FLIR Systems (FLIR) Andrew C. Teich on Q2 2016 Results - Earnings Call Transcript

| About: FLIR Systems, (FLIR)

FLIR Systems, Inc. (NASDAQ:FLIR)

Q2 2016 Earnings Call

July 27, 2016 11:00 am ET

Executives

Todd M. DuChene - Senior Vice President, General Counsel, Secretary, and Chief Ethics and Compliance Officer

Andrew C. Teich - President, Chief Executive Officer & Director

Amit Singhi - Senior Vice President, Finance, and Chief Financial Officer

Thomas A. Surran - Senior Vice President and Chief Operating Officer

Shane R. Harrison - Senior Vice President, Corporate Development and Strategy

Analysts

Ben Hearnsberger - Stephens, Inc.

Jim Ricchiuti - Needham & Co. LLC

Peter John Skibitski - Drexel Hamilton LLC

Jonathan F. Ho - William Blair & Co. LLC

Jeffrey Ted Kessler - Imperial Capital LLC

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Noah Poponak - Goldman Sachs & Co.

Operator

Greetings and welcome to the FLIR Systems Second Quarter 2016 Results Summary. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Todd DuChene, Senior Vice President, General Counsel, Secretary and Chief Ethics and Compliance Officer. Thank you, sir. You may begin.

Todd M. DuChene - Senior Vice President, General Counsel, Secretary, and Chief Ethics and Compliance Officer

Good morning, everyone. Please note that our earnings press release and presentation slides that will be referred to on this call are available under the Events & Presentations section of www.flir.com/investor. Before we begin this conference, I need to remind you statements made on this call, other than historical facts, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and are based on our current expectations.

Words such as anticipates, estimates, expects, intends, and believes and similar words and expressions are intended to identify forward-looking statements. All of these statements are subject to risks and uncertainties that could cause actual results to differ materially.

Please refer to the press release we issued earlier today for a description of factors that could cause actual results to differ materially from those forecast. The forward-looking statements we make today speak as of today. And we do not undertake any obligation to update any such statements to reflect events or circumstances occurring after today.

Let me now turn the call over to Andy Teich, President and Chief Executive Officer of FLIR Systems. Andy?

Andrew C. Teich - President, Chief Executive Officer & Director

Thank you, Todd, and welcome everyone to FLIR's second quarter 2016 earnings call. With Todd and me today is our CFO, Amit Singhi; COO, Tom Surran; Chief Marketing Officer, Travis Merrill; and Senior Vice President, Corporate Development and Investor Relations, Shane Harrison.

I'll start the review of the quarter with slide three of the presentation. This morning, we reported second quarter revenue of $403 million, an increase of 2% compared to the prior year. Commercial product revenues grew 1% over second quarter of 2015, while government product revenues grew 5%. Year-to-date, government products revenues are up 12% over the first six months of 2015.

On the commercial side, softness in our Instruments and Security segments was only partially offset by growth in our Emerging and Maritime product lines. Deliveries of cooled and uncooled thermal camera cores, MSC systems and Man-Portable products helped drive the growth in government products. However, both the MSC and Man-Portable products carried relatively low margins.

Earnings per share were $0.33, which were negatively affected by a $2 million write-down in the carrying value of a minority equity investment we hold in a third-party company. Excluding this non-operating expense, earnings were $0.34 per share. While gross margins were pressured by unusual product mix and somewhat elevated manufacturing costs, we improved our operating margin by a 110 basis points over the first quarter of this year.

Total company 12-month backlog finished the quarter up 17% year-over-year to $629 million as we saw 9% growth in overall orders versus the prior year. This is our highest backlog balance since 2008, which was the height of our activity for the Iraq and Afghanistan wars. Backlog in the Surveillance segment is up 19% over the balance at the end of Q2 2015.

On the new products front, the Surveillance segment introduced the new Star SAFIRE 380-HLDc at the Farnborough Airshow this month. The 380-HLDc is our latest variant of the 380-HDc gimbal platform that adds laser designation capability to this highly differentiated compact, airborne, EO/IR system.

Surveillance also announced the new LTV-X, all-terrain turnkey mobile surveillance vehicle, which has onboard attack FLIR gimbal multi-sensor as well as our new R6SS Beam-Forming long distance ground radar.

And also during the quarter, the Instruments segment introduced the latest infrared guided measurement or IGM test and measurement product, the DM284 all-in-one digital multi-meter.

During the second quarter, we completed a couple of financing transactions, will allow us to have more capability and flexibility in our capital deployment strategies. We expanded our revolving credit facility to $500 million and issued $425 million of new publicly traded notes, the proceeds of which have been used to repay our existing $250 million of notes and increased our U.S. cash balance.

We also completed the acquisition of sporting and tactical scopes business, Armasight, which will strengthen our presence in both the recreational and military weapon sights and scopes markets. Armasight did not impact our second quarter results and is not expected to meaningfully impact EPS during 2016, but we do expect to see acceleration under the FLIR brand as well as profit synergies in 2017, as the business leverages our brand and vertical integration in the thermal space.

On slide four, you'll see our updated outlook for 2016. We continue to expect full year 2016 revenue to finish in the range of $1.6 billion and $1.65 billion. Based on the profit margins seen in the first half of the year, we now expect the EPS to be in the range of $1.60 to $1.65 for the full year, excluding any charges related to cost reduction initiatives in the second half and the tax reserve and investment write-down booked in the first half. This represents a revenue growth rate of between 3% and 6% and an EPS growth rate of 3% to 6% when compared to the 2015 results, after adjusting to exclude the 2015 restructuring charges, investment gain and discrete tax items.

We expect to see improved margins in the second half driven by favorable product mix changes, targeted price increases and reductions in manufacturing and SG&A costs. These changes are expected to result in an overall gross margin improvement of approximately 2 percentage points over what we saw in the second quarter.

We also announced today a quarterly dividend of $0.12 per share, which will be payable on September 2 to shareholders of record as of August 19.

I'll now hand the call over to Amit to review the second quarter financial results. Amit?

Amit Singhi - Senior Vice President, Finance, and Chief Financial Officer

Thanks, Andy. On slide five, you'll see our second quarter financial results. Consolidated revenue was $403 million, a 2% increase compared to the second quarter of 2015. Overall impact of exchange rate changes on revenue and operating income was minor. The largest drivers of the revenue growth came from the OEM & Emerging, Maritime, Security and Surveillance segments increasing 23%, 6%, 6% and 5% respectively. Instruments and Detection revenues declined by 14% and 2% respectively.

Recently, revenue increased in the U.S., Middle East, and Africa and Asia by 9%, 10% and 3% respectively, while it declined in Europe by 12% and in Canada/LatAm by 9%. Sales to the U.S. government increased $24 million or 32% and represented 25% of total revenue compared to 19% in the second quarter of 2015.

Consolidated second quarter gross margin was 46%, 273 basis points lower than last year, primarily due to changes in product mix, manufacturing costs under absorption, and additional costs associated with the ramp-up of our low cost IR lens capability.

As a result of cost control measures, operating expenses reduced by $1 million year-over-year, despite the addition of expenses related to the DVTEL business. Our operating margin fell from 18% to 16% as a result of the decline in gross margin, partially offset by operating expense reduction.

We now expect our 2016 effective tax rate to be 25%, excluding any discrete tax items, and our second quarter tax expense was $14.5 million. Net earnings for the second quarter of 2016 totaled $45.4 million or $0.33 per fully diluted share. Excluding the impact of a minority investment write-down of $2 million, adjusted net income was $47.4 million and adjusted EPS was $0.34, compared to $0.36 in the second quarter of 2015. We closed the second quarter with cash of $903 million, an increase of $393 million during the quarter, primarily driven by proceeds from the debt refinancing and strong operating cash flow.

Our cash flow from operations for the quarter was $81.7 million or 173% of adjusted net income, driven by improvements in working capital as a result of our special initiatives. Accounts receivables and inventory improved during the quarter resulting in a lower quarter-over-quarter cash conversion cycle.

During the quarter, we acquired Armasight for $41 million and had capital expenditures of $10.9 million. We repurchased 950,000 shares for $29.7 million and returned another $16.6 million to shareholders through the payment of dividends. Our cash balance increased as a result of the $425 million of new debt, $250 million of which was earmarked for repayment of our previous notes, which was settled in early July.

This concludes the summary of our second quarter financial results. Let me now turn the call over to Tom Surran to cover our operational highlights. Tom?

Thomas A. Surran - Senior Vice President and Chief Operating Officer

Thank you, Amit. Slide six shows a summary of our second quarter segment results. While four of our six segments achieved good growth during the quarter, overall growth was hampered by softness in our Instruments and Detection segments. Segment level operating profit was down 9% as we saw gross margin headwinds due to product mix, under absorption of manufacturing costs, and acquisition related intangible amortization.

Moving to slide seven, which covers the Surveillance segment. Second quarter revenue for Surveillance was $113.4 million, up 5% over the second quarter of 2015. Increased revenue from the MSC program, Man-Portable product line and Personal Vision Systems product line, each contributed to the growth. Delays related to export licensing requirements created a headwind to this growth during the quarter.

Operating profit for the Surveillance segment was $26.1 million, which was down slightly from the prior year, while operating margins declined due to an unusual product mix in the quarter, the significant amount of MSC shipments, as well as large deliveries of a certain Man-Portable product each came at lower than normal margins for the segment.

Based on our backlog, we expect shipment of these products to be lower in the second half, while shipments of higher margin products should help bring Surveillance operating margins back to the high 20%s. Surveillance backlog increased $27 million from the end of Q1 to $341 million ended up 19% from one year ago. Strong order flow from international customers, including ones in Latin America, Asia and Europe helped add to the backlog.

Additionally, the acquisition of Armasight and the delay in getting certain export license further increased our backlog. Surveillance segment book-to-bill ratio was 1.1x in the second quarter, which was the fourth time in the last five quarters that book-to-bill ratio exceeded 1x.

As Andy mentioned, during the second quarter, we acquired Armasight, a leading night vision and thermal tactical scopes company. The addition of Armasight's product line in management team will provide us with meaningful scaling and additional capabilities in the hunting, outdoors and military scopes space.

As we integrate our existing PVS and military scopes business with Armasight, we have renamed the combined business FLIR Outdoor and Tactical Systems or OTS, which will be reported within the Surveillance segment going forward.

During the second quarter, Surveillance introduced three new products as shown on slide eight. At the Farnborough Airshow, we showcased our new 380-HLDc gimbal EO/IR system that features HD thermal and visible imaging, and precision laser designation capability in a low profile form factor. By integrating laser designation capability into this form factor which offers improved ground clearance, the 380-HLDc brings laser designation capability to aircraft that were previously unable to perform this crucial role.

Our radar team introduced the R6SS portable ground radar that utilizes advanced Digital Beam-Forming to enable detection and tracking of people from up to 15 kilometers away. Also launched this quarter was Surveillance's new integrated vehicle system, the LTV-X. The LTV-X is a compact modular four-wheel vehicle that features our TacFLIR 280-HD multispectral gimbal, the R6SS radar and onboard command and control software. The product offers a turnkey highly transportable solution for advanced border surveillance and reconnaissance.

On slide nine, you will see a summary of the Instruments segment. Revenue declined 14% compared to the prior year to $78.1 million. Significant MERS related sales in Asia and a communicated price increase in Europe, each drove higher shipment in Q2 of last year, which created a difficult comparison for Instruments in the second quarter of this year.

While we continue to see very good growth in firefighting and automation lines of business, it was not enough to fully offset the relative declines in the other businesses, including continued weakness in the plant and predictive maintenance line of products. The softness in the PPM product line related to mid-range products was partially offset by strong sales in the recently introduced high-end T1K product.

Instruments' operating profit was $19.1 million, a 25% revenue in the quarter. Manufacturing overhead, investments and development of low-cost molded infrared lens production capability and reduced operating leverage related to lower revenue levels contributed to the relatively low margins. We expect that margin improvement initiatives implemented in Q3 will allow instruments to return to second half operating margins in the 30% range, which is customary for the back half of the year.

During the second quarter, Instruments introduced the DM284, our latest IGM test and measurement tool. With the digital multimeter, we have integrated our Lepton thermal camera to create a differentiated version of an everyday tool that electricians use, allowing them to now visualize temperature anomalies and other electrical problems that are not visible to the naked eye.

On slide 10, is our Security segment results. Security second quarter revenue of $63.4 million was up 6% over the prior year. Growth in Enterprise-class products was offset by lower sales of thermal products versus difficult comparable on the prior year, where we saw significant shipments of high-end long range cooled camera systems.

Security operating margin was 5% in the quarter, up significantly over Q1 of this year, yet below the prior year. Gross margins were largely in line with last year. However, increased operating expenses and intangible amortization related to the DVTEL acquisition pushed down profitability.

We are taking costs out of the Security segment as we right-sized this operation. During the quarter, Security segment acquired the assets of Innovative Security Designs or ISD. ISD provides advanced security hardware and software solutions to the enterprise security market. While not meaningful from a financial standpoint, the acquisition has strategic importance and that we are brought on board a very experienced engineering team that will add significant capabilities and knowledge to the company to help with our innovation of advanced solutions for the security industry.

The results for the OEM & Emerging segment are shown on slide 11. Reaching an all-time high, OEM & Emerging second quarter revenue was $57 million, increasing 23% over last year. Strong growth occurred in our IR camera cores, as well as our FLIR ONE and FLIR drone camera sales continue to grow significantly.

OEM & Emerging operating profit was $16.1 million in the quarter, increasing 53% over the prior year and reaching 28% operating margin, as increased revenue resulted in meaningful operating leverage benefit.

During the second quarter, OEM & Emerging introduced a new version of the popular Vue series of thermal cameras for commercial drones. The Vue Pro R is a radiometric thermal camera that enables drone operators with the ability to accurately measure temperature remotely down to the individual pixel level as well as import images into our FLIR Tools application for detailed analysis and reporting.

Turning to slide 12, Maritime segment revenues were $55.2 million representing 6% growth versus the prior year. Higher sales of radars, thermal cameras and multi-function displays drove the revenue growth. The marine variant of our Scout TK handheld monocular was introduced in the quarter and was well received by the market.

Maritime operating income was $6.7 million in the quarter, reaching 12% operating margin in the segment's seasonal high quarter. Our recent inventory improvement initiatives showed good result in Maritime segment as our ending second quarter balance was down $10 million versus Q1 and down $3 million compared to the last year.

Maritime introduced several new products during the quarter including the R17 release of Raymarine's Lighthouse Operating System for multi-function displays, which incorporates advanced dock-to-dock Autorouting capability for boaters as well as sonar-enabled mapping.

Raymarine introduced two HD visible cameras the CAM210 and CAM220, which enable boaters to monitor their boat and keep themselves and their passengers safe on the water.

Also introduced was the new Raymarine Evolution R4 autopilot. The Evolution R4 brings advanced patented wind correction capabilities to its adaptive core in addition to increased accuracy and tracking and waypoints.

The Detection segment results are summarized on slide 13. Detection second quarter revenue was down 2% year-over-year to $35.7 million. The timing of deliveries under our DRSKO orders can result in quarter-to-quarter variability and in the second quarter of last year, we shipped the most units since the program began, causing it difficult comparable for the quarter.

All the Detection's other product lines grew year-over-year to mostly offset the decline in DRSKO. Unchanged gross margins combined with reduced operating expenses resulted in over two percentage points of operating margin improvement. Detection finished the second quarter with $74 million of backlog, declining $23 million since Q1 due to shipments under the DRSKO order.

That concludes my summary of the segment second quarter. I'll now hand the call back to Andy.

Andrew C. Teich - President, Chief Executive Officer & Director

Thanks, Tom. Overall, the quarter was below our expectations. Delays related to our licensing processes for international customers pushed approximately $20 million of revenue into the second half of the year. In the back half of the year, we expect to see revenue growth rates that exceed, what was seen during the second quarter. Supporting this was year-over-year bookings growth of 9% in the second quarter resulting in the highest backlog we've seen in nearly eight years.

We expect to enhance both our gross and operating margins in the second half as well. Recent margin degradation is the byproduct of successes in certain lower margin business lines, temporary product mix headwinds in Surveillance and increased manufacturing costs.

As stated earlier, we intend to improve our operating efficiency and cost structure to bring our margins back in line. Including the benefits from our margin improvement initiative and the expectation of a more usual product mix of Surveillance, we expect to see gross margins to improve by approximately two percentage points over what we saw in the second quarter.

Sensor volumes increased considerably during the second quarter. Success in selling Lepton camera cores to OEMs and success of our own branded Lepton based products have helped drive 200% growth in the number of Lepton units produced compared to last year. While we're working diligently to build relationships with high volume OEMs, this volume ramp is helping to reduce the cost to manufacture all of our uncooled sensors.

Our long-term strategy of being The World's Sixth Sense is centered on innovating advanced sensing technologies that solve people's needs for safety, security, process efficiency and environmental preservation.

When we look at our core technology of thermal sensing, the runway in front of us remains very long. Price and awareness continued to be barriers that we are gradually overcoming. We have a strong presence in many existing markets, but continue to be focused on developing new applications and use cases to drive overall growth in both awareness and utilization of the technology.

Our sensor costs continue to come down, allowing us to expand the overall customer base while maintaining our margins. We remain focused on building our product suite, distribution channels and overall product solutions in a way that utilizes our capital efficiently while creating strong returns for our shareholders.

That concludes our comments on the second quarter. We'll now ask the operator to open the call up for your questions. Operator?

Question-and-Answer Session

Operator

Thank you. We'll now conduct our question-and-answer session. Our first question comes from Ben Hearnsberger with Stephens. Please state your question.

Ben Hearnsberger - Stephens, Inc.

Hey, thanks for taking my question. I wanted to start with the Instruments' EBIT margin, which surprises to the downside. I think the expectation heading into the quarter was that we would see improvement relative to 1Q and clearly that didn't play out. I guess, relative to initial expectation, what surprised you in the quarter that ultimately drove the mid-20%s margin?

Andrew C. Teich - President, Chief Executive Officer & Director

Sure, Ben. There were actually a couple of things there. I mean number one is really the headline revenue there. The revenue was lower than we expected. We had a difficult comp, as Tom mentioned in his prepared comments, that we had executed a price increase last year that pulled some orders from Q3 into Q2 last year.

The other issue that occurred last year is we had a little over $4 million of both bookings and shipments last year that were related to the MERS outbreak in Korea that did not reoccur this year. So that the lower revenue resulted in lower overall absorption, manufacturing overheads in the Instruments business.

The other thing – there were couple of other things going on there. We have had an ongoing investment in new optics capability that is centered in the Instruments business. We fundamentally have three optics technologies at the company, wafer scale optics, molded optics and diamond point turned optics.

And we have a fairly concentrated investment effort going on in the molded side to be able to produce our own molded chalcogenide optics in the future and those will be used across the business segments. There are five out of six of the segments will utilize those optics going forward. And the expenses in that area were a little bit higher than anticipated and not fully absorbed by the operation.

Tom, you want to add anything else to that?

Thomas A. Surran - Senior Vice President and Chief Operating Officer

No. It's also just as you mentioned the revenue and the operating margin leverage. The expenses were set for a higher level of revenue which we did not achieve as you discussed why.

Andrew C. Teich - President, Chief Executive Officer & Director

Yeah. So we'll be making some adjustments in that business spend to make sure that the operating overheads of that business are in line with the expected revenues in the second half.

Ben Hearnsberger - Stephens, Inc.

So if we think about the back half of the year, getting back to the 30% range, we need better volumes, but let's just look at any absence of volume showing up, with the initiatives you have at hand, what type of margin profile do you see in that segment, assuming margins do not show up in the back half of the year?

Andrew C. Teich - President, Chief Executive Officer & Director

Well, we expect that the operating margins in that business will be in the 30% range in the second half as a result of the initiatives that we're taking. We're seeing if you move up to the gross margin level, I think we'll see some improvement there as well, as we've got our high-end products are in the market now and at a maturity level of manufacturing, they're generating their expected margins.

So this is products like the T1K which was introduced late in 2015. So that's a product now that's shipping and getting good traction in the market, and we feel there's a good opportunity for replacement cycle, as we've got a very large installed base of P600 and T600 units that are used in industries where that level of performance is required.

Ben Hearnsberger - Stephens, Inc.

Can you maybe touch on the product development pipeline for the mid range tier products in the Instruments segment, and when you expect an upgrade to those products to be released?

Andrew C. Teich - President, Chief Executive Officer & Director

Sure. So we've mentioned in previous calls that those are products where we're seeing some pressure in terms of growth. They're products that are older products in our product line, and so, we've been focused more on the corners of the product value ladder in that business.

There has been an ongoing effort to refresh the midsection of our product line, and that's going quite well, and we'll utilize new technology that we've developed at the company at the core level. And those products are expected to launch early in 2017.

Ben Hearnsberger - Stephens, Inc.

Okay. Gentlemen, thank you very much.

Andrew C. Teich - President, Chief Executive Officer & Director

Thanks, Ben.

Operator

Our next question comes from Jim Ricchiuti with Needham & Company. Please state your question.

Jim Ricchiuti - Needham & Co. LLC

Hi, thank you, good morning. Wanted to talk a little bit about what you're seeing in the Security segment, clearly, a deceleration of growth. And can you walk us through what some of the dynamics might be? Is it just slower uptake on thermal, which I think had higher expectations or is that market taking longer to develop? And is there any share shift going on within maybe the traditional video base portion of the business?

Andrew C. Teich - President, Chief Executive Officer & Director

Sure, Jim. So I'll talk first about the thermal end of the business. That is a business that is still very much in its infancy. The value proposition for thermal cameras in the security space is quite strong, as it significantly improves the accuracy of video analytic based systems.

We've introduced some new products in that space just recently, our FC-ID series, which is the first product that we've introduced that has fully integrated edge-based video analytic capability that's very quick and easy to set up and quite reliable from an accuracy standpoint. That really brings a differentiated value proposition to outdoor perimeter security applications, you're leveraging the capabilities of thermal imaging.

In Q2, we changed some of our export licensing processes to refine those and that resulted in the delay in obtaining some export license and that manifested itself in the Security segment, to some degree in the Instruments segment, and more so in the Surveillance segment. And as a result, that pushed some deliveries from Q2 into the second half and that was manifested in the security-based revenues and that again pertains only to the thermal products.

In the visible space, the competition there has increased, and as we've seen some of the larger Chinese suppliers enter the markets directly, that has put some pressure on margins as a result of increased competition. Our strategy there is to offer more Enterprise-class products and that will be supported by the DVTEL integration.

Also in that space, we believe that over the long-term, the opportunity to offer integrated thermal and visible products or hybrid products as we call them, will give us a differentiated solution that will not only be unique, but also have the ability to generate higher margins than traditional visual products.

Jim Ricchiuti - Needham & Co. LLC

Thanks. That's helpful. And just with respect to the margin improvement that you're anticipating in the second half, I think I heard you, you're anticipating a 200-basis-point improvement in gross margins in the second half versus the Q2 levels. I wonder if there's a way for you to perhaps maybe quantify, if there are some major components of that, that gets you there, clearly mix, I think, right?

Andrew C. Teich - President, Chief Executive Officer & Director

Yeah. There are fundamentally three things that drive that. Mix is one of the big ones. So we did have an unusual mix in the first half of the year that will resolve itself in the second half of the year, particularly in the Instruments segment.

The second area is we'll have some price increases. So we've implemented a price increase program. So we'll have some targeted price increases that will affect each of our segments.

And then, the third area is we'll address the under absorption issue. So we'll take some cost out of the manufacturing operations that will help both absorption and some of the variances that we saw in the first half of the year.

Jim Ricchiuti - Needham & Co. LLC

Okay. Thank you.

Operator

Thank you. Our next question comes from Pete Skibitski with Drexel Hamilton. Please state your question.

Peter John Skibitski - Drexel Hamilton LLC

Hey, good morning, guys. I guess either Andy or Amit, can you guys talk about the working capital improvements? It was a nice cash flow quarter and I remember about three years or four years ago, there was a lot of talk about the working capital takeout opportunity. So I'm just wondering if in the second half we might see more working capital takeout and it's longer term, there's an opportunity there as well, whatever color you can give will be great on that front?

Amit Singhi - Senior Vice President, Finance, and Chief Financial Officer

Yeah. Thanks. This is Amit. So yes, so we are also pleased with the improvements we're seeing. Again, it's the result of lot of hard work and effort and special initiatives across all the three components; receivables, inventory and payables. We saw about a $20 million improvement in AR, about $12 million in inventory that was net of – there was an addition due to Armasight coming onboard and AP was off by about $5 million.

So about $30 million working capital improvement in the quarter, a lot of it is again driven by special initiatives on collecting faster and on inventory, I'll let Tom speak to that in a minute. Overall, our cash conversion cycle improved by 13 days, and we expect to continue that same trend going into the second half.

Inventory turns also improved slightly from 2.1 to 2.2. And I'll turn it over to Tom who's leading our inventory reduction initiatives.

Thomas A. Surran - Senior Vice President and Chief Operating Officer

Yeah, Pete. So Amit made reference to the fact that our core inventory reductions, excluding that inventory that was acquired, were down $17 million for the quarter. And last quarter, we talked about some of the things that we are doing in these programs and each segment has its own improvement program, but there were the consolidation of our distribution centers, safety stock reduction, supplier agreements, and then, liquidation of the problem inventories. And we're seeing traction with all of those things and we're pleased with the success.

In fact, we expect further progress in the current quarter, because as Andy mentioned, there were certain things that hampered some of our revenue at the end of the quarter, so we had some finished goods inventory that we expect to flow through in the current quarter. And then, over time that we'll see just a more – not as significant of improvement, but continued improvement because these are long-term programs that we'll be working on.

Peter John Skibitski - Drexel Hamilton LLC

Yeah. That sounds great. It sounds pretty systematic now. So that's excellent. And then, just was wondering if you could provide any color on the Armasight deal. My sense is number one, it's a pretty competitive market, I'm wondering what your estimate is of the size, but kind of how do you differentiate, and then, anything you can give us in terms of price paid or revenue outlook will be great.

Andrew C. Teich - President, Chief Executive Officer & Director

Sure. So let me just talk about the thematics of the deal first and what the industry landscape looks like. We have a business today that is part of Surveillance that we call PVS, Personal Vision Systems, and that is a tactical scopes and sight business. The products that we've launched there are products that were designed to create new opening price points in that market. So we have typically been the price leader in that space.

Also, in our Surveillance business though, we have some higher and more CDMQ oriented tactical scopes and sights. And Armasight in the thermal space actually kind of fills in the gap between those two product ranges between our true consumer and a military product with products that are more prosumer and paramilitary oriented.

The other thing that Armasight has is a fairly large business of enhanced night vision products. So these are combination of I2 technology Gen 1, Gen 2 and Gen 3 I2 technology and also low light CCD and CMOS based products.

The opportunity here I think is quite good for two reasons. Number one is the outdoor hunting market, night time operations of outdoor hunting is increasing and also the interest in digitally based scopes and sights is going up, both with the availability of lower cost thermal technology and the availability of lower cost low light visible technology.

So Armasight really brings a capability to us particularly in the low light visible space and I2 space, but also will allow us to create more of a center of excellence and provide some scale to the business around that tactical outdoor scopes and sights areas. So we're pretty excited about the space. It's a growing space. We also see the international market as a pretty strong opportunity for us as most of Armasight sales are U.S. based at this point and we've got a little bit larger footprint internationally that we can leverage their products through.

Peter John Skibitski - Drexel Hamilton LLC

Okay, very good. Very good. I'll squeeze one more in. Andy, can you talk about – I think you've introduced this, but this idea at Security of integrating the DVTEL VMS system with some of your command and control software, what the name in that new product is, if you started selling it yet and kind of what kind of growth opportunity you think is there?

Andrew C. Teich - President, Chief Executive Officer & Director

Yeah. It's an interesting opportunity for us actually, because what it does is it brings C2 or command and control capability into the traditional VMS environment. So we have a group that's called 360 Surveillance that was part of our Surveillance group, and we have moved them out of the Surveillance group into the Security group at the beginning of this year.

And fundamentally, what it does is it creates a full end-to-end solution between a network of visible and thermal security cameras, combined together with radar, ground-based sensors, with the video management system, and then, 360 brings in that top-down view of the C2 system, and that will be utilized both for stationary systems and for mobile systems. So this is also a technology that we've deployed in the new LTV-X product that Tom mentioned earlier that was launched in the Surveillance space.

That level of capability of having a true C2 layer on top of a VMS is something that really not many people are offering in the market today, and I think we're going to have a very unique product offering there. And particular for the markets where we're particularly strong, which is sort of the outdoor perimeter surveillance market, this gives us a true end-to-end solution which has been one of our strategic goals for the year to produce more solution-oriented solutions for our customers.

Peter John Skibitski - Drexel Hamilton LLC

Okay. Thanks guys.

Operator

Thank you. Our next question comes from Jonathan Ho with William Blair. Please state your question.

Jonathan F. Ho - William Blair & Co. LLC

Good morning. I just wanted to start with some of the cost containment initiatives that you guys have talked about, just given sort of the company's history of going through and restructuring, what do you see as the low-hanging fruit, what's the pattern that we should expect in terms of the cost containment initiatives to show up, and can you just give us a sense of that pattern?

Thomas A. Surran - Senior Vice President and Chief Operating Officer

Yeah. I think, Jonathan – this is Tom and it's not so much a category, but rather a model. And it's structuring the expenses to an expected level of revenue and making sure it's in line. So we had certain growth expectations in, say, Security that we didn't achieve, but we can clearly structure our business for our expected level of revenues and that means all the way through the business and all the areas and the line items for the spending on both the cost side as well as on the operating expense side.

Jonathan F. Ho - William Blair & Co. LLC

Got it. And then, can you talk a little bit about the competitive dynamics in the Security business, particularly around Lorex? Should we just expect the growth rates in Security to be lower at the current levels? Is there much concern for in terms of future inventory issues? I just wanted to understand sort of the dynamics that you expect in that market, as you start to transition upstream.

Thomas A. Surran - Senior Vice President and Chief Operating Officer

Yeah, so the competitive dynamics, you particularly focused on what we would call the retail business or consumer business. So there's three – we divide the market and we talk about in three ways. We have kind of the consumer business, we have a small business or SMB, and the Enterprise-class.

And the consumer business is highly competitive. The differentiation is relatively low. We have very good products. The amount of inventory we hold, it moves almost in the quarter we receive it. So it's not a large inventory balance. That's pretty competitive on price. It's a very high volume business. And I think that's not where we're focusing.

SMB is the business, where Andy mentioned, we're seeing the major Chinese manufacturers enter and competing primarily on price. Again, there are certain things we can add a little more differentiation and we're participating in that business, but is again not the focus.

What Andy was referencing is that third market is the Enterprise where we can create differentiated products and solution, the ability to have healthy margins, and that is much stronger, the importance of thermal in an end-to-end solution is stronger. And so that's where we're focusing our efforts and that's where we can achieve the superior margins and that shift towards the Enterprise products will improve the margins for the business overall.

Jonathan F. Ho - William Blair & Co. LLC

Great. Thank you.

Operator

Thank you. Your next question comes from Jeff Kessler with Imperial Capital. Please state...

Jeffrey Ted Kessler - Imperial Capital LLC

Thank you. A number of obviously my questions on Security have been answered, but just as a point of reference axis, which does go toward the Enterprise segment also and pull out of the SMB and small business area has tried to cast about a 6% to 7% growth rate for that Enterprise area.

So I'm wondering with regard to DVTEL, above and beyond the amortization issue, what – and above the command and control issue potential there, what can you do to essentially get individual sales forces from other divisions to start using the technology that DVTEL can bring because it's not just a high-end VMS or camera company, it obviously, is a technology company that could be used across various division lines, is there a way to incentivize the sales force to do that?

Andrew C. Teich - President, Chief Executive Officer & Director

Well, I think the issue, Jeff, it's an interesting point that you raise, is how do we leverage technology from the Security segment into the other portions of the business and they're actually quite applicable.

There are really two fundamental technologies there that can be used elsewhere and those are the VMS technology and the cloud-based technologies that the DVTEL engineering team is working on. Those are applicable. The cloud-based technology is fundamentally applicable across each of our segments and the VMS technology can be utilized in Surveillance, in Maritime, and of course, it's already being used in the Security segment.

The opportunity for having high level integrated VMS system tied together with the C2 system and then backed up with cloud access capabilities is something that is quite attractive for boaters, for example, in terms of being able to keep an eye on what's going on in a boat both while at voyage and while the boat is at harbor.

And also, on the Surveillance segment, at the end of the day, what we do on the Surveillance segment is we provide ISR capabilities across a variety of platforms and the ability to both record and disseminate that information is becoming increasingly important and that's fundamentally what the Security segment capabilities will bring to the other segments.

Jeffrey Ted Kessler - Imperial Capital LLC

Okay. One other question that is in your refinancing, you obviously now have some dry powder, and you clearly are looking at anything that's opportunistic for you. Is there a general, some broad-based comments you can make about where you feel the inorganic or acquisition related types of capital employment can be focused?

Andrew C. Teich - President, Chief Executive Officer & Director

Sure. We continue to look at opportunities to leverage our core technology and there are still a lot of opportunities out there where thermal technology can be leveraged into other business spaces and examples there include machine vision, automation, there's additional opportunities in Security and Surveillance and the UAS space, there are a number of different opportunities there.

You look at channel expansion opportunities out there as well. So we have the ability to pick up organizations that will expand our footprint and reach to the market with our existing products. And then, we're also looking at technology expansion, so looking at other wavelengths in the imaging spectrum. So today, we cover sonar and radar, visible imaging, thermal imaging, but there are opportunities in other products of the spectrum that I think can be leveraged as technologies that they can be complementary to the imaging technologies that we do today.

Jeffrey Ted Kessler - Imperial Capital LLC

Okay. Finally, given your strong cash flow generation in the first half, but also your expectations for both margin and, more importantly, revenue growth in the second half, which may mitigate cash expansion a little bit, do you have any – can you provide us with any guidance with regard to where you see cash flow from operations for the year going?

Andrew C. Teich - President, Chief Executive Officer & Director

I'll ask Amit to talk about that.

Amit Singhi - Senior Vice President, Finance, and Chief Financial Officer

Yeah. I think overall, we expect to stay – it won't be quite as strong as the second quarter compared to the net income. We were a little bit behind in the first quarter, we made up in the second quarter. So as a percent of net income, it won't be quite in the same range, but it will still be a very strong second half that would still generate over a 100% of net income in terms of operating cash flow.

Jeffrey Ted Kessler - Imperial Capital LLC

Okay. Great. Thank you very much.

Andrew C. Teich - President, Chief Executive Officer & Director

Thanks, Jeff.

Operator

Thank you. Our next question comes from Michael Ciarmoli with KeyBanc Capital Markets. Please state your question.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Hey, good morning, guys. Thanks for taking my questions. Just some quick ones for clarity here. Have you guys disclosed or can you – how much of the Security segment revenues are being driven by thermal related sales?

Andrew C. Teich - President, Chief Executive Officer & Director

We don't break that out, but what I will tell you, Michael, is that it was lower in Q2 than the norm and primarily as a result of the changes that we made in our export licensing processes that delayed some shipments into the second half. So we expect that to normalize in the second half.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Got it.

Andrew C. Teich - President, Chief Executive Officer & Director

We also – we mentioned in the prepared comments also the Security comp for Q2 last year was a pretty tough one, because we had a significant amount of cooled long range shipments in Q2 2015 and very few in Q2 2016 and that's just lumpy. We've a very competitive product line there, but those programs tend to be lumpier than the normal cadence of uncooled cameras in the security space.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Got it. And then, just on OEM & Emerging, obviously, the 20% plus growth, how much of that growth was contributed by defense customers? Were there any meaningful defense shipments in the quarter?

Andrew C. Teich - President, Chief Executive Officer & Director

They were – I'm going to have Shane see if he can have that breakout. I'm not sure if we have it at that level of fidelity, but we have seen a strong order uptake there – our – as we mentioned in the prepared comments, our overall government revenues were up 32% and DoD was up 17%, and we had very strong growth in the Federal area, it was up 140%, but that's not specific to OEM & Emerging. Do you have a number there?

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Okay.

Shane R. Harrison - Senior Vice President, Corporate Development and Strategy

Yeah, Michael, the growth in the core business that's going in (48:43) government customers was strong. It was north of 15% in the quarter.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Okay. Got it. That's helpful. And then, just a last one on kind of trends here. Maybe if you can comment on defense, what you're seeing in terms of sales and orders in the Middle East. And then, obviously, you've got this strong second half, how you guys are thinking about your European markets in the context of Brexit? Does that pose any risk? Are you seeing any disruption?

Andrew C. Teich - President, Chief Executive Officer & Director

Sure. So if we first just look at what things went on from a geographical standpoint, in Q2, we saw the highest growth coming out of the Middle East, that was up 10%, U.S. was up 9%, Asia was up 4% and Europe was down 12%, as mentioned previously. And then, as we previously mentioned, the U.S. government oriented revenue was up 32%.

In terms of Brexit, our exposure there is not terribly significant. Our total revenues in GBP are less than 4%. From a cost standpoint, we think we're properly leveraged there. So we don't see that we'll – we don't expect to see a significant change in margin.

I think the big question here and I'm sure everybody is talking about this is what will the impact be on the EU in total. We're currently expecting our European revenues to be flat with H1. We actually had some aberrations last year. H1 was stronger than H2 from a European revenue standpoint, and this year, we're going to – we believe that that will flatten out. Last year, we saw that delta primarily because of the fact that we had price increases on a few of the segments in Q2 of last year and it pulled the order from H2 into H1, and this year, we won't see that recur.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Okay. Okay. Perfect. And then, just anything on order trends in the Middle East? I know you said 2Q was strong in terms of revenues, orders, presumably then tracking with revenues.

Andrew C. Teich - President, Chief Executive Officer & Director

Yeah, so I mean thematically, the demand there continues to be high, interest level and demand continued to be high as a result of the relevance of our intelligence, reconnaissance targeting and explosives detections technologies are I think quite relevant and our CDMQ model, thematically, I think is quite well received by customers in the Middle East, and we're spending a lot of time right now. We're quite strong in border surveillance platforms, and then, airborne ISR platforms in the Middle East.

The wild card there is it's just, it's a market that's very difficult to predict. Timing is – it's the most challenging market that we deal with in terms of predicting timing, but that said, we're reasonably bullish on the performance that we'll see out of the Middle East in the second half.

Michael F. Ciarmoli - KeyBanc Capital Markets, Inc.

Got it. Thanks a lot, guys.

Operator

Thank you. Our next question comes from Noah Poponak with Goldman Sachs. Please state your question.

Noah Poponak - Goldman Sachs & Co.

Hey, good morning, everyone.

Andrew C. Teich - President, Chief Executive Officer & Director

Good morning, Noah.

Noah Poponak - Goldman Sachs & Co.

What's the right long-term segment operating margin range that an investor should expect to see for FLIR?

Andrew C. Teich - President, Chief Executive Officer & Director

We expect the long-term range to be in the low 20%s.

Noah Poponak - Goldman Sachs & Co.

Okay. Got it. The $20 million of international that's left that you mentioned, I may have missed it, but did you – can you provide more detail on exactly what that was and when you get it?

Andrew C. Teich - President, Chief Executive Officer & Director

Well, fundamentally, we have revised our export licensing practices, tightened those up and added some additional documentation and process to that, and that's an effort that Todd has been heading up, that was carried out in Q2, and it had some aberrations in terms of the delay of the receipt of export licenses for international customers and that's revenue that won't go away. It's revenue that will come back into the plan in the second half of the year, but it was an aberration for us in terms of our normal cadence of the execution of international revenue.

Noah Poponak - Goldman Sachs & Co.

Do you have any of it yet in July?

Andrew C. Teich - President, Chief Executive Officer & Director

Yes, some, but I don't have it quantified. There were some licenses that were delayed from Q2 and they have been received in July.

Noah Poponak - Goldman Sachs & Co.

Would you expect to have all of that in the third quarter or the majority of it?

Andrew C. Teich - President, Chief Executive Officer & Director

Yes. The majority of it, we'll get back in the third quarter.

Noah Poponak - Goldman Sachs & Co.

Okay. A few questions ago, when you were saying highest growth came from the Middle East, and then, it was up 10%, was that a total FLIR or a government growth rate?

Andrew C. Teich - President, Chief Executive Officer & Director

That's total FLIR.

Noah Poponak - Goldman Sachs & Co.

And could you speak to just the government growth into the Middle East in the quarter or the first half?

Andrew C. Teich - President, Chief Executive Officer & Director

I'll have Shane look at it.

Noah Poponak - Goldman Sachs & Co.

Okay.

Shane R. Harrison - Senior Vice President, Corporate Development and Strategy

For the quarter, Noah, Middle East, for Surveillance, we have the detection business as well, but for Surveillance, which I think is the crux of the question, it was up...

Noah Poponak - Goldman Sachs & Co.

Yeah, it is.

Shane R. Harrison - Senior Vice President, Corporate Development and Strategy

...it was a little over 5%. And for the year...

Noah Poponak - Goldman Sachs & Co.

Up 5%?

Shane R. Harrison - Senior Vice President, Corporate Development and Strategy

...yeah, 5%. For the year, I'll have to crunch in some numbers here.

Noah Poponak - Goldman Sachs & Co.

Okay. And then, last thing I wanted to ask, do you guys have numbers on – I know you have a partnership with DJI in the commercial unmanned world. Do you know how many units you're selling in that business and how it compares to how many units are sold in that entire end market and what, if there's any penetration rate you are thinking of as reasonable in that product?

Andrew C. Teich - President, Chief Executive Officer & Director

Yeah. So we do – I mean we know exactly what we're selling in that space, but I don't want to go to that level of fidelity on unit volumes. But I can tell you a couple of important factors here. In terms of the number of thermal imaging cameras that are being flown on drones, both commercial and military today, I mean we dominate that space by a long shot. And we not only have a relationship with DJI, but we have a relationship with several of the other leading commercial drone manufacturers today. In fact, most commercial drones that are being flown today with thermal cameras on are being flown with either the FLIR Vue Pro or the DJI FLIR Zenmuse XT.

Growth in that business has been quite strong and the penetration is extraordinarily low. As a percentage of the total number of commercial drones that are being sold today, it's still quite a small number, but we expect that to continue to grow through three potential initiatives here.

One is this product expansion line. So we're expanding the product offering there to be beyond the current product offering, which is primarily Tau-based. So we'll be adding in Lepton-based platforms as well. We've just added radiometric capability, which is remote temperature measurement capability in the FLIR Vue Pro R and that will get expanded across other manufacturers as well. So temperature measurements can be done.

And the third issue is the back-end software processing. So at the end of the day, these drones get the cameras in the air and the cameras capture images, but ultimately, what you do with those images is really where the value gets delivered. So the ability to create 3D Orthomosaics and how those be radiometrically calibrated are important characteristics for that market and we've been working very aggressively both independently and with partners to develop that capability and we'll have more to talk about that during the second half of the year.

Shane R. Harrison - Senior Vice President, Corporate Development and Strategy

Noah, the year-to-date, Middle East is similar. It's up about 6%.

Noah Poponak - Goldman Sachs & Co.

Thank you.

Andrew C. Teich - President, Chief Executive Officer & Director

Thanks, Noah.

Operator

Ladies and gentlemen, that was our final question. I will now turn it back to management for closing remarks.

Andrew C. Teich - President, Chief Executive Officer & Director

Great. Thank you. I'd like to thank everyone for joining us on the call today. I'd also like to take a moment to welcome the employees of Armasight and ISD to the FLIR family. They join a dedicated team of more than 3,000 employees worldwide that are committed to our mission of becoming The World's Sixth Sense. I look forward to reporting our progress on that vision on the call next quarter. Thank you again for joining us today.

Operator

Thank you. All parties may disconnect. Have a good day.

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