Flir Systems (FLIR) is an interesting business in my opinion. The company is an essence a mini-conglomerate, being active in a range of industries. Most of these businesses are pretty defensive in terms of their nature as the advanced technology typically supports very solid margins.
The high margin profile of the business and strong balance sheet make me attracted to the shares as the valuation is not too demanding yet. The company has recently indicated that it is more active to use its strong balance sheet, recently announcing another bolt-on acquisition.
Flir generates little over $1.5 billion in annual sales, accompanied by very healthy operating margins of 20%. The company is active in a wide range of industries, characterized by the fact that they all involve sophisticated engineering and technologies. Typical products made by Flir include thermal imaging equipment, maritime applications, security solutions, diagnostic tools, test & measurement equipment, defense systems, science solutions and industrial automation.
The surveillance business is the largest segment, responsible for a third of sales. The business is very lucrative as well, reporting operating margins of 27% of sales. The instruments business makes up 22% of overall sales and is very profitable as well. Segment margins exceed 32% of sales.
The remaining four segments make up 45% of sales. Flir has a smaller presence into the security, OEM & engineering, maritime and detection business. In general these segments are somewhat less profitable than the top two business units. With many of Flir´s segments being somewhat defensive in terms of their nature, Flir has solid diversification. This is certainly the case as the company is active in a wide range of industries, as well as geographic locations.
A Solid Growth Play
Flir has demonstrated on healthy growth over the past decade. The company has essentially tripled its sales from roughly $500 million in 2005 to a current revenue base just north of $1.5 billion. Organic growth has certainly paid a big role in this growth, as Flir has engaged on acquisitions as well. All in all, Flir spent roughly $750 million to acquire a range of businesses over the past decade.
It is very important to realize that the company has achieved this growth while it maintained a healthy balance sheet and actually bought back a tenth of its outstanding shares as well.
While this is very impressive, there are some challenges for the business as well. Sales have been pretty flat since 2011, hovering around $1.5 billion. Lack of sales growth and acquisitions into lower margin business segments have weighted on the margins of the business. Operating margins have fallen from 30% of sales in 2005 towards 20% by now.
The Pro-Forma Business
While Flir has certainly seen its fair share of challenges with regards to margin developments and lack of sales growth in recent years, the 2016 outlook is reasonably solid. Sales are seen up 3-6% despite the fact that the strong dollar has an impact with roughly half of total sales being generated abroad.
Revenues are now projected to come in at $1.60 to $1.65 billion, with earnings projected at $1.60-$1.70 per share. Important to realize is that this guidance excludes the impact of a large tax bill in the first quarter. With shares trading at $31 per share, equity of Flir is valued at market-equivalent multiples of 18-19 times earnings.
The real potential kicker in my eyes is the strength of the balance sheet. Flir holds $510 million in cash and equivalents with debt amounting to $355 million. The net cash position of $145 million is very strong. The 139 million outstanding shares value equity at $4.3 billion at $31 per share, for an enterprise valuation of $4.15 billion.
Note that EBITDA comes in at roughly $370 million a year, which implies that the entire business is valued at 11 times EBITDA. While this is not a very cheap multiple, Flir´s business is relatively capital light. The stability of operations could easily support a leverage ratio of 2 times EBITDA, for a net debt load of $750 million.
In other words, given the $145 million net cash position, Flir could borrow $900 million to finance share buybacks or acquisitions. Such a potential buyback program could reduce the outstanding share base by 20%. This could be hugely accretive to earnings per share even if we take into account additional financing charges.
Putting Money To Work
Flir is already putting its strong balance sheet to work, announcing the acquisition of Armasight in a $41 million deal. With the deal, Flir will reinforce its position in night vision and thermal imaging products, among others. These products are typically used by hunters, law enforcement and the military.
The reported deal tag represents just 1% of Flir´s own enterprise valuation, as the deal will not make any meaningful impact on revenues and earnings. While the immediate impact is small, it are these kind of bolt-on deals which can provide some icing on the cake for Flir´s investors over time.
Given the strength of the balance sheet, investors could look forward to more of these kind of deals.
All in all I like the business and its shares for the potential value being created.
While the reliance on government agencies creates some potential risks, government agencies make up just 20% of sales. The right peer group for Flir are thereby not defense conglomerates, but rather names like recently acquired FEI (NASDAQ:FEIC), as well as Teledyne (NYSE:TDY).
Thermo Fisher (NYSE:TMO) recently acquired FEI at a $4 billion valuation, for a 20 times EBITDA multiple. Remember that Flir has a similar valuation as well, but its sales of $1.5 billion exceed those of FEI by half a billion. Flir´s operating margins of 20% are higher than those of FEI as well. Teledyne trades at a similar 11 times EBITDA multiple, but unlike Flir, it has taken on quite some debt already, leaving few potential triggers for equity holders in the firm.
Real potential has to come from the hope that Flir can deliver on organic growth, bolt-on dealmaking and margin expansion. If sales growth now becomes structurally positive again, Flir should be perfectly able to post sales of $2 billion by 2020. The target should be to deliver on some margin gains, allowing for operating profits of $450 million by that year. That is equivalent to a 22-23% margin profile, up from the current margins around 20%.
If Flir delivers on these potential improvement, net earnings might come in at $340 million by 2020, assuming a 25% tax rate. If we furthermore believe that Flir might reduce its outstanding share base by 10% in the coming years, the company might have the potential to post earnings of $2.75 per share by 2020.
With a 18-20 times earnings multiple, to reflect the balance sheet strength of the business, shares might be worth $50-$55. That leaves potential returns of upto 15% per year for the coming four years. This looks pretty attractive, certainly as the revenue goals of this projection appear not to be too demanding.
Disclosure: I am/we are long FLIR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.