A few weeks ago, I confessed a fear: I may have become a bit too "value" focused post-2008. No doubt, my growth-oriented clients aren't shy about sharing their concerns too. Curiously, my more value-oriented clients still think I see the glass as perennially more than half-full.
A few days after sharing a screen that I had reconfigured to help me make sure that I don't lose sight of the possibility that a great growth company at a good price can be as good or not better than a good company at a great value (New Year's Resolution: Finding Rockets to Ride), I "upgraded" the Top 20 Model Portfolio by selling a pawn shop operator to buy Technology company Flir Systems (FLIR).
FLIR has been on my watchlist for several years. What has kept me interested in following the company is that they have unique technology that is being applied to both state-of-the-art defense and security applications as well as increasingly to commercial ones. I thought that they were attractive this summer and almost added it then, but the stock ran up after they announced their second deal of the year (more below). The valuation and the changing chart earlier this month captured my attention about the same time as I was opening my mind to being a bit more aggressive on growth opportunities. I ended up spending time doing a full diligence which you are welcome to download.
I have a 42 target a year out on FLIR, which I arrive at by applying a 21 PE to earnings interpolated to January 2013 (earnings that will be expected over the next year a year from now). To put that in perspective, over the past decade, 21 is the median. When we bought, the forward PE was 17 (18 now). Note also that the stock traded as high as 45 in 2008 (and 30X forward earnings) (click to enlarge):
So, why am I expecting FLIR to break out of this consolidation and move to new highs? Investors are overly concerned with the risk of a slowdown in the defense business and failing to appreciate two bold acquisitions that closed last year.
FLIR makes infrared cameras and thermal imaging equipment. Naturally, this technology is a staple of modern warfare, and defense makes up about half the business. Customers are varied and are all over the world, but the U.S. Government does account for 35% or so of sales. Customers include the Coast Guard, Marines, National Guard, Army, Border Patrol, UAVs, Customs, the FBI, the DEA and many other entities.
Commercial applications are just as exciting and include Security and Surveillance, Automobile Night Vision (BMW, Audi, Range Rover - partnering with Autoliv), Marine, Law Enforcement (handheld devices), OEM relationships, including helping firefighters, Predictive Maintenance that helps factories run, R&D, Process Control, Building Inspection and Gas Detection. It's not too hard to imagine that the recession most likely slowed commercial adoption of the technology, but growth has still been impressive. The company remains focused on driving costs lower to broaden the market.
FLIR was founded in 1978 but was in big trouble in the late 90s. Current CEO Earl Lewis, who is 67, came in after a financial scandal and has been an exceptional leader with fantastic capital allocation. Note that the company continues to maintain a debt-free balance sheet even after some large acquisitions in 2010. The bench is very talented with deep experience with the firm. For those not familiar with Lewis, he was instrumental in the success of Thermo Electron (TMO) before joining FLIR.
Flir has a rich history in integrating acquisitions, and the two deals from 2010 offer great potential. After spending $74mm on three acquisitions in 2009, the company spent $178mm to buy Raymarine and $268mm to buy publicly-traded ICx Technology last year. Investors seemed to like the Raymarine deal, which gets them much deeper into marine applications, though there may be some concerns that the latter acquisition somehow suggested that the future of IR technology is limited. I listened and listened again to their Q3 conference call, and it seems very clear to me that this was no such admission at all. Instead, it was a great example of an adjacent technology that needs to be bundled (ICx makes sensors used in chemical, biological, radiological, nuclear and explosive threats and had thermal imaging technology as well).
While I get the feeling that these acquisitions as well as a resurgence in commercial growth (organic growth has been double-digit in 2010 through Q3), it doesn't appear to be appreciated due to concerns over defense. I caught the IIVI conference call last week (and had spoken to their CFO earlier as well), because I know that the company is a supplier (as well as competitor). I wanted to get a better understanding of the risks to the type of defense that FLIR provides (as well as IIVI). For those not familiar, these programs tend to be Intelligence, Surveillance and Reconnaissance (ISR). It would seem that this high-tech stuff is essential and ultimately very cost-effective. I am aware of a large program that is winding down that has put some near-term pressure on FLIR's Government Systems business (flat through Q3-10), but it seems unreasonable to expect that the company won't grow this part of the business over time.
It's not hard to understand why investors may fear "paying up" to get FLIR. After all, look at how cheap the big defense contractors are. I view FLIR as a totally different animal due to its exposure to the best part of defense as well as the other half of their business (Commercial). FLIR, which sports a market-cap of $5 billion, is in a position to continue to consolidate, but I view it as a potential take-out itself. Even without that outcome, I expect that the stock can significantly outperform the market over the next year as earnings reaccelerate and investors award a more typical PE for this rather unique high-quality company.
Disclosure: We are long FLIR in the Top 20 Model Portfolio at Invest By Model