's coming and I guess I'll repeat my comments. It's a little hard to know how fast it is coming.

Operator

Your next question, sir, is from the line of Tim Quillin with Stephens Incorporated.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Hello again, Tim.

Timothy Quillin - Stephens Inc.

Hello. I thought that was an enlightening question about the mix of products and CVS. I have the same question for Arne, I guess, in terms of what percent of Thermography is the high-end PS and GasFindIR products and what percent of revenue is the low-end T and iSeries, etc? Thank you.

Earl R. Lewis - Chairman, President and Chief Executive Officer

We tend not to give that out as such, but, I don't know…

Arne Almerfors - Executive Vice President and President, Thermography

I think without giving percentages, we'll definitely say that what we have done over the past year is to create a kind of a mid segment that is taking off very nicely.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Mid-segment is doing well. Low-end is doing well. I don't know.

William A. Sundermeier - President, Government Systems

We've avoided breaking them out. I mean, directionally, clearly a higher percentage is coming from that mid-segment and the high-volume segment. But the upper end, even though it has been soft, we still anticipate long-term because that's a growth market as well.

Earl R. Lewis - Chairman, President and Chief Executive Officer

Yes. It's definitely a good business with good margins, no question. As a percent of the total, it's kind of hard to know, because these things do migrate back and forth a little bit. The new iSeries takes a little bit of the new high-end series and I guess I just don't have a good number for you.

Timothy Quillin - Stephens Inc.

Thank you.

Operator

Your next question is from the line of Jeremy Devaney with BB&T Capital Markets

Jeremy Devaney - BB&T Capital Markets

Hey guys, thanks for taking a follow-up. Just wanted to circle up with you guys on the R&D tax credits past October 3rd, are we going to see any of that drop in, in the fourth quarter for you guys and will there be any expected impact for next year?

Earl R. Lewis - Chairman, President and Chief Executive Officer

Yeah. There will be a little bit. Somebody has forecasted it to be significantly more than it is, in our case, I think Steve, here feels a penny a share in Q4.

Good. Operator, I think that was the last question. We appreciate very much your questions today and it was… certainly would be nice to have these numbers appear in a more robust market. I'd have to say that. But anyway, we're proud to be able to deliver them and hope to continue to do so. Thanks for tuning in.

Operator

Thank you for participating in today's FLIR third quarter 2008 results conference call. You may now disconnect. .

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Source: Flir Systems Inc. Q3 2008 Earnings Conference Call Transcript

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