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FLIR Systems, Inc. (NASDAQ:FLIR)

March 07, 2013 9:00 am ET


Earl R. Lewis - Chairman, Chief Executive Officer, President and Chairman of Strategy & Technology Committee

Anthony L. Trunzo - Chief Financial Officer and Senior Vice President of Finance

Andrew C. Teich - President of Commercial Systems

William A. Sundermeier - President of Government Systems Division


Timothy J. Quillin - Stephens Inc., Research Division

Peter J. Arment - Sterne Agee & Leach Inc., Research Division

Jeremy W. Devaney - BB&T Capital Markets, Research Division

Jonathan Ho - William Blair & Company L.L.C., Research Division

Earl R. Lewis

Thank you for coming and braving the weather. So we actually have weather, I've been in my room before I came down here, and they did say -- I listened to it briefly this morning and they said 8 inches this afternoon in New York, right? Anyway, we'll let you go fairly early, I think around noon. I did want to make a few opening comments, and then turn it over to Tony for some introductions in the financial review, then Bill will talk and then Andy.

The introduction, if you will, to FLIR from me is a bit of a mea culpa. 2012 was certainly not a year we're proud of in our financial performance. It was the first year we actually had a reduction in earnings and a reduction in revenue. With that said, I hope what you'll learn in the next approximately 3 hours is that during this period that I'll respectively call a lull in our growth, we've done a lot of work, a lot of work in every area that you might think of. I'm kind of proud of the fact that our R&D spending did not decline during this period. It stayed about the same. We were able to make significant cost reductions across the board in selling and administrative activities. We were able to combine a number of factories to reduce costs. We've been able to generate cash in a very positive way during this period. And I think we put in programs for our people, relative to bonuses and relative to the future, for this year that are very positive that will be -- play back well for all of us, and are shareholder-friendly, let's put it that way. You may be able to read some of those in our 10-K, I guess it's out.

With that said, we have new products to talk about that we have engineered last year. We have new facilities, we have new acquisitions, we have a new dividend, we have a new share buyback period. And I think what we have accomplished in 2012 will be more obvious when the folks are done talking today. But it was a lot, even though our results were ones that we're not at all pleased with.

So with that, the only last comment is our guidance relative to this year, I think is relatively conservative. We took the orders that we received last year, and we said that's what our shipments will be this year. Effectively, we had a slight increase in backlog last year, so our plan is to take no more potential growth orders and ship, essentially, what we booked last year.

So I believe we have a conservative forecast. We have lower costs, so we enter 2012 with one other big feature, and that is a significantly lower tax rate. So all of the work that we did in 2012, I think, we should see some pretty good results in 2013. But with that said, we're not bullish. We're not saying we're going to have high top line growth. We are managing these businesses as if it's relatively slow growth in 2013.

With that, Tony, you've got some introductions, and we'll go into the financial part. As I understand, it will be about 40 minutes for each of the presenters, with 20 minutes for Q&A after that. And then, of course, we'll all be able to take whatever questions come out of the meetings later. Thanks.

Anthony L. Trunzo

Thank you, Earl. Thank you very much, Earl.

First, I want to acknowledge the people that are here from FLIR that helped put this day together. In addition to Earl and myself and Bill and Andy whom you all know, Shane Harrison, who most of you know, our VP of Corporate Development, is here. Yvonne Kemhus, who assists Andy and I, is here. She's actually, I think, still at the reception desk. Dave Strong, VP of Finance for the Government Systems Group -- I'm sorry, you're the VP of Finance. That's right, yes. Sean Jordan is the VP of Finance for the Government Group. Bruce Cumming, also a part of the marketing group in Government Systems. Haley Ellison, there she is in the back, who is with the Commercial Systems Marketing Group. And Jim Hands, who is right there, who is with the Raymarine Marketing Organization. I don't think I missed anybody, did I? I think I got everybody? Okay, great. So thanks to all of you for being here. Yvonne did tell me that we're going to have some stragglers because apparently the subways are a little slow because of the poor snowflakes that are floating around out there.

So I thank you all for coming. I know a lot of you have come a long way. We've got some investors here from Europe, which is great to see. Earl talked about the agenda. I'll spend 40 minutes or so talking about the corporate overview, some of the works that we did in 2012, what our initiatives are going forward and a little bit of a quick overview for those of you who are maybe a little less familiar with the business. Then Bill is going to talk about the Government Systems business, and then Andy will talk about Commercial Systems. And we'll pause at the end of each of these sections to take questions. And then at the very end, we are happy to take questions as well.

So most of you know FLIR as the global leader in thermal imaging, and the largest commercial infrared company in the world. As the company has grown, as the technology base and the market opportunity have expanded, the mission has evolved a little bit. And it really does circulate more now around the ability to enhance perception in a variety of ways with a variety of sensors. Infrared is still the core of the business. But more broadly, we are thinking about more than just thermal imaging, we are thinking about the information and the data that gets provided, not only through thermal imaging, but through all of the other technologies that you'll hear about today at FLIR.

Last year, revenue was approximately, yes, $1.4 billion. We had an operating margin of 22%. Operating cash flow was a record at $286 million, and we'll talk a little bit more about that in terms of what we're trying to accomplish going forward. Earnings per share was $1.45. We almost peaked out in Q4 because of some strength growth over the prior year, but we did not do that and that was the first time in a long time.

Our total shareholder return of 377% over the last 10 years compares with 123% for the S&P 500. We have had one of the longest runs of earnings per share growth and revenue growth in the S&P 500 interrupted last year.

We increased our dividend this year, 29%. Our dividend payout ratio is now 22%, and we have bought back 774 million shares of our own stock since 2003.

In 2012, we continued the strategy of deploying our capital across a variety of different areas. We spent $58 million in capital expenditures, which was meaningfully higher than it has been historically. And that is because of the investments that we have made in our high-volume, low-cost initiatives, that Andy will talk a little bit about. We paid $42 million in dividends. We bought back $214 million worth of stock, and at the very end of the year, we made 2 acquisitions of Lorex and Traficon that totaled $106 million.

We are a global organization. We have just under 3,000 employees worldwide. And many of you know us as a high market share company in terms of virtually all of our markets. And the market shares that you'll see later today, I want to underscore, they're in dollars, and our market share in units, because of our focus on unit volumes, is going to be materially higher than the percentages that you'll see across the board today.

So operating portfolio. We have 2 divisions, and we have 5 segments under those divisions.

Our commercial division represents 56% of our revenue, and it's broken into 2 pieces. Thermal vision and measurement, which is fundamentally the infrared piece of our business and really the heart of that business, with markets ranging from cores and components to security, Personal Vision Systems and of course, our traditional thermography business that is used, that brings the added capability of sophisticated temperature measurements to thermal imaging. And then we have the Raymarine segment. We acquired Raymarine in 2010. We've improved that business meaningfully in a very challenging environment. You'll hear a good bit about that today.

Government Systems is separated into 3 different groups: Surveillance, which last year reported $486 million of revenue and an operating margin of 33%; detection, which last year had revenue of $63 million and a small operating profit of 2%, excluding onetime expenses associated with restructuring that business, the operating margin was 7%, certainly, not where we would expect it to be over the long term but certainly much better than it has been; and integrated systems, last year with $69 million in revenue, a 7% operating margin, and we think that this business has a really exciting future in terms of being able to coalesce a lot of FLIR's technologies around things like border security, port security, observation towers and those types of things. We are very excited about the opportunities that are in that business. And Government Systems overall contributed 44% of revenue in 2012.

So stepping back and looking at that 10-year track record that I indicated earlier. Our Government Systems business has grown 270%, representing a 14% compounded rate of growth, and the commercial business has grown at a compound rate of 24%, yielding 738% growth over a 10-year period.

Our TFR represents a return of 17% a year, and our 23% average return on equity is meaningfully higher than what the S&P itself has been able to generate.

During the last 10 years, we spent $908 million on acquisitions, and as I said earlier, we bought back $774 million worth of stock. And that total free cash flow of $1.33 billion, $286 million of that came last year, and more than 1/3 of it has come in the last 2 years. So we're seeing a rapid acceleration in the amount of free cash this business generates, and our ability to deploy that cash against our strategy.

FLIR is a global company. And it's really interesting when you look over a 5-year period at the growth rates that we've seen. Our business in the United States has grown 8% a year, and that's despite the decline from 2011 to 2012, really across both of the major divisions.

Our European revenue has grown 14% a year during that period, and in the rest of the world, our revenue has grown 22% a year. We did have a slight decline last year. But this has yielded a significant shift from the U.S. to the rest of the world here from 38% international revenue as recently as 2008 to 49% in 2012. And there is a very good chance that more than half of our revenue will come from outside the United States in 2013 and going forward, and that's despite the fact that one of our acquisitions is primarily a U.S.-based company.

And of note, by the way, our revenue from the U.S. government has grown at a 4% compound annual rate from 2007 to 2012. And that 2007 number still has some RAID in it. So the growth rate, excluding the RAIDs that we had in 2007, is actually 7% or 8%, something, I think it's 8%.

So we have still been able to eke out a little bit of growth in this business. Now obviously, the last few years, you've seen the decline as RAID has rolled off and as we face some challenges in the market, particularly the U.S. DoD market. But that business is still bigger than it was 5 years ago.

2012. Earl mentioned that we were not pleased with our performance in 2012, and we have no interest in sugarcoating that. The results that we put up were not FLIR-like and they did not meet our expectations.

We had our first year of revenue decline since 2000. We had our lowest gross margins in 8 years. We had our lowest operating margin in 10 years. And we had our first year of adjusted earnings per share decline since 1999. We did generate very strong cash flow for the year. I mentioned that operating cash flow of $291 million was above the prior year, so we did make a little bit of progress in that area, but we were not at all pleased with the results, as really, for the first time in a long time, both of our businesses faced challenges at the same time.

Capital budgets were significantly constrained, and the slow burn euro crisis continued, which really impacted our commercial business significantly and especially for our premium thermography products. The -- you know what, I'm going to exit out of this because it's hard for me to read it. I guess that wasn't better, was it?

Okay. Our premium thermography product revenue declined by 12% last year. Our Commercial Systems EMEA business dropped by 11% as we faced the euro crisis. And the Americas region of Commercial Systems struggled a little bit as well because of the decline in the components and cores business, so it was down 3%.

U.S. DoD budget base and OCO down 11% over a 4-year horizon here. The U.S. budget has caused some real uncertainty in this business. Our overall Government Systems business was down 13% from a revenue perspective last year, and the components and cores business that is inside of Commercial Systems was 6% smaller than it was in 2011.

And macro economically, the entire world really struggled on a relative basis. You saw a declining performance in the euro region, you saw weaker performance in China. And for us, Europe and the United States were both down double digits, and then the rest of the world, revenue was down just a little bit, a couple of percentage points.

So what did we do about it? And this is the really important part of what happened in 2012 in the context of what we expect for FLIR in the future.

We cut our overhead. We cut overhead significantly and aggressively. We were able to bring our SG&A spending down by 12%. We made some very good progress in gaining leverage out of shared services, and we're going to continue to drive that forward. And we are in the process right now of continuing to standardize our IT systems, which will provide meaningful operating leverage going forward. We saved a significant amount of money in IT in 2012 just by consolidating that organization and focusing more clearly on exactly what we want to do. But moving forward, there is going to be a significant opportunity to continue to get operating leverage out of SG&A as a result of this.

We consolidated 6 manufacturing, R&D and sales sites. Many of those were in the detection business. But we also moved facilities at Raymarine, which meaningfully reduced our costs there. We went from a very high-cost facility to a much more modest and FLIR-like facility a few miles away. And we moved more of our manufacturing to low-cost regions. As I think you all know, we have an in-source, low-cost manufacturing site in Estonia, and we continue to migrate manufacturing of our thermography cameras in particular, and eventually beyond our thermography cameras, from Sweden to Estonia.

We took on strategic pricing decisions. Last year was a soft year across the business. So we did not push hard on driving price down at the low end of the market. That resulted in lower growth of unit volumes, at the low end that we've seen. Unit volume growth last year was about 5%. But we felt like it wasn't appropriate in that kind of a market to really aggressively drive price. And in fact, in places where we could, where the competitive environment and the value that is provided by our equipment was appropriate, we actually went out and raised prices in some of our premium markets, and we were successful in making that happen and enhancing our margin profile a little bit in the process.

And as Earl said, and as you'll hear much more about from Andy and Bill, we introduced a series of new products. We addressed some product gaps in the thermography line of business. We have a new handheld for law enforcement. We improved our software and service capabilities. Early this year, we introduced the Firefly -- or the Dragonfly, which is a first introduction into the freshwater market for Raymarine and the first market expansion for Raymarine, really, in anybody's memory. So we're taking a much more aggressive posture in that business and it's an exciting product. And there's a firefighting camera back there. We've entered the firefighting market at the systems level, and that camera is there for you all to take a look at as well. So the new product introductions continued.

And we did not stop investing in research and development. We spent $138 million last year, despite the fact that revenue was down, R&D spending was about flat. So we were at the upper end of our 8% to 10% range, at about 10%. And as I said, we spent $58 million on CapEx, and that CapEx investment is largely reflecting the opportunities that we see in the low-cost, high-volume markets.

We focused on building backlog. We expanded our presence internationally. We established position in a series of non-DoD agencies. And we focused on really converting a growing opportunity set by bringing together the capabilities of the various segments that we have, particularly in Government Systems. And Bill will talk about that.

The bad news about the stock being in the high teens last year was that none of us in this room were particularly happy about that. If there was a silver lining, it was the opportunity for us to -- because of our strong cash flow, to buy back 10.5 million shares at an average price of just over $20 a share. In Q4, we were able to get 3 million shares at $18.55 a share, which was a really signaling -- signature opportunity for us. And our share repurchase program, many of you know this, that we're not in the market all the time. We try to be selective about when we're in the market. That program has generated a 44% internal rate of return for us since 2003. And I can say that we, thus far this year, have been active and through open market repurchases and a modest accelerated share repurchase, year-to-date, we purchased nearly 4 million shares.

Our dividend increase for 2013 was $0.02 a share a quarter, or 29%, from $0.07 to $0.09, and we've increased to 50% since inception. Still a modest payout ratio of 22%, giving us a lot of flexibility.

And Earl hinted at this, we did some significant compensation alignments. FLIR has been a growth company for a long time. When the company doesn't grow, the philosophy was that bonuses aren't paid, and that's exactly what happened in 2012. There was significant savings as appropriate. None of the folks in this room unfortunately received bonuses in 2012. The executive team forfeited stock options that were granted in 2010 and 2009, I believe, because we did not achieve the performance thresholds that were set out there. There was about $2 million over the last 2 years of stock compensation that was forfeited. And Earl indicated, we put in place a new total shareholder return base equity incentive program, I won't go into the details of it other than to say that over the next 2.5 years, if FLIR does not outperform the S&P 500, none of the shares in this will vest. And to the extent we do outperform the S&P 500, there'll be a vesting of shares for the leadership team at FLIR. And our preliminary proxy was filed last week, the details are in there. I encourage you to read it, and we're happy to answer any questions. But the real focus here is aligning our compensation with performance and aligning it with the interest of our shareholders.

So how did it work? Well, we talked about the fact that SG&A spending was down meaningfully last year. Surveillance bookings exceeded deliveries for the first time since 2007 -- I'm sorry, 2008. We had a book-to-bill of just over 1 last year, which was good news. The revenue trend is still negative, but we are recovering from the weakest portion of 2012, which was the first half, and because of the actions that we've taken in terms of taking capital out of the system and really aggressively using our cash flow, we've been able to maintain a return on equity in the very high teens, despite that fact that the profitability of the business took a step back last year.

So looking more in a forward fashion, what is the formula, what is the FLIR formula? Well, it's not -- for those of you who've been around this company for a long time, it's not that much different other than it's broader, right? I mean, going from thermal imaging to the ability to utilize the technologies that we have to enable and enhance people's perception of the world around them, through the ability to gain energy efficiency and drive safety and enhance perception, and expanding the technology base really beyond just the image to be able to use the data that's available in that image, and the analytics that can be applied to thermal uniquely, are some really important pieces of what we're going to be doing in the future. And we apply that strategy across the Commercial and Government market space that we think is quite large and still has a lot of opportunity for expansion.

We execute against that with a meaningful investment in R&D and innovation. We are very aggressive about aggregating volumes. And we very much want to be the market share leader in dollars, but it's critically important that we have a substantial leadership from a volume standpoint as well.

We've developed new markets, and you'll hear about those today. Price-to-value relationship and the ability to drive very high value for money from our -- for our customers is a very important aspect of this, and in a constrained budgetary environment in the U.S. DoD, that's an extremely important thing. We continue to grow our brand. And very importantly, we continue to maximize profitability. I spoke about the fact that 2012 was not a great year for FLIR. By many companies' standards, it wasn't that bad a year. But the threshold that we set for ourselves in terms of profitability is crucially important because it gives us the ability to continue to do these things. We can continue to invest 10% in R&D, that's a big number. You've got to have great margins to be able to do that. We can invest in capital and take the opportunity to do some of the things that we're doing in Santa Barbara these days. And we can make smart M&A that can help us expand margins, give us the ability to optimize our capital structure and return appropriately excess capital to our shareholders and to pursue initiatives within the company that help us to get -- become more scalable, more efficient and have better control, and thus, be able to grow the business with operating leverage going forward. And you do that, you do that again and again, and over a long time, that's what brings this superior total shareholder return.

Commercial momentum. There wasn't a lot of it in 2012. But if you look at it over an extended period of time, we've seen a 14% decline in average selling price on an annual basis and a 27% increase on an annual basis in unit volumes in the TVM segment. Now the price decline is a little bit of a misnomer because we're not taking the same product and dropping the price an average of 14% year. It's a mixture. The upper end of that market in terms of units continues to grow. Our premium thermography units have grown 10% a year over the last 5 years. But the volume side of the business has grown 3x as fast. So you still have a premium segment, you still have that segment growing, but you're shifting to a much higher proportion of your sales at the lower end of the market. And that's what's bringing down that average selling price when you do the calculation.

What's really interesting about that though is we have not suffered any margin pressure as a result of that, and that's because of our vertical integration model and our cost leadership. Our gross margins -- our revenue has been up 10%, our gross margins have been flat, and our operating income has been up 11% a year since 2007, despite the fact that you see these price reductions. So we are not sacrificing margin as we change the mix in our thermal vision and measurement business. It gives us the ability to really reduce end-user pricing while increasing our revenue and profitability over time.

A little bit about our government markets for a moment. They are diversifying. You can see that the U.S. government in 2007 -- this is for the totality of the business, in 2007, was 39% of our total revenue. And again, by the way, that was pre- the majority of RAID. And in 2012, it was 27%. So we continued to diversify away from that even within Government Systems itself. And what's interesting is on a -- excluding RAID from 2007 to 2012, our U.S. revenue has grown 7% a year and our international revenue has grown 20% a year. That international opportunity is one that you'll hear more from Bill about in a little bit, but it's very important for this business, there are significant opportunities there. And we made long-term investments. We put $4 million into our global sales infrastructure over the last couple of years. We've continued to pursue the fixed price cost model, and we've actually driven contract R&D out of the model. And we've seen increasing penetration into nonmilitary agencies.

The DoD amount in backlog has declined by 28% since the end of 2010, even as backlog itself has been up since 2010. I spoke already a couple of times about our margins and the focus that we have there. If you look at our consolidated margins, they look -- they bounce around, but they look flattish over the last several years. But if you take Raymarine and ICx, which both, still, are not yet to where they need to be in terms of their margin profile, out of the mix, you can see that our margins today have actually edged up a bit over the last couple of years. And over the last year or so, we've taken a little bit of a sharper focus on some of the nuts and bolts of margin. We were more aggressively trying to get improvements in our procurement and supply chain. We're more aggressively looking specifically at strategic pricing, and we are focused on things like detector and product yields to improve margin as well.

Corporate expenses are coming down. We have worked very hard to control them. And I'll talk a little bit more about that, but as you can see, corporate expenses have gone from just over 5% to just over 3% of revenue over the last couple of years, despite the fact that we're working to try to deliver more value.

You all are familiar, I think, with the acquisitions that we made in 2010 of ICx and Raymarine. Both of those businesses were not profitable or marginally profitable when we bought them. Today, the ICx business is broken up a little bit. There's a piece of it that's inside of surveillance. But the detection and integrated systems businesses are purely former ICx. And we've made substantial progress here. You can see that in 2010 and 2011, the detection business lost money. 2012, we were able to generate 7 points of operating margin in that business. We took -- the revenue actually is down in that business because we really squeezed out a lot of the R&D. We took $14 million of contract R&D out of that model last year. We reduced the number of operating facilities from 7 to 3. It was expensive to do, but we made some significant progress. And we expect that business going forward to have some very good growth opportunities and also some margin expansion. Integrated systems had a remarkable turnaround from a significant loss in 2009 to a very nice profit in 2012. The MSC contract is a very important piece of our future, and Bill will talk in some depth about the opportunity to commercialize that and grow that platform. The first 30 units or so will not drive significant margin. So integrated systems' margins for the next couple of quarters will not be great. But over time, we expect this business to see significant margin improvement as well. And this business doesn't really reflect -- the performance of this business isn't fully reflected in its financials because of the sell-through of surveillance products here.

And Raymarine, as I said, revenue continues to go down because of the challenges that we faced globally in that market. But the operating margins continue to go up. And in 2013, we expect that business to do better.

Raymarine is in a great spot right now in terms of their product lines, their supply chains, their facilities. As I mentioned, for the first time, really, in anybody's memory, they're on the, sort of, on the more aggressive side trying to bring their products to new markets, including special market and broader market with the Dragonfly, and we're excited about that.

And we're under-penetrated in our existing markets. Market share data is tough to get, especially when you're growing and developing new markets. But we took a stab at it. Some of these are from third parties, some of them are assumptions that we've made, and I'll be happy to take you through some of these assumptions, but the security camera business today is $7.7 billion. The military infrared business today is $7 billion. There's a $4.3 billion global market for hunting and outdoor scopes and sights, and our Personal Vision Systems business is just starting to tap into that. Chem/Bio procurement alone which is only part of our CBRNE business is $800 million a year when you take out all the contract R&D. And then there is markets like first responders and automotive and technical equipment and -- that you really can't tell just how much opportunity there is for our technology in those markets until you make some assumptions. And I'll just use 1 example. Automotive, if there's $100 worth of content from FLIR in every car sold, that's a $6 billion potential market for us. And I can tell you, today it's not anywhere near $6 billion in revenue for us. Still a lot of market runway in a lot of different places.

I'm passionate about having a strategy of capital deployment to deliver long-term value. And that takes a lot of different levers, at FLIR, it takes on a lot of different characters. The constraint to all of this is our investment-grade credit rating. We achieved a BBB- credit rating a couple of years ago. We want to maintain that, and ultimately see that edge up into the BBB+ profile as the company grows and evolves.

We've talked about R&D spending in that 8% to 10% range. Rapid development of new products. We're going to continue to make those kinds of investments, because we continue to see very high returns on those investments.

Our maintenance CapEx is not high. We don't have a lot of fixed equipment today for the scale of business that we generate. We will be investing in facilities and yield improvement as we move forward. The high-volume, low-cost initiative is going to require some investment in some semi-cap equipment, some for our own facilities and some for third parties, but we are going to be making those investments this year and going forward.

Acquisitions, we'll continue to do them as they're appropriate and as they become available to us. Largely, they're going to be to expand distribution and to complement product offerings. You'll hear about Lorex and Traficon in detail today. I think they're excellent examples of what we expect to be doing as we move forward.

The dividend we like because it's a regular and consistent return of capital. As I've said, we've taken it up fairly rapidly over the last couple of years. We've seen a 50% increase in the 2 years that it's been out there. I will anticipate that if the business performs as we expect it to, we'll continue to grow that dividend over time, and we will find the opportunity to buy back shares when we think the stock is relatively attractively priced. As I mentioned, we -- as Earl mentioned, we received a new 25 million share authorization at the board meeting we had in February, and we've already acted against about 4 million of those shares quarter to date.

So what does that mean? Well, since 2007, we've generated that $1.4 billion dollars worth of cash that I mentioned. We did do our first investment-grade bond offering for $250 million. During that time, we spent $236 million on capital; $688 million on M&A; dividends, $80 million or only about 6%; and share repurchases of $524 million. So we've ended up with a cash balance that's just a little bit bigger than it was back in 2007.

This kind of mix and this kind of diversification of application of our resources feels right to us. It feels like a good way for us to make very well-managed, balanced investment across a variety of different opportunity suites that we see. And those improvements have -- in terms of dividends and share repurchase, have yielded an additional $0.14 in earnings per share, and nearly 2 points in additional return on equity.

So I'll finish with the 3 words that my staff is really tired of hearing now: scalability, efficiency and control. These are the 3 things that if we're going to do work globally across FLIR, really enterprise-wide improvement, we've got to meet those 3 hurdles.

Scalability. Systems designed for growth and evolution so that when we put something in place, we're not just putting it in place for today but we're thinking forward about what the business is going to look like in the future and how the business is going to be supported moving forward, and really trying to be in a position where we don't have to keep adding IT resources and resources for back-office activities at the same rate that we're growing the business.

Efficiency. What we do today, we've got to do it efficiently. We -- if you go back 3 years, we had a mishmash of IT equipment and hardware across the company. Might sound like that's not a very big deal, but the cost of training and support and maintenance when you have a variety of equipment is not trivial, and that progress is going to yield significant benefit over time. We pulled our telecom resources with a series of other similar-sized companies, and ended up in a situation where we're going to save about $0.5 million a year. We've reduced the number of legal entities which reduces statutory reporting requirements and legal support and really back-office functions. And we're in the process of putting together an M&A playbook that puts a little finer point on how we go about integrating our acquisitions and getting efficiency from them a little bit quicker.

Now, if you do these 2 things, the control piece really should happen by itself. But we've worked very hard to generate through our -- through the enhancement of systems, better real-time information and better reporting for management. We also have evolved our internal controls environment to focus

We also have evolved our internal controls environment to focus much more on enterprise-wide controls and ensuring that we're identifying areas of weakness inside the company and acting on them. And as I said, that stability and efficiency piece, if you get those right, the control piece sort of follows out of it, that's resulted in operating leverage and significantly better positioning for the future.

So I'll stop there. I'm happy to entertain any questions on the work that we're doing globally in the company or the financial results or anything of that nature. And then after that, I'll be turning it over to Bill. Yes, Tim?

Question-and-Answer Session

Timothy J. Quillin - Stephens Inc., Research Division

Tony. What, on a corporate level perspective, would a turn reduction in inventory mean in terms of cash flow?

Anthony L. Trunzo

One turn of inventory would be, let's see, a couple of hundred million dollars, plus or minus.

Timothy J. Quillin - Stephens Inc., Research Division

And what are the goals on inventory?

Anthony L. Trunzo

A lot less than we have now. Inventory is -- if you look at FLIR's balance sheet, inventory is the glaring weakness, from my perspective, and I think across-the-board, you look at what we've done with inventory, we have not driven out inventory at the rate that we'd like to. Some of the work that we're doing in terms of harmonization of systems and bringing together our procurement folks from around the company ultimately should help in that. It is, I will say, especially in a low-volume, high-mix business like Bill's in particular, very difficult to bring down inventory at a time when you're facing revenue challenges. And we have taken the approach of, what I'll call, just-in-case inventory there. And we have not pushed aggressively to try to drive that out. There is an opportunity to do more there. That opportunity, I think, over the next few years, you will see us capitalize on. Earl has a question.

Earl R. Lewis

No, I'm sorry, it's just a comment. We added that back through the course of the year [ph].

Anthony L. Trunzo

That's right, yes, thanks for reminding, yes. We -- so just for those of you that didn't hear, 25% of the bonus funding, the pool funding this year, is driven by, for the first time, a cash flow from operations metric. And the way we approached it was we've introduced the idea of cash flow from operations of a multiple, it's not a multiple by 2 but of more than 100% of net income. This past year, even despite the inventory challenges we had, we generated cash from operations of about 128% of net income.

Yes, Peter Arment?

Peter J. Arment - Sterne Agee & Leach Inc., Research Division

Okay. Sure. Could you -- the share buyback, the IRR returns have been very attractive, and nice timing in the fourth quarter certainly helped. But could you walk us through on what the returns you're looking for, for on the M&A front and how you weigh that against your authorization now?

Anthony L. Trunzo

Yes. So 2 answers to the question, Earl may have some comments on this, too. But we generally target -- so our -- in a low interest rate environment, I'd be interested to engage some of you in the question of what cost of capital really means. But we view our cost of capital as being around 10.5%, plus or minus, just based on finance theory. When we do M&A, we look for internal rates of return of at least 15%. Why that premium? Well, because lots of M&A often ends up not to work out quite the way you anticipate it to. Our has, fortunately, in overall terms, but we look for a premium there. And mid-teens, again as I said, sort of feels about right in terms of the way we're building models.

To your question of how do we decide at any given time whether M&A or share buyback or just letting cash build on the balance sheet is the right thing, there is a lot of judgment that goes into that at any particular point in time. We generally -- we tend not to be companies that -- we tend not to buy companies from books that appear on our desks. If you look at the companies that we've bought, and there's been 15 or 16 of them over the last 10 years, in only one case that I can think of did we not have some meaningful dialogue with that company prior to the acquisition itself. And by meaningful dialogue, I mean measured in months and a couple of cases, years. So we generally have a pretty good idea of what's on the horizon for us, when it's likely to be actionable. And M&A tends not to be a surprise to us. We know what we need, we know who the people are, and we tend to be able to position that. I will also say, though, that there have been times where we've had to decide between an attractive but maybe not overwhelmingly so acquisition, and an attractive opportunity to buy back shares and then, in the case that I'm thinking of, we broke on the side of buying back our own shares, and it turned out to be the right thing to do. Earl, do you want to add anything to that?

Earl R. Lewis

No. We have certain ideas as to what technology, for example we might want to acquire, and you can't predict when that's going to be relevant. The absolute calculations are probably going to go out the door [indiscernible]. But we do have some ideas right now of what kind of technology we might like to add. We're looking for that.

Anthony L. Trunzo

Let's go to the back of the room here and then we'll come back around.

Unknown Analyst

Tony, I think you said you bought back 4 million shares already year-to-date. How close are you to what you had planned for the year? I think you had said some was factored into your guidance at the beginning of the year?

Anthony L. Trunzo

Pretty close.

Unknown Analyst

Pretty close, already?

Anthony L. Trunzo

Yes. Pretty darn close. Yes. And definitely ahead of where we would have thought we'd have been.

Unknown Analyst

Okay. And then how close are we to what your target tax rate is at this point? Are we about there, or is there more tailwind on that?

Anthony L. Trunzo

This year, the tax rate will actually -- if you look at it globally, if you just calculate it as a tax expense as a percent of pretax income, it will actually probably tick up a little bit, because we had some discrete items last year that won't recur this year. But the effective tax rate, excluding discretes, will probably come down just a little bit more, maybe another point or 2, over the next couple of years.

Unknown Analyst

So 25% headed slightly lower?

Anthony L. Trunzo

Yes, right. Yes, and then we'll come over here, promise. We'll get them all.

Unknown Analyst

Something new to me I saw there was that you broke out the premium units in thermo and those had grown, which is great. Are you defining that by a price range? And if so, how is the ASP track along with that unit growth?

Anthony L. Trunzo

We are defining it by product family. And the product family, the breakpoint is between the T- and the E-Series. So the low-end of the T-Series is $8,000, something in that range. And the high-end, the high-end P-Series are now high 20s, low 30s.

Unknown Analyst

Well, do you have a sense then of how ASP across that scope has trended?

Anthony L. Trunzo

Clearly, there has been a migration to the lower price points in that grouping. If you look at the P-Series cameras, and maybe you can give Andy the mic so he can -- I'm sure he's going to want to comment, too. The P-Series cameras, which are the $25,000 to $35,000 cameras, the volumes there have come down. And the T-Series, which is the next level down the volumes, have come up, because we've introduced some very attractive features in the T-Series.

Okay. Yes, Jeremy?

Jeremy W. Devaney - BB&T Capital Markets, Research Division

Tony, on the deployment of cash, this break out that you gave of the ROE improvement from dividends and repurchases was very helpful. Going forward, are you working to any specific target on ROE, or when you look at the compensation structure, are you using a target for corporate compensation?

Anthony L. Trunzo

We don't have an ROE target in our bonus structure. I'll express my opinion, what I would like to see is I would like to see us get back into the low 20s on a consistent basis. Companies -- our ROE average has been 23% over the last 10 years. Companies that generate ROEs at that level, consistently, over multi-year periods of time are the ones that earn premium multiples, and that's the objective there.

Jeremy W. Devaney - BB&T Capital Markets, Research Division

And when you look at that 20%-plus ROE target, in your mind, are there specific steps, actionable steps that you can take that you could help us think through to get there?

Anthony L. Trunzo

Sure. Yes. Improving profitability, generating cash off of the balance sheet to opportunistically take capital off of the table are the 2 pieces. I mean, it's math, really. You've got those 2 levers to pull, and I think we want to try to pull on both of them.

Let's go over to this side of the room. There's a lot of questions over there. Let's start with Mike.

Unknown Analyst

Given kind of the restructuring, some harmonizing of systems, I think you've still got a little bit of a drag from ICx and Raymarine, how should we think about the operating margins? How are you guys thinking about them, especially with volumes coming up on lower-end products. I mean, what's sort of the goal internally over the short-term and maybe as you improve the operations of some of those acquired entities, and even deal with Lorex and Traficon?

Anthony L. Trunzo

Yes, yes. So if you look at the gross margin at the product level in the Detection business, that business has the ability to get its operating margins up above 20%. Their overhead carry right now is down dramatically from where it was. But it's still higher than it is in a lot of the rest of our businesses, and there's an opportunity to get operating leverage out of that. What has to happen? Well, the business has to grow, and you'll hear from Bill the strategies for how that's going to happen. But that business, if it's $100 million-plus business, a lot of that additional $40 million in revenue should be able to really drop to the bottom line after -- a lot of the gross profit from that should really be able to drop to the bottom line. Integrated systems is a little bit tougher in the way -- internal transfer prices are always -- they are a bane of existence for all companies. You don't really get the full picture of what integrated systems is doing when you see those kind of high single-digit margins. Can they get better? Yes, I think they can. Mix is going to be a big driver there. If we can commercialize some of the products that have been developed, MSC and its commercial variance, for example, there's an opportunity to earn meaningfully higher margin there. But the real sort of secret sauce there is driving more of the surveillance products, in particular, through the integrated systems business. And Bill will talk about the progress we've made in that area, but there's opportunity there that should result in, all other things equal, better margins for the surveillance business as well.

Raymarine, that business is -- I think there's a consensus among the team at FLIR that so much has been done right there. They've taken so many costs out. They've done such a great job with their new product introduction. They've positioned themselves in the market in a really smart way. They're in the recreational marine market, which has struggled. And the traditional piece that Raymarine is in has struggled particularly worse than any other, because they're OEM-oriented, they're more OEM-oriented, they are more internationally oriented, and they're sort of at the upper end of that market. They didn't have a presence in the freshwater market, which held up better. We are addressing some of that stuff. But a tiny -- a little bit of a sales tailwind in that business will go a long way. There is a huge amount of operating leverage in that business right now. As we've improved that business and become more of a force in the market, the competitive response has been some aggressive moves on price. We've had to respond to those. Despite the fact that our pricing has ended up in a different place than maybe where we would have originally thought, the gross margins are still better than they were historically. So I think a lot of progress there. Like I said, just a little bit of help from the market there would go a long way.

Is that Noah [ph]? Yes. Hi, Noah [ph].

Unknown Analyst

Just as 1 follow-up to that, can you give us a view on your thoughts even if it's just directional on the surveillance component of that equation because that's still probably the largest needle mover there.

Anthony L. Trunzo

Yes. You guys were -- I don't know if you were here, the surveillance margins last year were 33 points. We've talked about that being sort of a low to mid 30s business, and I think we're probably in that zone. I'm not -- Bill and Sean can probably comment on that. I don't think that we're looking for meaningful operating margin improvement there. But this effort to try to improve gross margin across the company, it's really -- I think it's in its early phases. And if you look at our gross margins, and you think, wow, they're pretty good already. But the fact of the matter is that we can do better there. And we are already very price competitive in that business. We see pricing pressure here and there. But overall on balance, when we look at 2013 and forward, I think the margins in that particular piece of the business should probably be stable.

Unknown Analyst

So if I'm looking at the total company gross margin today, it's 200 basis points lower than an average, call it, '06 to 2009. It sounds like you're saying you can get that back to where it used to be.

Anthony L. Trunzo

Well, that delta is almost all attributable -- it actually is all attributable to acquisition. To the extent that we improve their profitability, yes, we should be able to get that margin back.

Unknown Analyst

So then if I look at what you've done below the gross line...

Anthony L. Trunzo

Now, I -- sorry, go ahead.

Unknown Analyst

So rough order of magnitude, right, you can get back to those gross margins. If that's true and then I look at what you've done below the gross line, it would imply the operating margins some day in the future could be higher than they were during that period.

Anthony L. Trunzo

So the reason I hesitated was our typical conversation is around operating margins, not around gross margins.

Unknown Analyst

Yes. But you've done so much.

Anthony L. Trunzo

When -- right, but I mean, to use Detection as an example, I don't know that we are going to see a lot of gross margin improvement, but we are going to see a lot of operating leverage below the line. So you'll see meaningful lift in the operating margin there. I think the same is true at Raymarine. There is an opportunity for a meaningful lift in operating margin. I don't know how much movement opportunity there is, it's a very competitive market from a price standpoint. But I do think, overall, there is an opportunity for the business. If you look at the individual components of the business, there really aren't any of them that we see downward margin pressure in. And there are couple of them where, if we can get some growth, there is an upward opportunity.

Unknown Analyst

So maybe just to pin it down a little, quantify it a little more. So do you think you can have the operating margin of the company be higher than it was when you're looking back at that '06 to '09 average period, call it 25%?

Anthony L. Trunzo

You're leaving out another component, which is mix. And I'm going to let -- I think Earl has a comment as well.

Earl R. Lewis

[indiscernible] Okay. As we get into more and more of consumer products, I think there will be more and more pressure on the gross margin line. So a return to the gross margins we had in '06, '07, I don't think we're going to see that right away. I don't think that's going to happen Noah. I think we'd be foolish to think we would. Lorex, for example, is not going to have a significant improvement in gross margin. Maybe we'll get a little bit better, but it's still going to pull us down. And like when I was in college, I get a D in 1 test and then A on all the others, I still got a C. With a few low margin businesses that are consumer-oriented, they'll have an adverse effect on us. Now, that doesn't mean we can't make up for some of that below the line, which I think we'll be able to.

Anthony L. Trunzo


Unknown Analyst

Tony, I think in one of your earlier slides, you showed growth in the commercial business at around 24%. And so if we think about what was the organic growth rate over that time period, and how should we think about the commercial business, the growth rate going forward?

Anthony L. Trunzo

I don't have the organic number off the top of my head. I would guess it was probably in the 12% or 13% range, Jim, something in that zip code. We can get that specific number for you. And I think -- again, Andy can speak to that maybe more than I can, but I think that those types of growth rates are again achievable in that business. You'll hear from Andy in some meaningful detail about his plans for that business and how we're going to grow it. And you'll hear about some new initiatives that really are sort of wildcards in terms of how much growth could be out there for us. But I think in a steady-state type of environment, that is still a low double-digit kind of growth opportunity on an organic basis for us.

Let's go all the way to the back. Just raise your hands up. So let's go here.

Unknown Analyst

I'm just curious on the IT harmonization, when this is all said and done without giving too much in the weeds, how many global instances of SAP will you have and how far across the organization will it reach?

Anthony L. Trunzo

One and everywhere. Yes. It's a big undertaking, as many of you guys probably know.

Unknown Analyst

On the earnings call, I guess you assumed no sequester, and it looks like now, we are having at least part of a sequester, and at the same time, you reiterated guidance for the year. I'm curious how much you bake in for sequester, and how you see it playing out, or are you seeing that in orders in any way?

Anthony L. Trunzo

Again, you'll hear from Bill on that. But after our earnings call I got an e-mail from someone in the investment community asking if we had included the sequester in our guidance. And my answer was a little bit flip. I said no, we've included lousy performance from the U.S. DoD in 2013 into our guidance. How that happened, right? Whether it's a continuing resolution or a sequester or some combination or a budget that creates a way for people to move money around, albeit at a lower level, we don't take -- I mean, you have to remember, we're not a military company, so we -- when we look at that business, we are looking at a very granular level. What are the opportunities available to us? What's the individual funding mechanism for those? At a low level inside of the front end of our business, we're doing the analytics to assess the likelihood of that funding in the context of continuing resolution, sequester, conversations with the purchasing organization and the contracting officers that we're going with, and we're making judgments on an opportunity-by-opportunity basis. So we don't take a global look and say, the sequester is going to do -- is going to have this effect, because we can't identify 3 or 4 or 5 or 6 individual items that are binary, either are or are not affected by a sequester. They are affected by the ability of that particular part of the government to get the funding, and that consideration is applied. So at that level, I -- the flip answer really is the true answer, what we have assumed and what our forecast says, I'm going to resist stealing the information that Bill will give you in a little bit, but we expect, in the context of the guidance that we've given you, that our U.S. DoD business, from a bookings standpoint, will be down meaningfully this year. Now, does that include or not include a sequester? I think that we're not surprised by where we find ourselves from the standpoint of what the government funding environment is as we sit here today on March 6.

Yes, upfront here.

Unknown Analyst

I have 4 sub-questions to your comment on strategic pricing. The first 2 questions are, is that a change in your strategy, the increase in price for the premium products? And how -- what percentage of revenues do those products -- do those premium products mean?

Anthony L. Trunzo

I think it's probably a refinement from a strategy perspective. In a time when you're faced with growth challenges, maybe we asked ourselves a little more thoroughly than we did in prior years, are these particular products priced correctly? But strategic -- I wouldn't call it a strategic shift globally, because I think we bake that type of analysis pretty carefully into our organization across the board. We asked it at a more senior level and maybe sort of challenged our folks to find those opportunities a little more last year, but I think strategically, I think it's built into our culture to be focused on appropriate pricing. You can see by our margins, we don't price to our costs, we price to what we think the appropriate market pricing should be. As Earl has commented, costs are set in the factory, prices are set in the market, and that analysis is the one that we'll go through market by market. I don't have a percentage for you on those products. And I'm not sure that I could really give you an off the top of my head answer for that.

Unknown Analyst

Then the other 2 questions. So that is -- that's not a consistent strategy that we can expect from now on?

Anthony L. Trunzo

I think -- no, no. I want to be clear. I think what you can expect from FLIR is a consistent strategy of setting price based on what we think is appropriate for that current positioning in the market, okay? We've always done that. What we did in 2012 is we asked the additional question. We said to folks, we want you to go back and look. Pay attention again to whether or not this product in this market can sustain this kind of a price increase. And we gave those folks a little bit of a challenge in terms of what we wanted those price increases to be. But there is no shift here. I mean, this is -- the way FLIR sets prices is pretty clearly market by market, and pretty clearly based on what we think optimizes the -- effectively the return on investment in that particular market for us.

Unknown Analyst

And how do you justify that price increase to your customers, as presumably the technology costs are coming down?

Anthony L. Trunzo

Probably better to have Andy and/or Bill address that question. You want to talk about that, Andy?

Andrew C. Teich

In most cases the price increases that we did were selective on higher-end products, and they're in markets where there is fairly nascent competition. And in terms of justifying them, frankly, we really haven't had to do that. I don't think that in terms of the magnitude of the increases at single-digit percentages, 3% to 5% kind of increases, and we haven't raised prices in those segments for quite some time. So I don't think it came as any significant surprise to the customer base.

Anthony L. Trunzo

We'll take 1 more, and then we're certainly happy to do more questions afterwards. But I want to make sure we stay on time with Bill and Andy as well.

Unknown Analyst

Okay. This is an easy one then for you, Tony. Your long-term business model, give us revenue growth, internal, external, operating margins, where they're going and earnings.

Anthony L. Trunzo

You know what, I left the 5-year model at home. I meant to put it up here for you, Brian, but I left it at home.

Unknown Analyst

None. No answer?

Anthony L. Trunzo

I think you're going to see FLIR be a substantial double-digit growth business for a long time. You're going to hear today about a lot of exciting initiatives around the company. Those initiatives could drive growth from very good to outstanding. They could drive earnings per share growth that is significant, but as Earl indicated, could meaningfully impact the overall margin of the company because the markets we're going into are more competitive. I think it's extremely difficult in a business that is as dynamic as ours is today to say that we expect to see steady improvement in operating margin from 22 to 22.5 to 23 to 24. What I do think is, given the opportunity suite in front of us, this is still a 15% to 20% earnings per share growth company opportunity given all the things that we're doing: Taking capital off the table, investing aggressively in the business, paying attention to scalable and efficient operations, top line growth, good acquisitions, all those things are part of the FLIR story. That's what I really tried convey just now. This really is a portfolio approach to growth that we think has substantial upside associated with it. And then some of these other projects that we're working on could affect that to the upside in a fairly meaningful way. So yes, I guess no answer.

I'm going to stop there. Like I said, happy to entertain more questions afterwards. I'll introduce Bill Sundermeier, who most of you know, who is President of our Government Systems business. Bill?

William A. Sundermeier

Right. Good morning, everybody. Government Systems. 2012, certainly a disappointing year for us. But there were some very bright spots in 2012. Our orders were up 7% domestically; 9% internationally; and 8% overall.

While we had a difficult revenue year, it was really nice to see that our orders were starting to come in at a much better pace. That's because we expanded internationally. It's been our focus. I've been talking about that for the last couple of years. We're continuing to do that. You'll see more of our strategy as I move forward here. We rightsized all the businesses, started with surveillance in 2011, and went through the other 2 businesses in 2012. And we reduced the CRAD that was in the Detection business. There was a lot of CRAD contract R&D that was in that business that wasn't really focused on our core product portfolio. And so we finished up those contracts and didn't pursue additional CRAD in that space.

I'm going to talk about each one of the 3 subcomponents of the business. But I'm here to tell you, it's been our strategy all along to get these businesses more and more integrated. We're going to talk about that throughout the presentation. They are integrated every quarter, it's becoming closer and closer, and certainly, every year. And let me remind you, the strategy here has always been to take sensors and instruments that exist in the entire electromagnetic spectrum, and put them all together. So we started off with infrared. We've been moving into mass spec and other technologies that go into wavelengths that are in different parts of the electromagnetic spectrum. So we have physicists and chemists and people that are throughout all the sciences working on great tools and technologies throughout the EM spectrum.

So first, surveillance. Remind you of our product portfolio, please stay afterwards. We've got a sampling of products in the back there and brochures, mostly in our handheld range of products. This family is continuing to grow, focused on infrared and imaging capabilities. So our gimbal products primarily are the big revenue drivers, but our lens-based systems are growing quite rapidly as well.

So performance for surveillance. Backlog for the first time in a long time has increased since 2008. While our revenue, certainly not where we want it to be, but when we look at it without the RAID program -- for those of you who are new to FLIR, that was the systems that we put on the aerostats and the towers throughout Afghanistan and Iraq, nearly 900 systems were deployed to protect our troops in the theater. It's a nice, big opportunity for us, generated a lot of cash. But here we are, from '07 to '12, with 11% CAGR, still heading in the right direction in '12 -- excuse me '13, we'll be heading in the right direction as well, while maintaining our gross margins. This business has fantastic gross margins, and we're keeping it that way and improving our operating leverage on the bottom line.

So 2012, we built our backlog. Even the face of a slow U.S. procurement, a difficult year and small U.S. programs. I call them, if you will, maybe doubles, if you will. In the past, we've had triples and home runs, $100 million contracts. Last year was really full of a lot of 10s, 20, maybe $30 million, and I kind of foresee that's what's going to happen to us here in 2013, a lot of doubles. And it takes a lot to fill up this kind of a book, order book, when you're hitting a lot of doubles. So -- and that, the frequency, the number of orders that we're getting is growing. And of course, international growth continues for us. Operationally, we remain very, very lean. Profit per employee, revenue from employee continues to be very aggressive. And we continued our R&D investments. It's so important to us to be at the leading edge. And some of our price considerations were the fact that we're really the only company out there that's providing a true high-definition systems with our full 1280 infrared detectors. And we can ask for a premium for those because it is the best that's in the market space. And we focus on international sales force expansion, and I'll talk a little bit more about that.

So sequestration, continuing resolutions. Everybody wants to know what's going on out there. As Tim and I talked about earlier, if somebody can explain it in detail exactly what's going to happen, we want to talk to you, because it's very, very confusing. What I can tell you, sequestration has happened. To Tony's point earlier, we were pessimistic about this year about what was going to happen. I always thought sequestration was going to happen, and really started thinking about this year a little more than pessimistic. Sequestration has happened. What I can tell you is that we haven't seen any impacts from it thus far, mostly we are hearing labor, and people aren't hiring, maybe travel's not happening. So I think the impact of sequestration are really going to affect our budget when it comes to 2014, 2015, 2016. What's probably more important than sequestration right now is the continuing resolution approval that is supposed to happen on March 27.

The House just passed their version of the continuing resolution. In there, they put a measure in there to be able to move money around, to be able to handle what was necessary. The President said he was going to veto that. So we don't know exactly what's going to happen with continuing resolution. But both sides are at least talking about it being passed, and our Washington insiders say probably by the 22nd.

What happens when sequestration and this continuing resolution environment to our business is really procurement slowness. It's the hesitation, the trepidation to release orders. And it's my belief that if we can get a continuing resolution approved, we'll have a budget, we'll at least have a budget for 2 more quarters. Government fiscal year ends in October. So at least, if we have a budget, the procurement agencies will start spending. And actually, in the last couple of weeks, we've been hearing from procurement agencies, hey, it's going to pass. Start spending your own damn money, you're behind on that. Start spending O&M as fast as you can. The resolution's going to pass. Congress is not going to stop the government. We're going to have a budget, start spending. So we're hearing that in the last couple of weeks. Stopping the government is probably not going to happen. So if we can actually get to a continuing resolution, we'll have a budget for the second half of the year. By the way, it's that sequestration level of spending and I think that -- the fact that we have a budget is more important than what's going to happen with sequestration in the future now.

President's budget is going to come before Congress. Maybe we'll get a budget for 2014, maybe we won't. We're going to have to see what happens with the President's budget as we move later on in the year.

But so far, to me, it's about whether or not those procurement agencies are willing to spend or they're holding back. We see some really crazy things go on. For example, we're anticipating an order this quarter that they're buying off of GSA. For those of you who know what GSA is, GSA goes through, and they come in and they do an audit and they find out whether or not the pricing is valid. It's reasonable to the government. We have had one agency say, well, we're not going to trust that. We're going to spend 2 more months reevaluating what GSA has already evaluated to determine whether or not we're going to give you this order.

By the way, they, a week ago, said, "Oh, yeah, GSA. They did a good job, and we are going to give you the order now." So crazy things like that happen and slow up procurement. And so what I'm anticipating is continuing resolution happens, hopefully. For half of the year, we'll have some sanity put back into the system where procurement organizations will start spending again.

The scrutiny on the investment accounts is really important. We can't get there, to those budget cuts, by just cutting people. So it's going to have to come out of procurement. It has to come out of procurement. So unfair shares are going to come out of the procurement side of the acquisition process. But as you know, we're focused on the things that matter most, we think, to the military and to the government, increased reliance on ISR. These are force multipliers out there. Those programs that we see that are focused on ISR are not waning. Things that are going for special forces. Again, those programs seem to still be on track.

So to me, the most important thing is get the budgets released, get the procurement officers ready to start spending again and get focused on the areas that we excel in.

Focused on our key customers. Continue to promote our model of our business, our CDMQ model, with our commercial pricing, rapid delivery. One of the problems there is our amount of inventory that we have to be able to provide rapid delivery. And of course, we certainly have the best service in the industry. Our service book -- the surveillance book-to-bill ratio continuing to increase slightly above one in 2012, which has been long-awaiting. Our international space is fantastic. We've booked $40 million -- more than $40 million in Turkey. We were actually invited to do a fly off in Turkey and beat the local Aselsan program in there and busted into that market. We're going to be setting up an office in Turkey because of the continuing programs that we see in there is a nice space. So new programs in the Middle East. It's growing well for us again. It's going to be opening up an office, not only in the UAE, but we have one in the UAE, one in Abu Dhabi, one in Riyadh. And we're going to be opening space in India here shortly. We've hired folks to go into India. I mentioned a little bit about strategic pricing already. When we have the high end of the market, we're able to ask a little bit more for our products. Surveillance international revenue, 2011 to 2012, nice 6% bump there. Again, we're focused on international, pessimistic about U.S. DoD.

So 2013, what are the dynamics there? Cautious forecasting. Tony started to allude to it but I can tell you, when we look at the bookings plan for 2013, in the plan, in our forecast, to our guidance, we reduced U.S. DoD orders by 20%, okay? A conservative look at U.S. DoD this year. Maybe we can do better, but we need to get that growth internationally and that growth internationally comes at better margins. So we took a long, hard look at that and I think that's a good model for us moving forward for this year. We planned and budgeted for procurement delays. There's some big programs out there in that second base kind of category, some of those are just like they're in our forecast at 50 points. Looked at a couple of them and said, a couple of those might get shot, so let's be very careful about how we plan and budget for this procurement slowness.

To improve, we've taken Portland and Boston look. Both of those organizations have produced great products over the history, but we're taking their back office, which means we're taking the SAPs, tightly integrating them so that we can look at all the procurement from both of those organizations. They are the big drivers of the Surveillance business, and make sure that we're getting price leverage from the combined procurement of both of those organizations. And we've taken Terry Outcalt, who's the leader of the Portland operation, and put him over both organizations. Terry and his team have had a phenomenal run, not only with the RAID program, but they live a culture of driving out costs in our products and the culture that we need to instill into our Boston operation and get it to run leaner and look at costs and drive down the costs of our handheld products, as well as our small gimbal products.

In 2013, take that new sales force that we've taken internationally and continue to expand. The R&D organization, not only are they focused on new products, but design for manufacturability, driving out cost. There are still some more levers there to pull. And as I mentioned earlier, procurement efficiencies. The entire organization has goals for reducing material costs. And this is a trend. I mean, we just came from a supplier convention at Sikorsky. They -- basically, we are a sub-supplier to them. They're saying, hey, if you can't drive out 5% to 10% in a year, you might not be here. So we've been focused on that. We have a legacy of driving out cost, and we're still going to be a great supplier to our folks while managing our own margins and keeping them high.

So this year, we're going to continue to focus on what we call full high-definition systems. What do I mean by that? Every single sensor in our systems is full high definition. There are people who tout that they're HD, but they don't have, for example, a 1280 infrared sensor in their system. So we have full high definition so every sensor in there is going to be headed towards full high def. We're already there with infrared -- excuse me, with low wave -- excuse me, mid-wave infrared visible and heading in that direction with other sensors.

New SWIR functionality, short-wave infrared, big hot buttons in military, it's right beyond visible light, and it gets some great capabilities in maritime environments. But the real leverage is this picture down here, white dot is a laser for laser designation. So with SWIR, we can actually see where the laser is hitting on the target. So all these systems that you see, what they're doing, shooting laser-guided missiles today, they use kind of a quadrant tracker to be able to say the laser is in this area on the screen. And you can get close, and you can kind of depend on where the radical is pointing and those have to be aligned. It's a very complicated process where we have to do in-flight bore sighting and I'm not getting into all the technical aspects of it. But this allows you to see exactly where the laser and where the missile is going to hit, first time ever. So this is a great technique, not only for the airborne folks, but the special forces on the ground, too. They want to be able to identify where those lasers are hitting. So that's a very exciting new capability for us.

Value leadership. We provide the best technology at the best price in the marketplace and continue to do that.

And reliability. Our products continue to be the best reliable products in the infrared space in the market, and we're well known for that. And some of our optempos are the best that are out there in the theater.

So continue to work on our model, internal funding, full ownership of our IP, getting to market as fast as we can, DFM, leverage the total company [indiscernible]. So all these things are a little bit different than our DoD contractor counterparts, which enable us to bake a better value product. And of course, when we think about our products, we're not just thinking about them for the U.S. DoD, we're really thinking about them from a worldwide perspective. And that's always done us well and has helped us migrate all these products internationally. So it give us the lowest pricing mission-critical capability. And really, when you look at our life cycle costs compared to the competition, there are so many people that are worried about that right now given the current budget. I mean, this is a strength of ours. You would hope, if anything, during sequestration and tightening of budgets, that a company like ours would become more and more appealing in that kind of environment, where total cost of ownership is much less, reliability is high and entry into these kinds of technologies is lower than most companies.

Detection. It's been a couple year hall with these folks, but we're turning them around. Backlog is fairly stable. Last year, revenue was down, again, consciously looking at contract R&D, pulling that out. These are really programs that, yes, they generated revenue, but they were not focused on our product portfolio. And we're happy to take other people's money or the government's money to develop products, but it has to be things that we think that we can sell to multiple markets, not to a point end customer. It just doesn't go anywhere. So we finished up those programs and backup and just focused on the contract R&D that would help us leverage our product portfolio.

Gross margins improving and our operating profit certainly heading in the right direction not, in FLIR terms, where we want to be, but we're heading in the right direction with them.

We changed the channel. In 2012, there was a lot of restructuring that went on, from 7 sites down to 3. We reduced the headcount by 23%, caused some pretty good disruption there. We were still able to execute and we can talk a little bit about new markets and penetrating new markets. So a lot of work went on OpEx. We removed $10 million out of OpEx last year. So this business is getting poised in the right position for us.

So in the different product categories. Explosives, this year, we are heading into TSA, extremely important to get on the qualified products list, the QPL. TSA won't buy from you unless you've gone through TSA testing and you got on the QPL. So we're focused on that. ECAC is a European certification and the CAAC is the China certification. So we're going into all these testings. Once we can get passed by these organizations, we're moving faster in Europe, and in China than the U.S., not too surprising there, but that will open up a new market space for us.

Adding ammonia detection capability, and we're very focused on turning this from an explosive device into narcotics detection. It's the same capability, take a little swipe, whatever you're doing, but this time moving it towards first responders, law enforcement agencies, forensics, being able to swipe whatever it is to test it immediately instead of trying to collect it all and take it back to a lab to do the analysis. Don't disrupt the evidence chain. So it could be very -- we think this could be very exciting. We're working with a lot of test customers and it opens up a whole new market space for this kind of technology. Again, what does FLIR specialize in? Take things that -- or define for the military, take those technologies, make them less expensive, expand them into new market spaces, commercialize them.

Radiation. Our identiFINDER product, which has been a very successful handheld radiation product, it can do spectroscopy. We can tell what kind of radiation it is, not just like a Geiger counter, is there radiation, but what kind of radiation it is, what kind of isotope it is. We're expanding those into food monitors. These are in Japan right now for taking food, moving it across them to see if there's a radiation in the food. That can be expanded into lots of different countries in Asia where produce is being exported. And then taking that same technology and putting it into large portal monitors for vehicles, as well as humans. Again, our claim here is that we're not just detecting the radiation, but it's spectroscopic. So we can tell, is it medical, is it harmful, where a lot of these devices will just tell you something bad is here and then you need to go inspect it. We can actually do spectroscopies on whatever is passing through these large portals.

And we're making history in Mass Spectrometry. There's a long way from very huge devices, so now we're getting into smaller and smaller devices. This program got started by having -- the military wanted a mass spectrometer that they could take out to a nasty site, right? Instead of going out and scraping up whatever it is and taking it back into a base to determine what it was, take the mass spectrometer out to the incident site to determine what it is, that you're not taking the effects of potentially damaging lots of troops. So they wanted something that was portable and small and invested heavily into that. And this year, we're going to -- there's one outside in the hallway, the world's first bench-top trace detection mass spectrometer. This is a fantastic device, uses Mass Spectrometry, not ion mobility, which has lots of false alarms. Those things that you see at the airport and they swab your bags with and put them in there. Those things have so bad false alarms that they crank them so far down that they're basically useless. They can't even detect gunpowder, by the way. I've gone shooting, wiped my hands with all the residue, walked in and said, please, swipe my hand. No, they can't even detect gunpowder on your hand.

So not only lower false alarms but gas, solid, liquid, it's a mass spectrometer. We can tell you exactly what it is through a huge library. So [indiscernible] and things that came across in printers, ammonias, cocaine, marijuana, boom shows up in a mass spectrometer. So again, this technology is exactly what we wanted out of this, from military CBRNE capabilities. We're selling into forensics capabilities now. China, several million dollars now just in environmental protection using portable mass spectrometers. We're going to get into airport and event security. By the way, the Russians just bought 6 of them for the Sochi Olympics. So it's going to be our scanners that are going to be scanning bags and hands going into the Winter Olympics. And we've sold them into prisons, huge drug problem, bringing drugs into prisons.

So this business could easily grow to $50 million or more in itself by converting from just this military CBRNE world into many different market spaces for this technology. We're driving the cost down, the capability up and it's the right technology for each one of these environments.

Last, integrated systems. Really exciting 2012, fantastic growth. Backlog grew tremendously. Revenue grew well. Gross margins starting to improve. MSC is going to happen this year, so I don't expect a lot of gross margin improvement in the first half. The second half of this year, we should start to see reasonable gross margin improvement. And of course, operating profits significantly improved in 2012, not where we want them to be, but we're heading in the right direction.

This is a rapidly growing business. We had to change leadership there and work on rebuilding the R&D staff to handle the new products that we have in the growth. And we've reworked MSC, I'll talk a bit more about that here shortly. And the FLIR content is increasing. Hard to see here. We're moving up from 134 centers in 2011 to 189 centers in 2012, so 13 million last year was pushed through this channel of infrared cameras and radars, so that's going to continue to grow in 2013. And these folks are basically U.S., Middle East, starting in Europe. We haven't even touched Asia at all and we're going to -- we have plans for doing that this year.

Unifying factories, consolidating that by leverage like we did in detection to get more efficiencies out of the factories.

Let me talk a little bit about the product. This is the MSC vehicle, which -- the commercial version of it, we'll call them the CERBERUS and leveraging the whole CERBERUS program that they won. The LX, the long-range version. You've heard us talk about in our earnings call the COSFPS program for commercializing what we've done with the Army here. Basically, same kind of capability but with a container, with a mast, very portable. And then a, if you will, Polaris vehicle that can be used out in the desert. We can put a Recon on top of it or a small gimbal system. Let me go into each one of these in more detail.

MSC, Customs and Border Protection. We're the only company who's passed, in fact, we have the seal of approval from Customs and Border Protection. This is a phenomenal capability. The truck, F-450. Inside here is a full C2, command-and-control station, they can fold it all out, moving map, be able to see the infrared camera, the visible camera where the lasers are pointing. And inside of here are lithium ion batteries that can make it run for 4 to 5 days without power -- I'm sorry, 24 hours without power. I'm talking about doing solar stuff to make it run even longer. No, they're not the same lithium ion batteries that are in 787s, so these work. And up here on top, our radar, long-range radar, 10 kilometers, 10 to 12 kilometers for detection, that's a long way, 6 miles. Of course, our infrared gimbal sensor up there, so it's fully stabilized so if that mast is buffeting in the wind. We've learned all this from Afghanistan and Iraq, very nice stable images for them. If they can run out and deploy this, put down jacks, stabilize it, they're up and running in less than 10 minutes. 3 buttons they have to push to be completely up and running. Fantastic capability for Customs and Border Protection. And I like to boast, Boeing couldn't figure out how to put these sensors on a tower, so we put them on a mobile platform. A stabilized, 10 kilometer solution that they can drop anywhere they want and be effective in a very short period of time. And there's a lot further we can go with this. Got a command and control station here. The border patrol has hundreds of our Recon handheld systems. We can integrate those in. So when their border patrol agents are out and about in a desert, they can be commanded and controlled by a C2 system like this.

So not only there's 30-plus systems on our $130 million IDIQ, they're going to go out in Q2. We got our first commercial off-the-shelf order for a company -- a country in the Middle East, and there is a funnel of an additional 30 systems already for the second half of this year. So those haven't turned into orders yet, but they are very nice prospects for us.

On top of that, we had our worldwide sales meeting here in February, and we trained the entire channel, the surveillance channel, the IAS channel, the detection channel, on how to sell integrated systems. The MSC system, the J2 system, which I don't have in here, to be able to have mobile CBRNE capability and our airport security initiative, what I'm going to talk about as well. So we're taking that worldwide rep, dealer and direct sales channel, over 200 folks, and train them on how -- we have trained them on how to sell this, and the funnel is increasing every day for these kinds of opportunities. And that is greater than $1.5 million of growth. This could be our next RAID. But better than RAID, because it's not going to be a bubble. This is a business that we can be in for the long haul. And it's an impressive business with our CBP seal of approval with units forward. That is not an easy process. I can tell you, this isn't just doing RFP, deliver 1 and they tell you whether they like it or not. This thing has been -- they take it for 1 month and beat the living heck out of it out in the desert, 4x4 with it. They actually -- the requirement was to see humans at greater than 10 kilometers. We actually -- during the test, did a bust at 14 kilometers. So this is a very, very impressive system.

We're taking that same capability, and we think we've done for the Army the same kind of capability in a containerized system where we have a generator here, we're going to add solar system with batteries. This system can last weeks without being serviced, beam back images, control via microwave to a C2 operating post back to the truck. Why would you have a fixed tower if you could drop these wherever you wanted to on the border? Or if you had a critical infrastructure, you could put them wherever the threat was. Again, infrared, radar capabilities, even shot detection capabilities, very powerful solution. We've got quite a few interest in COTS opportunities of these internationally.

This is all tied together with our CommandSpace C2 package, our software package, and this is growing extremely well for us in capability. Not only can we handle this, what's inside that truck for single sensor, but I can tell you, for example, one of our largest installations is Nion [ph], 1,000 cameras with 4 different command posts all the way from Medina to Mecca, covering almost 1,000 different cameras for surveillance during Hajj. So this is very expandable, very proven, very capable technology to handle, literally, hundreds if not thousands of infrared-visible sensors and radars all combined in.

So where are we going? Complete solutions for borders, as well as critical infrastructures. When you think about all these being networked, we have long-range trucks, mid-range trucks, if you will, dune buggies that can go out in theater, handheld devices for people who dismount. We're already on the borders with our aircraft with 380-HDs. I just spoke to one of the operators. CBP has some older technology. They just got ahold of one of our Star 380-HDs, and they can see footprints in the desert of the direction in which the people are going. That's what full high definition gets you out in the desert, you can watch footprints and direct where they're going from where they're hiding. Airborne, it's pretty impressive.

So with a crack in all these capabilities, of course, can tell you is fixed towers, as well, but really believe that this kind of technology is the technology of the future. Adaptive networks, be able to drop things down, have them automatically connect, beam video information back to command centers. You'll be able to know where the threat is, and you can read time and time again wherever a fixed tower is, they learn to operate around them. As a matter fact, during that 14-kilometer bust that we did, when the agents talked to them, they said, "How did you see it?" We knew that the last tower that was here could only see out this far to the trail, so we went out across the border and saw where the trail was. It was exactly another kilometer further out than which the past detectors were at. So in each one of our own cities, you're driving down the freeway, you eventually get to know where all the speed traps are, and you know where to slow down and where you can speed back up again. This is the mobile police force, right? You never know where they're at. It's much more of a deterrent to you than knowing where that tower is or that policeman is going to be.

So this is something that we're really, really pushing on. It's making a lot of sense abroad. There's lots of borders in the world. There's a lot of nuclear power plants, large critical infrastructures, pipelines that are very interested in this kind of capability. So we've been focused on building that solution set.

Next, airport security. This is Keppel Airport. It's one of our premier installations, covering it with radars and infrared. We've been doing a lot in the area of perimeter security, 20-plus installations. We've got another funnel of 20 to 30 more airports for this year that should happen. So nice growing opportunity for integrated systems. Great opportunity for surveillance. We're putting a lot of equipment in an area that we've never put them before.

And we've been focused on that whole border security. Now we're focused on integrated threat detection for airports, huge initiative for us, tying it all together, tying all these businesses together to one unified strategy. Not just perimeter, infrared and radiation -- excuse me, radar capability, but add radiation detection. Stanton, you know about our Stride capability for detecting radiation. We're going to add Mass Spectrometry to that for baggage and cargo, HVAC systems for our IBAC systems for doing air sampling. That's already tied and already integrated into our C2 system. So airports are thinking, "Great, I can get FLIR software. I can get their infrared and their radar capability. And, in the future, if I think that there's a threat and I'm worried about whether it's in my HVAC system, I can bolt that in. I already have the software capability to be able to handle that." So one C2 system that can handle multiple different threats, and threats of the future.

Then we're going to get our airport security game on and then we're going to be moving into maritime security. Same kind of capability, underwater sonar, an extension that's even a slower version of radar, but underwater, and our perimeter security capability, not just for a harbor like this, but coastal surveillance as well. So another great area for us to move into.

Pretty bullish on our Integrated Systems business. Again, different set of competitors. We've been fighting the big DoD companies and we've been doing it with our CDMQ approach. Now, we're heading up against some other different companies out there. But again, they're looking for a lean, agile company. One that's technology-based. There's a lot of integrators out there that like to run wires and pour concrete and say that they can build the best technology, but what we're finding is that customers like FLIR because we also build the technology. So if we really want to tightly integrate these products together, we can modify the products. We have the engineers, we have the scientists to be able to tightly couple, to fuse these sensors together, so they actually work. They're not -- because integration is like, great, you got this camera, you got this radar and we can couple them to our software. But to actually make them talk and handshake and pass off targets so I'm not getting multiple target hits, that's a different story, and it takes a technology company to do a good job integrating these products.

So where are we going? There are 400 nuclear power plants, oil refineries certainly been in the news, a lot of interest in that space. The airport security market is growing rapidly. China is going to add over 100 airports in the next 5 years. And we're getting approvals for our radars, our infrared equipment into the China space. Prisons, bases, ports, buildings, lots of places for us to go with our integrated systems technology. I really think, 5 years, 2 years from now, you're going to see a shift from where Government Systems is.

Our DoD business is continuing to be a smaller and smaller percentage of what we do. If you think about it, world military spending, probably for the next 5 years, is going to be flat. Already in Europe, we are seeing it back off. But what's not backing off? Countries are still worried about their security, their sovereignty, and they're not stopping investing in the security space. So we've been in ISR and ALE and force protection, and we're still going to remain focused in this area and it's a strength. It's a great generator for us. But the markets of border security, critical infrastructure and civil security are continuing to expand worldwide, and we think that we can get a piece of this. So you're going to see us move more and more into advanced security solutions around the world. The money here isn't a new space for us, we can grow in that space and then certainly believe that those markets are going to continue to grow, especially when you take a technology perspective and a solutions perspective into that space.

That's all I have. We'll get the mic here and...

William A. Sundermeier

Start at the back of the room. Jonathan?

Jonathan Ho - William Blair & Company L.L.C., Research Division

Just with regards to the backlog. I know you guys have done a lot of things to really improve that over the past year. With sequestration, what's your confidence level around the backlog and whether it will hold or whether potentially we could see some degradation in the backlog that you already have in hand today?

William A. Sundermeier

I think we're going to see some ups and downs throughout the quarters, but our plan is to leave this year with the same amount of backlog as we had going into the year... So again, going back to Earl's comments, we're going to shift the orders that we have received. So that's -- we've been very conservative on our plan, and I really think that's going to be the model that we're going to hit.

Unknown Analyst

Just a few related questions. So encouraging to know that you have U.S. orders down 20% in the plan, obviously, a good time to be conservative. #1, how can we be comfortable that, that is really enough? I mean, I know it's a big number. Can you maybe just talk about what U.S. orders were down each of the past 2 years, which were similarly difficult environments? And then, in terms of translating that to revenue, it would seem maybe a little bit more aggressive that, that will convert to only a mid single-digit organic revenue decline of this year. And then if the answer to that is there's a lag and the bigger impact is '14, should we all be modeling a faster rate of organic revenue decline in '14 than we are in '13?

William A. Sundermeier

Good question. I actually think we grew a little bit in the U.S. DoD in 2012. So I think going backwards 20% is, in comparison, is pretty large. 2014, it's really going to depend on can we get the president's budget. And I don't -- I'd hate to see us decline more in 2014 in the U.S. DoD revenue. I think that we can probably maintain after this decline in 2014, but we're going to be focused on every other market that we can find to grow the business.

Unknown Analyst

So the U.S. -- so maybe I'll ask it a little bit differently. Should the U.S. DoD portion decline at a faster rate in '14 versus '13, and then the plan would be to make it up with all these other opportunities. It just seems like -- I mean, if orders are going to be down 20%, that has to show up in revenue at some point.

William A. Sundermeier

Well, it has to show up if we can't compensate for it in another market.

Unknown Analyst

It has to show up in the U.S. DoD revenue.

William A. Sundermeier

The DoD revenue, right. So I would think in 2014, from what I can see today, I wouldn't expect as much of a decline, and that another 20% on top of that, probably not.

Unknown Analyst

I'm talking about that order number translating to the revenue decline.

William A. Sundermeier

Order number translating to the revenue number. A little further...

Anthony L. Trunzo

We're going to have lower yields in these revenues...

William A. Sundermeier

Right. Yes. As well.

Anthony L. Trunzo

Yes, for sure. But the revenues coming from the other parts of the business are going to flow into that...

Unknown Analyst

The MSC opportunity. How should we be thinking about that? You've talked about the margins being a bit lower, but what's going to be the impact on the gimbaled sales in the surveillance unit? I mean, do we get a lift surveillance as those volumes -- I would think you would see an immediate benefit in surveillance, and as you struggle with maybe the start up on integration of the initial units, we see that pressure in Integrated. How do we think about that dynamic of the intercompany sales?

William A. Sundermeier

Sure. As the intercompany sales happen, certainly there will be margins that's over on the Surveillance side without the revenue piece, because it's the revenue, external revenue, that comes out of the IS piece. So they're going to deliver 31 systems there with some margin associated with them, hopefully, we'll get a little bit of margin lift on the Surveillance side the first half of this year. We really have only modeled, perhaps, a booking in the second half of this year without more deliveries of MSC. If they accelerate and we deliver more MSCs the second half of next year, it would give better lift for us. But again, in that conservatism, we said, well, we'll probably get another booking for more MSC units on that $130 million IDIQ, but it might not take delivery of them until 2014. So if we can accelerate those, maybe there's some upward lift in the model.

Unknown Analyst

And then last one, any triples or homers in the pipeline? Not in the pipeline, just maybe in the RFI process, RFP process that you guys see as kind of right in your sweet spot?

William A. Sundermeier

None of the -- certainly not in the U.S. DoD space. Internationally, there are some really low probability triples out there.

Unknown Analyst

So you described some integrated systems for large infrastructure protection applications like airports, ports, things like that. Somebody does have to run all the wire, somebody does have to load all the software on those. Is that a service opportunity that's of interest to FLIR? Or could you describe your strategy for partnering with contractors who do, do that and what you're doing so that they can actually help you sell your products?

William A. Sundermeier

Yes, excellent. We -- basically the Integrated Systems group focuses on working on with integration organizations, so subs, if you will, that do that kind of capability within each one of those markets that we deal in. So we have partners in the Middle East who do promote our products internally, because they then know that if we can get a whole opportunity that they get to do a sub piece and we get to provide the technology. So we get involved with the installation and commissioning, but they're in there making electrical panels, running the wires, pouring the concrete, building the buildings and taking on that piece. So we have partners in the Middle East, in the U.S., in Europe, in all the spaces that IS is presently at, that co-market with us, as well as take advantage of the whole RFI. So some of our margins -- when we get a big order, some of that will go off our partner and we'll have a very low margin on that, so that's why this business, I don't think, can ever be, for example, 30 points of operating profit or -- well, we might be able to do that. But on a gross margin perspective, we're not going to get 50 points of margin on it, because there'll be a certain amount of passthrough that happens to get an installation done.

Unknown Analyst


William A. Sundermeier

Smaller. Smaller. I can get a list of our current partners for you, but I don't have them off the top of my head.

Unknown Analyst

Bill, a question on price. You talked about the GSE example, the water torture regarding, looking at everything. What are you seeing regarding -- I mean, you've always offered a very compelling value proposition in terms of the value and the price compared to the prime. So what are you seeing regarding their discussions with you on price in this kind of tougher budget environment?

William A. Sundermeier

Yes. There is a lot of talk about price and a lot of price pressure. Fortunately -- and we always get challenged on commerciality. Since we sell when we sell to the U.S. DoD, it's a government product, give us all your custom pricing data because we're only going to give you 12 points of profit on this thing. And we're like -- we -- the first thing is, if you would have given us money to build this, we'd be interested in that, okay? But you didn't. This is a different model. So that's our first line of attack. Then we're always out there trying to make sure that we sell all these products to law enforcement agencies and people around the world, that's the second stage of proving that you're commercial. And then last, you do a price point analysis against the competition that's out there and say is this a favorable marketplace. So we -- sometimes they'll challenge and it causes a huge delay. The delays are 3 to 6 months in arguing with them -- this is commercial, this is acceptable, this is the right price. And we get challenged all the time, slightly more frequently in this environment than we had in the past. They're being more and more judicious, are they getting the right price. I'll take another example, the BRITE Star. How can a laser-designation system be a commercial system? Right? It shoots missiles. So what we've effectively argued is that the designator portion of that is military, but the rest of it is commercial because we've sold that product to other people. So that's the way we can maintain margins. So we get into a lot of complicated discussions with our customers to prove our commerciality, which maintains our price, which is extremely competitive in the marketplace? So I see more pressure, not every single one is being challenged, but there is more pressure out there to be prove our value.

Unknown Analyst

Okay. And just one other question, just on the international. The $40 million you referenced in Turkey, that's been notoriously a home court for Raytheon, could you give -- maybe give us a little more color on what exactly you saw from the customer there?

William A. Sundermeier

Sure. This was a great story of -- we have a [indiscernible] aircraft, and basically, we got a hold of a general who was interested in buying this equipment. And we said, "We'll bring our airplane in and we'll fly you and you can see what is available through OEM in-country or what we have." And what they're using is 1980s technology, okay? So when you get to see 1980s infrared versus a full HD system, it blows your socks off. And this general's like, this is unacceptable, I cannot live with this. He now -- and basically said, "Forget it, we're buying this." And really broke from -- I mean, a sale on a rocket -- I mean, those places -- I mean, and he's just blocked out. And this is -- we really, really knocked it out of the park there and broke into that. They realize that for them, even through coproduction, to get to that kind of technology would be years. They have a problem today, and they needed our technology and that's how we busted in.

Unknown Analyst

Bill, I was wondering if you could describe for us a little bit what you're seeing on changes in order flow from December where we saw a really strong capital goods order number, especially on the defense products side, to January, where capital goods orders were nonexistent. And now, you probably have a decent look at how February trended for you guys, any sort of sequential color on that would be helpful.

William A. Sundermeier

Sure. I mean you've really characterized it as fairly low. I mean, December -- our fourth quarter was okay. January, February, lots of fear and trepidation, not a whole lot has been released. And the last couple of weeks, we've been hearing, "Spend your O&M money, get it out there. We're going to get a budget, assume that we're going to have -- the continuing resolution is going to happen." And we're starting to see -- and I'm hoping that here, March, we're going to have a pretty good pickup.

Unknown Analyst

Alright, that's helpful. Could you describe your color of money a little bit on the GS side. Are you primarily procurement versus R&D versus O&M -- or how exactly are you positioned with your funding sources in the U.S. government?

William A. Sundermeier

It's procurement for the most part, but we do have several programs this year that will come out of O&M, but it's procurement.

Unknown Analyst

And then lastly, what happens to your business if the CRM budget fight happen again next year? Right now, we are hearing GFI-12 [ph] proposal to come out in April, is going to be on par with the Fido that was released last year and the OMD's going to ignore sequestration in their request, setting up another fight.

William A. Sundermeier

Yes. It's -- when hasn't it been a fight for the last 3 years, right? I mean, how many -- when was the last time we passed a budget? I mean, it's the same story. We've got a sequestration fixed in there, but we've been fighting through CRs and late CRs, and late budget passes. And 2 years ago, they passed the budget, they couldn't even spend it all. I think it's just going to be a fight in the defense space. And I hope that they do pass so that they can move funds around, because we have a history of being able to work in there and get money moved around for our program. So I don't think it's going to be much unlike what we have today. It's going to ebb and flow and ebb and flow depending on whether or not those CRs get passed or the president's budget -- I really hope we get a president's budget passed, even if it's at a sequestration level. Just, to me, the biggest driver is do they have a budget to spend to? Because it's just trying to pull all these orders out of the arms of these acquisition people. And I tell you, it's is a work slowdown program there, too. Because they don't want to lose their jobs, they're not pushing stuff off their desk, they want the pile to be this thick, so that they can prove that their job is important. It is a jobs program for them. They -- nobody wants to have an empty desk. They do not want to place all their money. So it's going to be a fight.

One more? Okay.

Unknown Analyst

Bill, on timing. Did I hear you right in the second quarter, in Integrated Systems, you're going to have 30 MSCs flow through at like a $1.5 million per? Did I hear that right?

William A. Sundermeier

No, no, no. Our cut program is typically about $1.5 million per on those. I don't think we've released what our -- there's going to be 30 MSC systems, Bill? $26 million is our backlog. Some of those will end up in Q3, a bunch of them are in Q2, 10 or more, actually, we deliver them but it's a revenue recognition. Actually like, for example, we're delivering 6 at the end of March, so we can't rev req them until they've accepted them and that will be in April. And then there will probably 20-ish that go out in Q2, should be accepted in Q2, and then another 10 or so in Q3 that -- '13? 13, they get accepted in the first part of Q3?

Unknown Analyst

Got it. Okay. And then one follow-up within Surveillance. Just given what you've said about DoD orders, the international side of Surveillance, did you say the international side would fully offset the DoD decline? Or can you add some color in terms of...?

William A. Sundermeier

It won't be fully international, but outside the DoD within the U.S., from DHS and other agencies within the U.S.

Unknown Analyst

So you think Surveillance probably will be flat in 2013? Okay. And any color on the Middle East? What's going on -- is that you're big international market now? And is it more Hajj protection or -- what else is going on there?

William A. Sundermeier

Hey, the Middle East, they're worried about their neighbors, they're worried about Iran, they're worried about their borders. It's -- there's a lot of interest there for our technology. So from Turkey all the way down to Oman.

Unknown Analyst

It's your biggest market now internationally?

Unknown Executive

It's one of the more important ones, I'll say that.

Unknown Executive

We're going to [indiscernible]. We're going to take about 10 minutes to [indiscernible] to step out. If you could be back here within 10 minutes, that'd be great. [indiscernible].


Andrew C. Teich

Okay. If I could ask everybody to take their seats, we'll go ahead and get started again. We're going to shift gears here and talk about the Commercial side of our business, which is a business that I continue to be very excited about. I just celebrated my 29th year anniversary with the company in February. And most of that, with the exception of about 6 years of that, I spent -- have been spent focused on the Commercial business. And it's a business that I used to say to the folks that work in that organization that we had 28 years in a row of growth in bookings for the area that I was managing, and this past year was the first time that we actually saw a decline in that, so it broke a 28-year chain, which was very disappointing to me, but I think we've got great prospects for the future.

So I want to start out today's presentation with 2 words, and those are 2 words that for those of you who have been to this presentation in the past have seen before: Infrared Everywhere. Why do we start with those 2 words? Well, it's been our strategy that we've had for quite some time. It's a vision for the business, it's clear, it's concise, and it simply communicates the vision that we have for the business.

It foresees a time where infrared is part of everyone's everyday life, where we extend human perceptions to include seeing heat variations, seeing in the dark and measuring temperature. If we look at how the strategy is working, well, it's been a successful strategy. We've made good progress towards the goal. We've pioneered and developed the technology significantly over the last 10 years, both at the sensor and the camera level. For our products, that technology has advanced our products to the extent that we sell Cores & Components to our competitors, so it's advanced their products, and it's allowed us to develop world-class end use products and distribution for specific verticals in the industrial, professional and, increasingly, consumer markets, which I'll be talking about in greater detail today.

Our efforts in building awareness have driven up our unit volume. So you can see that our unit volumes have increased over the course of the last 5 years at a 27% compound annual growth rate. Our AFPs have come down over that time, and Tony showed some of those data. As a result, our revenue has grown at a rate of 15% compound annual growth rate over the same period, but our market share continues to improve. So if you take a look at these pie charts here -- again, this is data aggregated from a number of different sources, you can see that our market share in terms of units, and Tony underscored this point, have increased significantly over a period of time.

We did have some headwinds in 2012, though, specifically on the order front. And as I mentioned it's the first time that I've seen that in my career. Overall, CS orders were down by 3%, led primarily by the EMEA region, and that hit really on all aspects of our business, in the Cores business, in the Systems business and especially in Raymarine's business. Overall, 3% decline. We saw growth in the APAC region, but at a significantly lower rate than what we have historically seen there, and the Americas was roughly flat, just down slightly. Revenue, however, was down 5.5%, so we did add about $22 million to backlog in the CS division during the year. And you can see the distribution of our revenue shown in the pie chart here, so the decline in Americas and EMEA more than offset the uptick in the APAC region.

So what do we do about that? We acted fairly quickly, midway through the year, had a 10% reduction in the workforce. We focused on efficiency improvements within the operations and we had some targeted price increases, which I'll talk about in a moment. And those efforts carry through into 2013, as well. So we haven't stopped our effort to improve the efficiency in the business, so we got a focused effort, which the 2 previous presenters talked about in terms of working on material and overhead cost, and that spans across the entire company, and CS will take advantage of that as well.

We also have manufacturing labor improvements to include more automation. Tony also talked about a contract manufacturing facility that we own in Estonia. We just bought land there, we're building a building there, we're adding increasing capability. And many of the new products that we have launched include many of the new products that have been launched in the thermography sector in the last 18 months have all been targeted at that Estonia manufacturing facility.

We also have been investing in our optics capability, and that's done at our in facility in Täby in Sweden outside of Stockholm. And there, we're looking for increased vertical integration and optics. We are one of the largest consumers of infrared optics in the world today, and, therefore, should be one of the largest suppliers. Today, we supply most of the optics for the Thermography business, that's probably 90-plus percent of the optics in the Thermography business, but we're moving that into our other businesses to include the CVS business where it's a much lower percentage.

We also talked about targeted price increases and we answered some questions on that earlier, but there we focused on product lines where competition is lower, the product uniqueness is high, and the tolerance to price increases are available on the market. And these are modest 3% to 5% kind of price increases, but they do have a meaning, particular in the higher-priced products.

We also recognized a shift during the year in terms of where the growth was geographically, and we have realigned some of our sales resources as a result to deal with that. So we've moved some sales resources from the EMEA region, for example, to APAC, to Russia and to India, and that's been an ongoing effort.

Also there's been a change in marketing materials. This is not uncommon in what you see in the marketing communication space. But there, a lesser emphasis on traditional means of marketing, print advertising, trade shows, moving more to digital media and e-commerce, social marketing methods and so forth, so that's been an active change that will be ongoing during the year.

Starting to talk about the business, though, the Cores & Components business is the horizontal foundation of our business, and that has not changed. It fundamentally presents the heart of our higher-level product. And there, we have a broad spectrum of products and this continues to get broader. We're most well known for our uncooled longwave cores, this is the highest volume in terms of unit count in our the business. However, we're also very strong in cooled cores, and there, we produce everything from the focal planes, to coolers, to optics and complete core systems, both into Bill's business and into several competing companies' businesses.

In 2012, we expanded our coverage of the electromagnetic spectrum and offered our Tau platform in 2 new wavelengths. One is what we call SWIR, that's short-wave infrared, shorter wavelength than the longwave uncooled and midwave cooled. And then we also developed a product called color night vision. It uses a very low light imaging capability to provide very, very low light color imaging. And these, again, are products that are used both internally, by Bill's division and my division, and then also sold externally to third-party systems completion houses.

We've made a couple of acquisitions in the Cores & Components space. AIS, Advanced Infrared Systems, and EOC, Electro-Optical Components, are 2 divisions that produce these devices that are shown here. These tend to be emitters and receivers, lasers for emitting and some receivers for doing things such as altimeters and rangefinders. And this is a business that has been a growth area for us.

We also acquired a business we call motion control systems, they do pan and tilt, and of course, those are used internally and pulled externally. And then at the very lowest level of integration we do read out integrated circuits and sensors in the infrared sector, of course, cooled, uncooled, and then we also work in the x-ray spectrum. So that's the Cores & Components business.

In 2012, the Core unit volumes grew again, despite a fairly significant decrease on Auto unit volumes, which I'll speak about in a few minutes here. The mix, however, continued to change towards lower-cost uncooled systems as a result of revenues declining by 9% during the year in the Cores business. Gross margin was flat, so even though the lower-cost products are coming, they still support the gross margin level. And we had several new products that were introduced the are shown in the lower right-hand corner here. Enhancements to our Quark platform, enhancements to the Tau platform, and then the other wavelengths that I spoke about a moment ago.

From a development standpoint, last year I spoke at length about this. We continue to focus on this acronym that the military uses, SWaP-C: size, weight and power and cost. We focus on those things in our development, which shows the evolution of that development in the uncooled space. Today, the Quark, which is shown to the far right of this chart, continues to be the smallest and lightest thermal core that is in volume production in the world today, and that makes it particularly well-suited as products get smaller and lighter and demand less power consumption. So that product continues to do well in the market. And we also continue to pull on the vertical integration lever. This is a real strength for FLIR. So we are vertically integrated starting at the very bottom -- ROIC is the readout integrated circuit, which is a piece of silicon with a base circuitry for an infrared detector, running all the way on up through vacuum packaging techniques, module packaging, cryogenic coolers for the cooled system, signal processing, lasers, electro-mechanical devices and so forth. And these are very important things. And I think that this is particularly important when you come to a discussion of commoditization. Because people think about, well, commoditization is a detector. And there's a lot more to a detector than just the detector itself. There's a lot of intellectual properties that's embedded in the layers that are shown here which FLIR currently possess.

Every year here, I talk about this virtuous cycle. Because at the end of the day, the detectors that we make, which are still the most expensive component of the systems, are a silicon device. And silicon devices, as I'm sure you all know, get less expensive as you build more of them. So driving volume for this business is critically important. And we drive volume through this business through creating demand by building awareness, which increases volumes, which brings costs down, then we pull on the price elasticity lever, which drives more volume, and we believe this to be a virtuous cycle. And that's the lever we pulled on quite hard in the preceding years, a little bit less so in 2012. Our thesis and the management judgment on this is that in a time of economic downturn, you get less effectiveness in terms of pulling on the price elasticity lever.

Our strategy of owning the sockets continues to be a core strategy for us, and we see those sockets in 4 particular areas here. Of course, the verticals that we've developed, which I'm going to speak about today, maritime security, personal night-vision systems and so forth. Then there are other system manufacturers that compete with us in those spaces, we sell to those people. There are new and emerging markets, I'll talk about some of those today. And then there are some markets that are adjacent to the existing markets that we're in and I'm going to speak about one of those in particular the we're pursuing today. And our goal is to play a

role in all of those, whether we're supplying detectors to ourselves, to our competitors, to new and emerging markets and helping those markets to be creative. We'd like to be active in all of those. We do that through our Cores & Components business. The Cores & Components business, of course, is supported by this foundation of other technologies that I spoke about a moment ago, which helps to protect the intellectual property there. And there, we sell to OEM customers. So then a very important aspect of our business and our strategy is building these verticals. We really got focused on this in 2006 when we formed the CVS division, and we got focused on these segments here. Subsequent to that, we brought thermography in, in 2010, and then when we brought in some new acquisitions, Traficon is an example that I'll speak about in a few moments. And all of those are focused, of course, on going after end customers, typically through distribution, and I'll speak about how we're doing in those.

So let's start with transportation. This one's important for us because it's a volume driver. This is kind of the big bar in the chart in terms of volume for us. It's not a big bar in terms of revenue, because, there it's automotive business, that's very demanding in terms of cost, we continued to lower our costs in response to demand from our key partner there, Autoliv. But as a result, volumes had been growing quite nicely. You can see on the chart to the left, through 2011, the volumes were growing nicely. Volumes tapered off in 2012. I'll talk about that in a moment. But as a result, revenue came down and gross margin came down, as well; gross margin, coming down primarily due to mix. So we had mix of what we call NVII systems and NVIII systems, NVIII 3 systems having a lower cost but very low volume associated with that, so the gross margins were low there. We think that's a temporary situation.

So looking at the challenges that we saw in the automotive business. 2012 was a tough year for luxury cars. A8 is an example, Audi vehicle that were installed, and they actually shut the A8 line down for some period of time. It's just recently been resumed. So that had an effect on us.

There were also some effects due to packaging. We had fairly high expectations for China and it turned out that the vehicle initially released in China only had the thermal option at the very top level of packaging. And that was unfortunate for us, that's been corrected. But as a result, the volumes were about 50% of the expectation that we had together with Autoliv for the year.

That said, 2013 looks like it's going to be a much better year for us. We can finally talk about the third OEM that I've been speaking of for the last couple of years here. It's Daimler, and they will be launching the new Mercedes S-Class early this summer, which will feature night vision 3, which I'll talk about in a minute. Night vision 3 has some nice new features. It has animal detection, it has this thing called a dynamic spotlight, and those are a couple of features that I'll show you some examples of in a moment. And those will also be available in the other brands, BMW and Audi. So we're expecting volumes likely will double in 2013 versus 2012, and that's the current expectation -- what just happened here? That's interesting. Okay.

So let's take a look at what night vision 3 is. So night vision 3 is actually what we call a fused systems. And it utilizes 2 cameras: It uses a near-infrared camera; and what they refer to as a far-infrared camera, that's our uncooled long-wave camera. What the driver sees here is the large image. They do not see the image in the inset. The image in the inset is coming from our thermal camera, and that is the device that is being used for the analytics. So the boxes that you see showing up on the pedestrians there, that is data that is being captured from the far-infrared image and then applied to the near-infrared image. The near-infrared image is the standard CMOS detector that's open to shorter wavelengths of light and is then illuminated by the headlights of the vehicle.

The reason they don't just use the near-infrared image is twofold. Number one is you really can't see any further than your headlights, and number two, is that, as a result of the type of imagery that you're looking at, there's very little contrast with the pedestrian. So if you look at the pedestrians here in this image and in the image below, you'll see you get a lot of contrast in the thermal and not a lot of contrast in the near-infrared.

So this technology has been getting a fair amount of play out there. This is an article that appeared just recently in the Wall Street Journal and it talks about the new features that are coming out: the pop-up detection alert and the directed spotlight, and they specifically highlight that in this article. And what happens with the directed spotlight is -- this is a feature where data coming from the thermal image is used to identify a pedestrian or an animal and then direct a spotlight from the vehicle to that target. So we'll take a look at a video here that shows how that works. And so what happens is the algorithm is running and when it detects a person, it -- there is a spotlight on the front of the vehicle which is motorized and can be positioned at the target. And this has a twofold benefit, because, as you're driving, the spotlight comes on and immediately illuminates the target that's out there, which is a big benefit from what we had before where you really had to go look at the screen. And then the second thing is, is that the object, if it's a human, knows that they're being looked at, so the spotlight alerts the person that the vehicle is coming as well.

The other thing that's been done with this is what they call pop-up alert. And when the image is displayed on the gauge cluster, if that image is suppressed, if the driver just wants to look at the gauges, when an alert is detected, the image automatically pops up in between the gauges for the driver so further calling their attention to the event.

Let's move over to the thermography segment now. The thermography segment, of course, is a segment that brings accurate temperature measurements to industrial, commercial, scientific and automation, gas imaging applications. Here, we've enjoyed about a 60% market share. Despite having some increased competition in the space, our market share has held steady. In fact, I think it improved somewhat in 2012. Here, we offer products into a number of different verticals to include the building, electrical and mechanical market, that's the largest application in thermography. We also have products that are dedicated to automation and machine vision. We have products for gas imaging, which has been a very exciting segment for us, particularly with the increase of natural gas exploration that's going on in the United States. We have targets -- cameras targeted at the science and R&D segment. We're going to be entering the firefighting segment, which I'll talk about in a moment, at the end user level. We have been active in that space at the core level for the last several years. And then we also have the test and measurement division with the Extech line that we have been active in.

2012 was a challenging year for this. Tony showed a chart earlier this morning about industrial procurement activity, that affected us. Overall, unit volumes were up 5%, but that's off from our historical compound annual growth rate of 28%. But we -- but revenue was down for the year. We did see an uptick in Q4, so the orders were up about 6% in Q4, and we added to backlog in Q4 for the thermography business. And we were very active on the new product front. So you can see here on the lower right, we had 10 major product launches during the year and we had 21 product updates.

One of the things that we've really been focused on in this segment is focusing our new developments around a key theme. So there, we've been focusing on having a consistent design language, intuitive user interface, full interoperability between the products, and making sure that we really deliver a world-class experience to our users. And this has been a big transition for this line since 2010. The products really go together, look like they go together, fit together and have a very easy user interface today.

This also carries to the back end of the products, which are the support software platforms and mobile applications. We call this the ecosystem for the product and you can sort of think about it as iTunes is to the iPhone, this is the same type of approach here. We've invested a lot in this and it's a real strength for our products. And again, interoperability, these products are compatible across the entire line.

And some evidences of those back-end things that were launched in 2012: We're the first and still only company today that have a really refined Mac-based image processing and reporting package for our products, it's called FLIR tools for Mac. It's available on the Apple Mac store. It's a free app today, and we have an upgrade, a buy-up version of it coming out shortly. We also released in 2012 a program called IR Researcher MAX (sic) [ResearchIR MAX], which is a very sophisticated R&D program targeted at the science and R&D user. And then we also launched a feature called MSX blending, and this is something that I spoke about a little bit last year, Multi-Spectral Dynamic Imaging or the multi-spectral experience.

And in this business, the concept of using a visible camera together with thermal has been out there for a long time. And conventionally, that's just blending, where they just take and they mix certain levels of those 2 signals together. The problem with that is, there's a number of problems with it, but fundamentally, to the extent that you bring visible in, you're taking thermal out, and at the end of the day, somebody is paying big dollars for a thermal camera, so to dilute that signal by taking down thermal and bringing up visible really doesn't benefit the user. So we found a solution that we have subsequently patented that combines visible and thermal imagery in a very clever way. What it does is it gives you much more detail in the thermal image by basically taking the high-fidelity details from the visible image, the high-frequency data which is the edges, and extracting those and applying those in a fully aligned way to the thermal images, essentially embossing those onto the thermal image. And it really has remarkable results and applies not only just to the thermography products, which is where we launched it in 2012, but it's ultimately going to apply to all of our products. And particularly, as we move to lower-resolution, lower-cost centers, you're going to see this feature really make a big difference.

There's a short video that I'm going to run here that will explain a little bit more about how MSX works and what the benefit are.


Andrew C. Teich

So as I mentioned, this is something you'll see a lot more of coming from our products in the future.

So an adjacent market I spoke about earlier. Our pursuit of adjacent markets is part of our strategy for this year. And one of those is the firefighting market. We know this market well for 2 reasons. 1, we were in this market back in the late '90s with a product called FireFLIR. Subsequent to that, we decided to just supply cores into that business and support some of the large players in that business, such as MSA. We've decided to take a new tack at this and look at this business from an end-system perspective as well, and we've developed what we believe to be a really nice solution for this market. And there's one of them in the back of the room that you can look at.

In this application, these are the 4 applications that people use a fire camera for: for initial attack of the fire; for search and rescue, finding people in a fire; for situational awareness, looking at the building from the outside; and then for hot spot identification after the fire has been put out to make sure that it's out. There, there are 3 main parameters that are important to firefighters: ruggedness, of course, in terms of being able to sustain the environment; image quality, which we're certainly the experts in; and ease of use. And we put a lot of work into this. There's a test where you throw one of these things into a cement mixer and run it through a battery of tests and then, of course, full encapsulation to make sure that it can deal with the moisture, heat and areas of problems that you see in that environment.

The display on the product is outstanding. We are the experts in thermal imaging. It's the -- one of the #1 criterion for firefighting is to get a good-looking picture, and this going to deliver the best picture in the industry. We've got some great colorization modes, which actually have patented, that we will be leveraging in the product as well. And then of course, there's the ease-of-use function, so it's got a very simple, 3-button, big buttons you can press with gloves on, user interface that are actually user-configurable as well.

So this is an example of the ecosystem. There is no firefighting product today that has an ecosystem. We offer this with the product, it's included with it. And it's a feature where you can connect to the camera and the user can go in and then define the button, define the modes that are associated with the camera, put their logo in as the start-up screen, and these are features that we find that -- firefighters are -- tend to be pretty technical people and they like to kind of tweak their equipment when they're not out in the fire, and this allows them to do that.

If you look at the space today, it's a fairly crowded space. There's several fairly well-entrenched players, many of whom we supply camera cores to. Our strategy is to come in here with a lower-price, higher-performance product. It's something we've done before. This is exactly what we did in the Maritime business, and we're playing from the same playbook that we've done before.

So speaking of Maritime, moving to that segment. There, we have a dual-brand strategy. The FLIR brand primarily being sold in the law enforcement, the workboat community, the brown water community, the cruise industry. And then we sell FLIR product with other marine electronics providers, and I'll talk about that in a moment. On the Raymarine side, there it's recreational; fishing; sailing; OEMs, boat manufacturers. And this is a segment that we've been pursuing well.

The key thesis here hasn't changed. This is something that I've shown before, which is our goal there is very simple: to make thermal imaging as important to boaters as their radars, their sonars and their GPS. And we believe that we can get thermal in terms of take rates in between depth-finding and radar, because it's easier to use. So the strategy there has been playing out, but it's been a difficult market. If we look at FLIR-branded thermal-only, our volumes did increase in 2012, but at a slower pace than previous years, based on what was going in recreational and commercial boating industry. The revenues declined somewhat as we saw a shift to some of our lower-cost handheld systems that we introduced during the year. However, the gross margins were actually slightly up, so the handheld systems, while lower cost, had very good gross margin associated with them.

We are very active on a new product development standpoint. So we launched new-improved -- new products to include our M-series. We added active gyro stabilization to the unit, and we also added a feature that we call radar slew-to-cue. And what radar slew-to-cue does is it -- when a radar target is detected on the radar, the camera automatically points to that cue. So this is one of the problems with radar, is that when you're looking at a radar you just see a blip on there and you don't know what that is. And with radar slew-to-cue, you can automatically designate one of the radar cues, and the thermal imager knows where that is relative to the boat and can point at it, and therefore you can determine what it is. And we always say, in this business, radar is somewhat difficult and confusing to use, but thermal, if you can watch TV, you can use a thermal imager on a boat. It's very simple technology to use.

So in the Maritime business, we have a value ladder there, products that range from $2,000 up to $100,000. But we did see a couple of opportunities there where we could introduce some new products. So just recently at the Miami Boat Show we launched 2 new products into the space. One is what we call the MD-Series, which is a fixed unit, which I'll talk about in just a minute, at the low end; and then the MU-Series, on the high end. So we feel that we have the corners of this market quite well staked at this point.

So looking at the MD-Series that offers an elegant solution for entry-level and fixed installations. It's particularly good for sailboats or non-planning boats where the angle of the boat doesn't change significantly with speed. So it is a fixed-mount system. It's available in 2 resolutions: 320 and 640. It has a full ethernet connection and starts at $3,500. So this is a segment that we have not addressed in the past.

At the other end of the spectrum, we've launched a new high-end system. This is a system that has up to 4 payloads: a cooled long-range thermal camera, a very lowlight visible, an uncooled thermal, a color visible. Or you can exchange one of these payloads for a high-powered spotlight. And this will be going in very-high-end boats. This is going to hit the upper end of the market and also potentially some law enforcement. It has things like radar slew-to-cue and video tracker on board, and, of course, full integration with the Raymarine electronics suite, and will be sold through both channels. This is also a fully exportable system. It was developed by a group in France, so it's free to be exported, in most locations of the world.

Let's talk a little bit about selling the FLIR brand to -- connected with other manufacturers' equipment. So we have alliances with these 3 major brands out there to be able to have connectivity with their products and their MFDs. And in all 3 cases, they've developed firmware on their MFDs that control our M-series so that if there's a boat that's equipped with one of these brands they're capable of putting FLIR units on the boat as well.

Moving over to the Raymarine business. We purchased Raymarine back in May of 2010 to further pursue the marine electronics vertical. It's been a work in progress, but we've really made significant steps there. I keep telling Earl and Tony that the fuel is on the way to the cylinders of this engine, because we've got a great new product suite, we've realigned the business from a cost standpoint, from a go-to-market strategy standpoint. We have had the richest and most rapid cadence of new product introductions of any marine electronics player in the business with this business, many of those are shown in the back of the room.

A couple of examples of those new product introductions are the a65 series, which is a fully networkable, smaller, low-cost system for the freshwater market that offers the features of the high-end system in a small, lower-cost platform. On the other end of the spectrum, we have the new gS series, which is a glass bridge. Premium MFD, very fast processor, advanced features like pinch-to-zoom, and a very elegant look. And there is one of those in the back of the room, as well.

We also recognize that one of the growth segments in this business has been the freshwater segment, and that has been growing through the course of 2011 and '12. We typically did not play in this space. This was not a strength for Raymarine. It will be now. We've launched a new product that we call Dragonfly. And Dragonfly has some very unique capabilities. This class of boater is -- cares really about one thing, and that's fishing. And fishing is aided by being able to detect and see fish, and Dragonfly offers a new capability of vision we call CHIRP DownVision, which is a broadband sonar system that actually gives you an image of the bottom of the water rather than just detecting fishes, this is shown in the image on the right. I've got a short video here that I'll show in just a moment that describes the features. The product did win the NMMA innovation award just recently, this was just awarded a few weeks ago. So we think it's quite an innovative product.

DownVision is best seen rather than explained, so I'm just going to run a quick video here to explain what DownVision is all about.


Andrew C. Teich

So this new CHIRP technology also expands up the line as well into our higher-end products so those will be available for all boaters.

The product development also continued through our instrument line. There we have 3 lines. On the entry-level, the i40, on the premium monochrome series, the i50, and on the analog hybrid display the i60 series. So those were all launched on the heels of the i70, which was launched late in 2011.

We also launched at the Miami Boat Show a new autopilot which uses a MEMS 8-hertz [ph] for positioning and boat attitude sensing. What's nice about this device is that it's self calibrating. So historically, that's been a problem with autopilots, is every hull performs differently, every hull-feed state engine combination performs differently, and this is one that constantly monitors the activity or attitude of the hull with this 8-hertz device and feeds that back into the system to provide predictable results.

Raymarine also has an ecosystem, and that consists of applications for iPads, iPhones, Android devices, also Bluetooth remote-control. And these are features that have not yet been matched in the industry, and we find is a significant and compelling -- competitive selling issue.

Moving over to the security segment. This is a segment that continues to really gain momentum based on increasing awareness and adoption. Unit volumes increased significantly in 2012, but we did have a shift in mix which drove revenues down. This is again the shift from high-end cooled systems to uncooled systems. And our distribution continues to grow as we further penetrate existing visual camera distribution channels.

So this blue graph here actually shows the ratio of cooled camera sales to uncooled camera sales over time. So that has changed quite considerably over time. And -- but in face of that, the total volumes have gone up significantly

Here we also have the value ladder of products ranging initially from about 4K up to over 200K. During 2012, we launched a couple of new products down at the bottom end of the line here. We have one of them in the back of the room that you can see. This is called the FC-Series. And this does 2 things: it lowers costs, it provides more options to the user, it's both analog and IP, and it also has signal processing in the camera, so it does video analytics at the edge, which is a very popular concept these days that allows us to have thermal video analytics at the edge running in the camera rather than on a server.

An example of the kind of customer that is taking up that kind of solution is this company, Insurance Auto Auctions. They're a reseller of cars that are owned by insurance companies. And they have a lot of theft problems. People break in and steal catalytic converters and airbags and valuable components out of these vehicles while they're waiting to be auctioned off. They've done 10 sites so far, 10 to 12 cameras per site. They're all using video analytics, which you see running in the lower image. And it's a real success story. The CEO -- I spoke with the CEO of this company recently, and they think it's just a great solution to them versus having roving guards which are far less effective.

That brings us to the Lorex-Digimerge acquisition, which was done at the end of 2012. Lorex is the primary brand here. Digimerge is a sub-brand for the professional segment. Lorex calls on these areas: retail, industry, business, home and outdoor, and their bent on the market is do-it-yourself security installation. So there it's lower-cost products that are typically installed by the user or a low-end installer or a contractor.

Lorex enjoys #1 market share in North America. This is IMF data from 2011. They are not #1 worldwide, that's something that we hope to be able to change. They have 3 primary product offerings, the largest of which is the Vantage line and this is a mix of cameras and DVRs that go in the aforementioned installation. They have a live product line. These are -- some people call these nanny cams, so it's a combination of a -- it's an application, keeps interrupting me here.

It's a combination of cameras that -- cameras and displays that automatically wirelessly plug-and-play, connect to each other. And then there's the Active line, which are products that have cameras and glasses or wearable cameras to monitor sporting activity.

Digimerge is a brand that is focused on the professional user there. And this is something that's a great interest to us. The Digimerge brand today has 4 primary camera offerings that range from moderately cost analog systems, all the way through to fully featured megapixel IP cameras. And these will all ultimately be migrated to the FLIR brand. This has already started, but we'll move forward significantly over the course of the year as this product all becomes FLIR branded.

We've been actively merging the front ends of these businesses, the distribution sides of this businesses. And it allows us to access a very large market. Lorex sold 900,000 cameras in 2012, and we'll do over 1 million cameras in 2013. And those all represent potential sockets for us for thermal imaging technology as the cost comes down. And this allows us to address the consumer space that we have not historically addressed. And immediately, the Digimerge brand allows us to bolster the offering that we have on the customers that we're calling on today, which are the higher-end system integrators. And Lorex also has a very rich product development capability based in Asia. Their products are developed at a much lower cost than ours are and a much more rapid cadence, and we'll be able to connect FLIR's core technology with that development chain.

Another new area for thermal that we have been working on for some time now is traffic. We started this investigation 3 years ago with the University of Las Vegas. And there, we found that thermal cameras being used in an application for what they call stop bar detection, controlling the lights in an intersection, is much more effective than visual cameras.

So an example of that is, is, of course, if you look at this image taken at night, you get the headlight glare situation here. Or if you look at this image taken during the day but the roads are wet, you get glare from the sunlight off of the wet road, and that is not present in the visible spectrum. You also have issues that you deal with in terms of color, in terms of shadows; so there, this vehicle under the bridge is very visible in the thermal spectrum and not in the visible. So there's a significant advantage here. We've developed a camera specific for the traffic market that did very well in 2012 and was part of the growth that we saw in the securities sector. And we felt that these 2 businesses could be put together.

So here's a quick video that shows some of the advantages.


Andrew C. Teich

So these are the 3 main applications here: stop bar detection, incident detection and then traffic counting, that are currently being pursued in this market. Incident detection inside tunnels is also a fairly big market where Traficon is currently enabled. And again, thermal brings some unique value capabilities there as well, being able to see through smoke.

So this acquisition was done in right at the end of the year, and it has 2 main advantages to FLIR. Number one is that it inserts us squarely into the traffic market. We can use their distribution organization, their product development teams to really go after this segment much more so than we have been. And then the second thing is, Traficon is basically a video analytics company. That's fundamentally what they do: video analytics and video analytics processing board. And it will allow us to leverage that technology into other markets like securities and maritime most specifically. And we've already started that activity.

Moving over to PVS. This is a business that's done very well for us. It's had 180% compound annual growth rate over the last 4 years since we've been in the business. We've got a strong value proposition. It's a fairly thinly penetrated market. And you can see very strong results in terms of volume growth here, on revenue growth. Good gross margins. They're down a little bit in 2012 as a result of mix on the consumer side, but they're still well in line with FLIR's overall expectations.

There we have a very nice product lineup. This is for the outdoorsman sportsman community. We also have a series of these products that are targeted at law enforcement. There we did a new product introduction in 2012 called the LS-Series. The LS-Series brings in some nice capabilities to that segment. It's got longer optics so that you can see further, it's got -- very easy to use, it's just got 4 buttons, no menus at all, excellent image quality. We offer it in the 640x480 thermal version. And it has as a tactical laser on board so that they can get the laser and point out where the object is that they're looking at, for other officers.

Got a couple of questions in the back of the room. Where do you sell this? It's a wide range of both brick-and-mortar and online retailers. Amazon is one of the biggest sellers of this product, but we're very strong with Cabela's, Bass Pro Shops, West Marine, ATN. There's a numbers of outlets there.

So this process -- I want to come back to our cores business and the virtuous cycle here, because this has really been what's fueling the growth in us. So back in 2004, we started to looking at automotive, and we ultimately launched in 2006 with a BMW vehicle as one of the key drivers for the business. Later, we brought in the Maritime business, the security business. We started going after volume thermography, the sporting and outdoors market. We got more auto OEMs on board and that continued to drive this virtuous cycle of volume. Most recently, we've been looking at expanding in a number of other areas. So home monitoring, retail tomography, the traffic business, firefighting, consumer channels, more automotive OEMs. They're all driving this virtuous cycle. We believe this market is very price elastic and that, that will ultimately drive the kinds of volumes that, someday, we really want to see, because what we believe is, is that, someday, seeing in the invisible thermal world, seeing heat instead of light is going to be as common as knowing where you are in the world, as common as the deployment of GPS.

An example of that is -- if you look at a home application there, occupancy sensing with thermal is far more reliable than any other technology. With a low-cost thermal device, we can tell the difference between a person and an animal. I have one of these cameras in my house and it's triggering all the time because I have 4 labradors, and I look at the little captured pieces of video, and I just see a tail going through the image. Thermal will solve that problem. Thermal will also be able to do things like detect a person that's fallen down, if you were monitoring an elderly person. And it's noninvasive. The image that you see from thermal is not going to be offensive to someone who's being viewed.

But we believe that, when you add in temperature measurement capability and the other video analytics capabilities that there's lots of different applications that will come in the home space, and those also carry over into the industrial or commercial space, where energy conservation, security, occupancy monitoring are going to be key drivers for return on investment over time.

So how are we getting to that vision? I talked earlier about the swap C phenomenon that you continue to reduce size, power, cost, weight. We've been engaged in a 24-month effort we've talked about during the last couple of conference calls in terms of significantly increasing our volumes and reducing our costs, and we believe that, that will result in new operating paradigms. And we've been totally committed to this. We've committed about $100 million of R&D in capital. Tony talked about some of the capital spend earlier today. And what that's ultimately going to result in is a completely new level of swap in terms of cost, volume and size.

We believe that, that new technology, together with the progress that we've made thus far in pioneering new markets, should enable the strategy that we've articulated today. So with that, I'd like to close with the same 2 words that I started with, that infrared everywhere is a vision for this business. We believe that we've got a plan and execution path to make that happen. And I hope you do share with me the enthusiasm that we have for making this goal a reality.

And with that, I'll take some questions.

Unknown Analyst

Andy, maybe not to shift off commercial, but within the Cores & Components, you've got OEMs in there, AeroVironment, Northrop, where we heard from Bill about a 20% bookings pressure. What kind of headwind are you modeling for in that portion of the Cores & Components business?

Andrew C. Teich

So that affects what we call our Santa Barbara cores business. So the Cores & Components business is broader than just that, because we have several other groups that are producing cores. The uncooled piece of that -- of which AeroVironment is a piece of that. We expect that we'll see some pressure there. And I think that, frankly, we're going to see it more in terms of timing rather than volume. That's probably the area that gives me the biggest concern in terms of shifting around when we see order placements and order acceptance. In total, it's not that big a piece of the business. It represents roughly about 10% in total of the cores business. It's a bit hard to predict how these programs will be affected, that's the real issue. We feel pretty good about the Northrop Grumman business. The signals that we've been receiving from Northrop Grumman seem to be pretty positive there in terms of their order cadence and deliveries. Like I say, some of it's somewhat unknown. We did go in with a cores forecast. A business forecast has a decline in the cores business, that core business, a single-digit decline but it is a decline. It's not quite as aggressive as Bill's, but it's far less tied to DoD spending. We've got one forward.

Unknown Analyst

In terms of the opportunity, how large do you think this profitable opportunity can be? You spoke about automotive and that being a big volume opportunity but not necessarily that big or that meaningful in terms of revenue. In terms of the profitable opportunity, what is most exciting? And how large do you think it could be?

Andrew C. Teich

So Tony tried to define some of the TAMs for some of the markets that we're going after, and they're measured in billions of dollars, $7.7 billion in security and so forth. So I mean, there's sort of a big gap between where we are today and where the TAMs are. The most profitable segments are going to be the end use verticals. And that's why we're focused on that as part of our strategy, is to have products at the end user level, because that's where the most total margin is going to reside with our vertical integration model. That said, the cores business is important to us, but we're not going to make the same kind of margins in the cores business that we do in the total business, particularly as you get back to just selling a detector, for example, the overall margins will be a little bit less there. In total, the commercial systems margins have held relatively stable over the years, and that's been a mix of both cores business and end systems business. So as the margins have come down a little bit in the cores business, we've re-bolstered those with margins coming from the end systems business. Some of the markets, like auto, those are classically low-margin businesses. So there we use those as volume drivers to bring the costs down for the end systems business.

Unknown Analyst

Andy, could you talk about the last 2 slides? You -- it certainly seem like a big effort, spending a lot of money in terms of CapEx. How do we think about the time line? And in some of those, will you be challenged because you don't have the channels built up for some of those? Or how do you -- how do we bridge to get to the volume there?

Andrew C. Teich

Okay, so 2 issues. Time lines, you'll start to see products slow from this development effort in the next 12 months. In terms of access to the markets, that's part of what these acquisitions are about. You look at a company like Lorex doing 1 million-plus cameras in 2013, those are sockets for this kind of product. And to enable that, you basically need 3 things: You need a product platform, you need a go-to-market vehicle and you need a value proposition. And the value proposition there comes from the acquisition of Traficon as well, because for these sensors to be valuable, it's not going to be just showing a thermal image. It's going to be a thermal image plus some analytics. Maybe the user won't ever even see the thermal image like we do in the NV III automotive system. So -- but that concept, for example, of being able to put a camera some place and reliably tell you when a person is there versus an animal, or if a person is loitering in an area for too long, we believe that really can only reliable be done with thermal. And that's the pieces there. Sure, and we will get over there next.

Unknown Analyst

Andy, when you talk about marine market, how much does the non-Raymarine marine market make up of your commercial systems group, either on a unit volume percentage or dollar percentage?

Andrew C. Teich

It is -- it's not that large today, but it's growing quite rapidly. I don't think we've defined that specifically...

Anthony L. Trunzo

[indiscernible] and a similar-sized system -- surveillance system, but smaller [indiscernible] PVS gets smaller there. The security segment gets smaller [indiscernible] segment. There's still the PVS business [indiscernible]. Can we [indiscernible] something like that in -- view half of that [indiscernible], and the other half is something that [indiscernible]. And then after that, [indiscernible].

Andrew C. Teich

Yes, yes. PVS and maritime have kind of been duking it out, but I think PVS is going to win the battle...

Unknown Analyst

Just to clarify what Tony just said. Did he -- in that scale, though, marine is lumped in with Raymarine at no...

Andrew C. Teich

No, no, that was thermal. The chart that I showed on that was FLIR thermal only.

Anthony L. Trunzo

We're in the long haul for it.

Andrew C. Teich


Unknown Analyst

And then when you look outside the U.S. market especially at the security opportunities, where do you see the greatest opportunity is now? And how much cannibalization are you seeing between what you're doing and what Bill does?

Andrew C. Teich

The opportunity, I think, is very, very good out there. We're quite active internationally. So a significant component of our business comes from international locations, EMEA and APAC. We really play at a different level than Bill's business does, both from a technology standpoint and from the customers that we call on. So in some cases, we supply cameras in the integrated solutions that Bill sells. So to the extent that he's selling thermal invisible cameras, they come from my group. But there are situations where the job is of a nature that integrated systems, either it's not within their scope of capabilities or they just don't win. And in those cases, this is another avenue to those markets. It's kind of similar to the maritime example where we sell FLIR-branded thermal with a Garman MFD [ph], for example. So I think it's a good strategy because it gives you multiple ways to go get us that socket at the core and component level, at the camera level, at the integrated system level. We don't sell at the integrated system level.

Unknown Analyst

Andy, can you talk a little about your decision in 2012 to not pursue the price elasticity strategy in terms of moving pricing down, and perhaps your thoughts around 2013 and whether you'd start to reaccelerate that strategy again?

Andrew C. Teich

Sure. So that was a management call. We have been pulling on the price elasticity lever pretty consistently, and we saw good results from it. We had some experiments that we were running out there in terms of some point discounting, and I just didn't feel it. In the -- with the consumer, the industrial consumer behavior that I was seeing, I just didn't feel like pulling on a lever was going to deliver the kind of leverage that we needed in order to have that make sense rather than just a dilution on revenue. So we chose not to do it. We have the capacity to do it if we need to. We will probably get back on that strategy later this year but -- and potentially with some new product introductions as well. But it'll be a strategy that will come back to life. I just didn't feel like, in an environment of constrained buying behavior, that it would pay off for us.

Unknown Analyst

Got it. And just in terms of your decision to maybe go and compete with some of your customers in spaces like MSA or mining or firefighting, how do you balance the opportunity between being able to expand the market a little bit more quickly along with potentially angering your customers that you would compete against?

Andrew C. Teich

Yes, it's a delicate balance there, because there certainly is an element of it. Our cores customers don't like the fact that we get into an end-use market. But on the other hand, it builds overall awareness. Overall awareness is one of the biggest barriers that we have in this market. And to the extent that we improve overall awareness it's going to make a bigger pie for all of us. And we have to maintain competitiveness on the Cores & Components piece. Those 2 businesses are completely segregated below my level within the business, so they're discrete businesses. And it's an issue that we have to deal with, but it's a little bit of a challenging situation that we have to navigate through. Yes, we'll take one more question, and then we'll wrap up. Go ahead.

Unknown Analyst

On the security segment, I wonder about your customer mix within security and I wonder how penetrated you are globally there. Are you fairly well penetrated there at this point? Or is there just a huge amount of runway to go? Any color you can add on that would...

Andrew C. Teich

Sure. I think the penetration is nascent. I think we are just at the very tip of the iceberg. You saw that's a $7.7 billion market. I've seen statistics say it's as big as $13 billion, and we're just a tiny fraction of that. So there's a lot of runway ahead of us there. The customer base is changing, as I showed in the charts. We used to -- that business was primarily the border patrol, high-end security systems, and now we're going into residences. So that's changing rapidly and I think the volumes will continue to change as we do that. The value proposition has to change there, too, because those lower-end customers want easy-to-use, easy-to-install and fully automated solutions: plug it in, turn it on and it works, whereas high-end border systems is quite complex. So the expectations for the user are different here.

Unknown Analyst

Okay. So do you see less runway on like the ports, borders, industrial security, more so moving to the consumer?

Andrew C. Teich

Well, the penetration is higher in that area. We've been selling to border patrols for 20 years, right? There's, I think, still a quite a lot of runway there, as Bill described, with the focus on making the world a safer place. But for me, for my business, that, the opportunity, pales in comparison to the number of units that can be sold in the consumer space.

Anthony L. Trunzo

Thank you very much. I think Bill, Andy, Tony are going to stick around a little bit [indiscernible].

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