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FLIR Systems (NASDAQ:FLIR)

Q1 2012 Earnings Call

April 27, 2012 11:00 am ET

Executives

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

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

Andrew C. Teich - President of Commercial Systems

William A. Sundermeier - President of Government Systems Division

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

Analysts

Michael S. Lewis - Lazard Capital Markets LLC, Research Division

Noah Poponak - Goldman Sachs Group Inc., Research Division

Timothy J. Quillin - Stephens Inc., Research Division

James Ricchiuti - Needham & Company, LLC, Research Division

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

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Josephine Lin Millward - The Benchmark Company, LLC, Research Division

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

Operator

Good morning. My name is Delina, and I will be your conference operator today. At this time, I would like to welcome everyone to the FLIR Systems First Quarter Financial Results Conference Call. [Operator Instructions] I'd now like to turn the call over to our host, Wit Davis, Senior Vice President, General Counsel for FLIR Systems. Sir, you may begin.

William W. Davis

Good morning, everyone. Before we begin this conference call, I need to remind you that other than statements as to historical facts, statements made on this conference call are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and are based on our current expectations. Words such as expects, anticipates, intends, believes, estimates, and variations of such words and similar expressions are intended to identify such forward-looking statements. All of these statements are subject to risks and uncertainties that could cause actual results to differ materially.

Please refer to the press release we issued earlier today for a description of factors that could cause actual results to differ materially from those forecast. The forward-looking statements we make today speak as of today, and 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 Earl Lewis, Chairman and CEO of FLIR Systems. Earl?

Earl R. Lewis

Thanks, Wit. And good morning, everyone, and thank you all for joining us today. As we anticipated, our first quarter 2012 financial results were soft. Revenue for the quarter was impacted by lower sales to the U.S. government as well as in Europe and in the Middle East. While our top line continues to be impacted by governmental budget and economic uncertainty, we were able to maintain overall gross and operating margins at levels very close to our first quarter 2011. We maintained a healthy level of R&D investment of 10.5% of revenue as we focused our development efforts on some exciting opportunities that we feel will yield growth and profitability long into our future.

Selling, general administrative expenses declined by 6% compared to last year as we worked to gain efficiencies and optimize our sales activities. When we met last November at our annual analyst investor day, I mentioned that we are focused on producing instruments that provide people with valuable information, and that have an established -- and that we have an established model that allow us to produce them at lower costs. The strategy is still very much intact, and I am convinced it will not only help us grow and provide value to our shareholders but will also improve the world around us by saving energy and protecting people. We've only scratched the surface of beginning -- bringing these technologies to the world. Because of that, I'm excited today to be where we are.

We'll now let Bill and Andy talk, we will start with Andy and the Commercial business.

Andrew C. Teich

Thanks, Earl. The Commercial Systems division finished the first quarter with revenue of $202.3 million, growth of 4% over the first quarter of 2011. Overall division operating margin was 21.3%. Our TVM segment grew revenue at 7% over the prior year reaching $155.7 million. While revenue growth was slowed by lower end -- by lower high-end Thermography, security and Cores sales, unit growth of the TVM cameras and systems were strong at 34%.

Raymarine revenue for the first quarter was $46.6 million and the operating margin was 8.2%. Raymarine saw a good growth in the U.S. and Raymarine new products are being well received. But while we increase the number of OEMs in Europe, their volumes have been down, which has weighed down our international results.

Turning to our bookings for the quarter. TVM segment bookings dollars declined 4% versus the prior year. This decline was driven largely by the European and APAC regions while bookings in the Americas improves compared to last year.

From a product line perspective, worldwide orders for our premium Thermography cameras, those with price points typically above $20,000, declined over 20% compared to Q1 2011, while our lower-priced and new E-Series and automation products performed very well.

Course and Components bookings increased in units by nearly 60% but declined on a bookings dollars basis due in part to fewer high-end cooled products. The growth in units booked during the quarter illustrates continued progress in growing volume, particularly in the uncooled segment.

Security bookings grew rapidly with dollar bookings up over 25% and unit bookings up 230%. Emerging markets such as critical infrastructure protection and commercial security has driven volume growth in our uncooled security products. We are also seeing expansion in the adoption of high-end cooled security products for mostly border protection solutions towards a more diverse set of customers and applications that protect infrastructure such as bridges, dams, power facilities and other high-value assets.

Our FLIR branded maritime products saw a 30% increase in bookings in the Americas, but the EMEA and APAC regions slowed compared to a strong comp from last year.

Once again, our Personal Vision Systems business grew significantly over the prior year with bookings dollars up over 70%. A significant aspect of this business is its focus on consumer applications and retail distribution and, interestingly, the areas of significant strength for PVS in Q1 were the international markets, where our strong channel development over the last 18 months has delivered a trend that is contrasting we've been seeing in many of our other businesses. In fact, our EMEA region booked more dollars during this first quarter than our America region, which is the first since we've introduced this new line of PVS products.

Turning now to Raymarine. We saw first quarter bookings dollars decline by 1% versus the first quarter of 2011 with weakness in the EMEA and APAC regions. Given the weakness in the European boat sales and the fact that the Raymarine EMEA region is more heavily skewed towards the OEM market, a decline in that region was not unexpected.

The Americas regions largely offset these declines with over 20% growth in bookings dollars this quarter compared to the first quarter of last year. We introduced some new products in February, including the larger format E and C-Series color multifunction displays, a broadband CHIRP depth sounder and a new line of high definition color radars. With these and other releases, coupled with the improved operational structure of the business, we're optimistic on the outlook for Raymarine for the rest of the year.

We see the expanding adoption of thermal technology every day as demonstrated by our focus on creating new applications in, and the relatively quick adoption rates of, non-border security, automated temperature monitoring and outdoor recreation. As an example, we recently induced the combination thermography and surveillance pan-tilt products called the A310PT that enables temperature measurement and security of high-value electrical substations. This product has garnered the attention of some large utilities, and we've booked over 100 units to date.

Continuing on the new product front, we also introduced the next generation of our popular I-series line of volume Thermography cameras and are excited to see the market response to the new look, feel and functionality of these cameras. We also recently introduced the T420 and T440 professional grade Thermography cameras, which include our new patent pending multispectral dynamic imaging algorithm, that applies high fidelity details from a visible image to a corresponding thermal image in a way that improves the depth and texture of the thermal image and gives the user the ability to do much more with an image such as read text, signs and equipment labels normally not visible in the infrared spectrum. This technology, which we have branded MSX, is one of the important breakthroughs I have seen in my nearly 30 years in the thermal imaging industry.

Organizationally, the CS division continues to rationalize the benefits of combining our former CVS and Thermography segments into 1 PVM segment. At the begin of this year, we've made some adjustments to our U.S. and APAC sales organizations that we hope will mirror the improvements we've made in the EMEA region in late 2010.

These changes in our go-to-market strategy took a few quarters to bear fruit, but we feel should yield to improve results in the second half of this year.

With that, I'll end my review of the Commercial Systems division, and we'll pass the call to Bill Sundermeier, who will discuss the results of our Government Systems division. Bill?

William A. Sundermeier

Thanks, Andy. Despite a difficult global budgetary environment, Government Systems division's bookings increased by 20% sequentially over the fourth quarter of last year. As expected, we saw a decline in revenue and profitability during the first quarter when compared to the first quarter of 2011.

Our focus continues to be on improving bookings to strengthen our backlog, and we made progress in that area during the first quarter. While domestic procurement remains sluggish during the quarter, we saw increased demand in order flow from international customers.

Total Government Systems division’s 12-month backlog finished the first quarter at $312 million, down just slightly from the end of 2011 and book-to-bill was 1x. Divisional operating margins declined 1.5 percentage points over the first quarter of last year to 25% due largely to the decrease in revenue after cost reductions that were put into effect last year.

Focusing first on the Surveillance segment, I'd like to point out a few of the significant wins we received during the quarter. The Persistent Ground Surveillance System, or PGSS program, with the U.S. Navy, yielded another 14-unit order under the IDIQ we won last summer. To-date, the U.S. government has ordered over 100 FLIR gimbals over the life of the PGSS program with nearly all of those being our second generation full HD Star SAFIRE EO/IR sensors.

[Technical Difficulty]

And I'll jump back in here at the Surveillance segment, where I was talking about the Persistent Ground Surveillance System or PGSS program. The U.S. Navy yielded a 14-unit order under the IDIQ we won last summer. And to date, they've ordered over 100 gimbals from us, and those gimbals are pretty much all our full HD Star SAFIRE EO/IR sensors. And we received another order from the U.S. Marines NSYS contract for UH Yankees. And that one was for nearly $7 million of BRITE Star II gimbals.

As I mentioned earlier, international market showed renewed strength during the first quarter, particularly in our Middle East and European regions. We sold our first systems into Turkey in Q1 with the Turkish national police ordering 12 million of our 380-HD EO/IR sensors and over 3 million of our Recon handheld products. But yet another Turkish customer booked a sizable number of our 380-HD gimbals to strengthen their ISR capability.

A Saudi Arabian agency put in orders for $8 million worth of soldier and vehicle level solutions, and the Canadian government placed a sizable order for our dual band rifle Night Sights.

Our Detection segment ended the first quarter with $24.7 million in backlog, which is roughly equal to the end of 2011. We have been making some significant enhancements to the selling organization and sales processes and detection, with a focus on product sales and an expansion of our international sales teams. These changes are only beginning to bear fruit. We've had some noticeable order activity during the first quarter with an order for over 200 of our IBAC bio-aerosol detection units to an OEM, as well as an order for over 1.6 million for the underwater versions of our identiFINDER radiation detectors. Our exclusive and radiation handheld units continue to do well worldwide. And particularly, in the Middle East, the reception of our new handheld products have been encouraging. With positive budget signals in the suburban [ph] space and the continuing evolution of the operating model, I am pleased with the direction of our Detection segment.

Integrated Systems finished the first quarter with $45.2 million of 12-month backlog, up $3.6 million from the end of 2011. Order growth was driven by several key initiatives including our J2 development program. We booked nearly $6 million under the program in the quarter. And we are confident we will meet the Army's requirements for performance and reliability on J2 based on testing to date and anticipate reaching production next year. Integrated system software capabilities won us nearly $4 million contract for command-and-control system for the Port Mann Bridge outside of Vancouver, British Columbia. We also continued our wide area surveillance success with airports by booking the Riga Airport in Latvia. We also booked our first integrated system sale into Latin America with 10 of our SkyWatch towers ordered by a national police force.

In all, the quarter was mixed, continued global military spending reductions and budget uncertainty was countered by some strong wins and promising activity for the future. Detection and Integrated Systems are beginning to adopt the FLIR operating model and have some very promising opportunities on the horizon.

And finally, I'd like to acknowledge our employees who have done an amazing job at maintaining their diligence and focus as these temporary headwinds persist. The ability to control our cost, innovate great products and ensure top quality and service are all hallmarks of FLIR and will keep us ahead of our competition long into the future.

I'll now pass the call over to our CFO, Tony Trunzo, to discuss the financial results in more detail. Tony?

Anthony L. Trunzo

Thanks, Bill. First quarter consolidated revenue was $348.5 million, a decrease of 7% compared to $376 million in the first quarter of 2011. Commercial Systems division first quarter revenue increased by 3.5% to $202.3 million. The Thermal Vision and Measurement segment posted first quarter revenue of $155.7 million, an increase of 7% compared with the first quarter of last year. TVM revenue growth was the result of strengthened Personal Vision systems, uncooled security and volume Thermography cameras offset by slowness in premium Thermography cameras and general weakness in European markets. Raymarine revenue declined 8% compared to Q1 of last year to $46.6 million as strong sales of recently introduced products was more than offset by significant weakness in the important European market.

Government Systems Q1 revenue was $146.1 million, a drop of 19% compared with $180.5 million in the first quarter of 2011. Surveillance segment revenue was $114.6 million compared to $149.9 million in Q1 of last year. Continued slow demand from key U.S. government customers as well as lower deliveries to Middle Eastern markets were the primary reasons for the lower revenue.

Detection segment revenue increased 8% in Q1 to $19.4 million, driven by increases in product revenues, particularly chem/bio monitors, offset by a decline in nonstrategic contract R&D. Integrated Systems segment Q1 revenue was $12.2 million versus $12.7 million in Q1 of 2011

International revenue was 42.9% on the consolidated total in Q1, down from 47.8% of revenue last year, reflecting slowness in the EMEA region. International sales made up 51.9% of Commercial Systems revenue in Q1 compared to 60% in Q1 last year, while 30.4% of Government Systems revenue came from outside the U.S. compared to 34.6% last year.

Total sales to the U.S. government were 28.3% of the total in Q1, down from 31.5% of revenue in the first quarter of last year.

Consolidated gross margin was 52.4% in the first quarter, essentially unchanged from last year. Consolidated operating income was $68.3 million compared with $76.3 million in the first quarter of last year and operating margin was 19.6%, down 70 basis points from 20.3% last Q1.

First quarter operating income in Commercial Systems was $43.2 million, a 3% decline compared with Q1 of last year. Thermal Vision and Measurement posted $39.3 million of operating income, up 6% from last year, while Raymarine operating income of $3.8 million was $3.6 million lower than last year due to higher operating expenses associated with changes to the European sales organization from costs associated with the building boom.

Despite difficult market conditions, we expect Raymarine's profitability to improve significantly for the rest of this year as costs come down and new products flow into the market.

Government Systems operating income was $35.9 million for the quarter compared with $47.1 million last Q1. Surveillance segment operating income was $34.9 million, down $16.4 million from last year. SG&A expenses in Surveillance declined by 8% in dollar terms due to cost reductions taken late last year in continued cost containment, and segment gross margin was stable.

The Detection segment performed very well in Q1 reporting operating income of $1.4 million compared with an operating loss of $3.9 million last year. The improvement was due to much lower SG&A expenses and the roll-off of $2.1 million in acquisition related inventory charges recognized in Q1 of last year.

Integrated Systems lost $400,000 in the quarter, roughly flat with Q1 of 2011.

Earnings before interest, taxes, depreciation and amortization and stock compensation in the quarter were $88.4 million compared with $101.2 million last year. Interest expense during the quarter was $3.1 million, an increase of $2.7 million from last year due to the $250 million in 5 year notes we issued last August. Our tax provision for the quarter was 24.7% [ph] of pretax income compared with the Q1 2011 provision of 31.5% of pretax income.

Cash flow from operations for the quarter was $49 million, representing 102% of net earnings. During the quarter, we repurchased 1 million shares of our common stock at an average price of $25.39 and paid dividends totaling $10.8 million.

Capital expenditures for the quarter were $12.9 million.

That concludes the summary of our first quarter financial results. Let me now turn the call back to Earl.

Earl R. Lewis

Thanks, Tony. And while this quarter was not about what we -- was about what we expected in terms of performance, it's not up to our overall standards. We have done and will continue to do a lot of work to position ourselves for growth by controlling cost, optimizing gross margins and invest in new products and markets. We are looking for our financial performance to improve in the second half of this year as all these initiatives take hold.

And with that, operator, we're ready to take questions. I hope the webcast people are back on.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Michael Lewis.

Michael S. Lewis - Lazard Capital Markets LLC, Research Division

Tony, I had noted a comment in the press release where you stated that some activity moved from discontinued operations to continued operations on the P&L. Can you give us some information on that?

Anthony L. Trunzo

It was a tiny amount, Michael. We -- I think that the revenue that went back into the P&L for Q1 of last year was about $2 million. So when you compare the Q1 2011 reported results with the Q1 2011 comparison that you're seeing today, revenue is up about $2 million because there were 2 pieces of PBA and 360 that we decided we wanted to keep, and we pulled them back out of discontinued operations in Q2 of last year, I believe. The operating income effect was basically nothing.

Michael S. Lewis - Lazard Capital Markets LLC, Research Division

Okay, got you. And as we look at the weighting of revenue from the first half to the second half, how should we think about that as a percent of the full year? Will it be, say, a 60:40 mix second half the first half, or something else other than that?

Earl R. Lewis

Pretty close to what we've been doing. But I think we'll see the government be a little bit more in the second half.

Anthony L. Trunzo

Yes. Clearly, second half is going to be bigger than first half, Michael. I don't know that it would skew all the way to 60:40, but clearly, the second half is going to be a larger revenue quarter than first half.

Michael S. Lewis - Lazard Capital Markets LLC, Research Division

Okay. And one final question for Andy. Last quarter, you talked about the introduction of 9 and 12-inch E-Series systems. How are they tracking? And are you seeing more momentum in the North American market versus, say, Asia Pacific?

Andrew C. Teich

Yes. First of all, they're been doing very well. Those products have been very well received, and we exceeded our target in terms of the number of units that we wanted to ship in the first quarter fairly significantly, so we're quite pleased about that. So not only have the products done well from an introduction standpoint, but they've done well from a production standpoint, and that's being able to fulfill the orders quickly. In terms of the comments of the U.S. versus international, it's quite strongly different. So we saw a decline in the international region given that the boat builders there are building fewer boats, and we have a strong OEM presence. In the U.S. market, we saw a nice double-digit pickup in terms of bookings. And that was also bolstered by the introduction of those new products. So we're quite pleased to see those results from the U.S.

Operator

Your next question comes from Noah Poponak.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Question on -- if I heard the numbers correctly there, the surveillance operating margin in the quarter was 30%, a little more than 30%. That's down pretty significantly from where that was running last year. Can you talk about how you think that progresses through the rest of '12? And then, what the right 2 to 3 year margin is there?

Anthony L. Trunzo

Q1 -- I made the comment, Noah, that we've taken our SG&A down in dollar terms. I think it was down 6%. We're still taking SG&A out of that business, so the dollar spending will come down. And revenue was low. Revenue will come up in the subsequent 3 quarters, so you will see a recovery in the margin there. Gross margins were stable. And that's the encouraging piece of the overall puzzle for Surveillance. We're continuing operationally to do a good job. But frankly, the revenue number was a little softer than we had originally anticipated it being, and that resulted in a higher SG&A load relative to revenue. So we said that our target for that business is in the mid-30s. We did 40 points in Q4 of last year. We were pretty clear that that's not sustainable. But I think that a trend back up a few percentage points over the next few quarters is what you can expect.

Earl R. Lewis

Well, it is cyclical, of course. I mean we will see improvement as the volume goes up. And volume will go up.

Noah Poponak - Goldman Sachs Group Inc., Research Division

And mid-30s is the right medium to long-term number to think about there?

Earl R. Lewis

Probably annualized. That's about right. Yes.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Okay. Is it possible to tell us or just say what you think the organic revenue growth rate will be for total government and total commercial in 2012?

Anthony L. Trunzo

No, I don't think we have it.

Earl R. Lewis

I don't know if we got that handy.

Noah Poponak - Goldman Sachs Group Inc., Research Division

I don't mean to give you guys so much grievance with my questions.

Anthony L. Trunzo

No, no. It's a fair question. When we look at our revenue, we clearly got a forecast. Over the last couple of days, as we were going through it, I didn't ask for a breakdown, I don't think any of us did, of the organic revenue by customer segment. Not that we couldn't get it, we just don't have it calculated.

Noah Poponak - Goldman Sachs Group Inc., Research Division

Okay. And then just quickly, expectation for the full year tax rate?

Earl R. Lewis

27%.

Anthony L. Trunzo

Yes, the 27% that we booked up in Q1 reflects our expectation for the year.

Operator

Your next question comes from Tim Quillin.

Timothy J. Quillin - Stephens Inc., Research Division

So I think you expect that the bookings in the Government business, particularly the Surveillance business, will pick up in the back half of the year. And maybe VOSS and PIGS is part of the rationale there, maybe confirm that. And maybe talk about what are the factors that give you confidence in a pickup in bookings? And if the headwinds persist in the Government business, do you still think you're able to maintain gross margins? Or at some point, do you have to adjust your production capacity in a more meaningful way?

Earl R. Lewis

Right now, we don't believe we have to adjust our capacity in a more meaningful way at all. What gives us assurance, it's -- actually, we had yesterday a review by Kevin Tucker, who runs the Surveillance business. So every project and every order he's working on between now and the end of the year. And at the end of the meeting, we basically asked him, "Are you going to do this?" And he said yes. Beyond that, we can talk about every single program in our factory and of each one of them, Tim. But I don't know if it's doing any of us any good. Rely on the manager of the group, and he is pretty certain he is going to be able to do what he said he could.

Timothy J. Quillin - Stephens Inc., Research Division

And a similar question on the commercial side. So Europe's been a little bit weak, the premium cameras. And I think that's probably both on the Core side, and Thermography side have been a little bit weak. What gives you the belief that -- or do you believe that we'll see commercial growth accelerate throughout the year? And that would be the factors that would drive that?

Earl R. Lewis

Well, Tim, we think that the bookings side of the Commercial business will certainly improve in the second half of the year. And the factors that roll into that, part of it is continued new product introduction. So we've got new products staged for both the TVM segment and the Raymarine segment throughout the rest of the year. That gap between the volume segment and the premium segment in the Thermography business is kind of an important one, because in the way that we had introduced products, our E-Series product, it basically went up to about $8,000. And then we introduced the T600 product, which started at about $20,000. So there's a big gap between there that was filled with our older T300, T400 product line. And that middle product there did not have the feature set that the new E-Series, the new T600 had. And we've just launched a new T400 line that fills that gap in. And we think that that's going really help the premium segment, because those products that are booked in that T-Series line are all considered premium segment products. It's a very rich feature set. We've got this new MSX feature that's in there. And we think that that's going to draw the customers in, both from competition and from lower end products to help bolster Thermography bookings.

But there's other measures, too. I mean, we look at the number of quotes, of course. We look at the level of activity in terms of people asking for literature, et cetera. And you put all those things together, Tim, and come to a conclusion as to where it's headed. And those ratios are good.

Operator

Your next question comes from Jim Ricchiuti.

James Ricchiuti - Needham & Company, LLC, Research Division

Just a follow-up on that. So, Andy, the premium cameras, the softness you saw was also in the Americas as well?

Andrew C. Teich

Yes, it was.

James Ricchiuti - Needham & Company, LLC, Research Division

Okay. I mean is there any sense that there's any kind of structural change in the market, just given the products that you've come out with at the lower end of the market? Or you just feel this is really just an issue where you had a gap within the product portfolio that presumably, those products are now shipping on the T400?

Andrew C. Teich

Yes, they are. We launched them 2 weeks ago, and we have several hundred units of inventory on the day of launch. Distributors who placed orders received products the following Monday morning. To answer your question, I do think it's more of the latter. I think it's more of a fact that we have this gap in our product line. There's certainly some issue with capital spending. I mean, when you move up into the premium segment, it's a CapEx product. And it's possible that some of those budgets were set during a time when CapEx budgets were lighter than they have been historically. We do believe in the concept that a bigger base fills a bigger top. And that the very large number of iX products that we're selling are primarily new thermographers coming into the market for the first time, and those people are going to buy up over time.

James Ricchiuti - Needham & Company, LLC, Research Division

Okay. And one follow-up. The strength that you're seeing in the commercial security market, is that across all geographies? Are you seeing that kind of strength even in Europe, where, just in general, you got more economic headwinds?

Andrew C. Teich

So, first off, it was where we are seeing strength, we saw very good, very strong bookings in the Security segment in the APAC region. It's on a small base, but it was up more than a couple hundred percent. In the EMEA region, bookings in terms of dollars in the Security segment actually declined, but that is just a result of the prior year having still strong orders coming from the Border Security segment, which has been quite quiet. There are things that are cooking there, but we haven't had orders come to fruition there. So we're having to backfill those fairly high dollar value pool systems with lower dollar value uncooled systems. The good is that channel continues to build, and those volumes are going up very strongly, so we feel like we're building a base for the future there.

James Ricchiuti - Needham & Company, LLC, Research Division

In the Americas, it looks like you've got good strong demand in that region.

Andrew C. Teich

The Americas did very well in Q1 in Security.

James Ricchiuti - Needham & Company, LLC, Research Division

And last question. Bill, can you talk a little bit about the pipeline on the international side of the business? You saw some encouraging signs this quarter. How does the funnel for new business look?

William A. Sundermeier

Great questions. The funnel for new business as we look out for the rest of the year looks very strong internationally. By the end of last year, we had some issues with Middle East sales channel, and we've got these problems resolved, and we're moving forward there. I'm glad to see in Q1 we had -- back to business in the Middle East, and I see some more good opportunity in Q2 and Q3. So this quarter, it's certainly the low point of the year, and things are going to get -- continue to build in Q2 and certainly Q3 as well. So not only are we going to see international orders increase in the territories that we're at, but as you saw, we're really focused on new territories. And Turkey was a spot that we've been trying to penetrate for years. And you're going to see us move into other countries where we haven't before, not only in Surveillance [indiscernible] order out of Latin America where iX had never been before. We're going to continue to penetrate lots of new territories. So that's a market expansion and product expansion on our 2 areas that we're focused on.

Operator

Your next question comes from Nathan [sic] Jonathan Ho.

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

This is Jonathan Ho. I just wanted to, I guess, maybe touch a little bit on -- first of all, the MSX opportunity that you talked about, you seemed to indicate this is of significant importance. Can you tell us why and how quickly of an impact that's going to have potentially on the business?

Andrew C. Teich

So these is a feature that currently we have relegated to the premium segment. And it's really amazing. Like I say, in 30 years in this business, this has been a real wow moment for me to see what this technology does. Fundamentally, what it does is it takes high fidelity information from a visual image and blends it together in an intelligent way, an algorithm doing that with a thermal image. And it brings critical things that are missing from thermal images to light, things like texture, depth and, more importantly, the ability to read printing, so reading signs, reading labels. Frequently when an inspector is in a plant, he is looking at equipment that has labels on it, circuit breakers are labeled, motors are labeled, et cetera. And suddenly, you can read all those things in the thermal image. So in the past, people have captured a visual image and a thermal image and used those separately or done picture-in-picture modes or some type of blending. But frankly, none of those things really work very well. And this gives the thermographer what they really want, which is one image that has all the necessary information to make their decisions. So we've deployed this initially in the Thermography business. We've got patents pending on this technology. But I think you're going to see it make its way into other segments as well. I think it's got broad scale applicability for improving the resolution of thermal images.

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

Got it. And can you give us maybe a brief update on what's been happening in some of your distribution efforts? Notably I think a few quarters back, you guys talked about expanding the trial at Home Depot and other retailers.

Andrew C. Teich

So on the retail front, we continue to bring on large scale distributors, [indiscernible] refers to them as super regional so they're -- an example here in the Northwest is a company like Platt Electric. But there are examples of those, and the HVAC space, the electrical space, the mechanical, the MRO space. So we continue to push those. We still have not made demonstrable traction with retail at a Home Depot or Lowe's level. We continue to work those sectors, but have nothing significant to report there. We continue to run a rental program at Home Depot, and may look at some expansion there in the fall. We use the Test and Measurements business as a vehicle into the retail segment. So we're in places like Fry's, RadioShack, Sears. So we've got channels open there for subsequent product introduction. And that's really our thinking on that topic now.

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

Got it. And if I can have just one more on -- as we look at sort of the Government business, you talked about a few programs like, J2. What are your expectations around some of these large programs at this point? And how much of a driver can it be, especially if you're transitioning J2 from I guess development to production?

William A. Sundermeier

Sure, J2 was a significant program when we acquired ICS and still remains. If we look into the 2013 fiscal budget in the program and still as a program [indiscernible] $350 million. So we anticipate going into production next year, and they certainly have budget placed up for numerous years for that program. Chem/Bios still is a priority there, and I think that that's going to morph into a nontraditional engine program as well. So there's J2 will continue to be a strong force in the future as well as some variations on that program.

Operator

Your next question comes from Michael Ciarmoli.

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Maybe, Bill, can you discuss sort of how the 4-year planning, especially with the volumes ticking up, might be impacted by another continuing resolution in the back half of the year? I mean, we've had it for a couple years now, so I imagine you guys are used to that environment. But how does that enter into the planning equation?

William A. Sundermeier

So far this year, we looked at our forecast for the remainder of the year and had some really nice programs on the line for the remainder of the year. I think the thing that we're all interested in is sequestration, what happens there at towards the end of the year. Really, this year's plans are solid with our forecast and what we think is going to happen. So really, to me, the inflection point is what happens with sequestration and that really won't impact us until 2013 and our plans [ph] there. So we haven't -- we started thinking about what might happen if sequestration happens before 2013. But right now, our 2012 plans are quite solid, and we anticipated Q1 to be a slow quarter just because of the backlog that we have. We just couldn't push out anymore because of timing issues, but bookings should grow for the remainder of the year.

Michael F. Ciarmoli - KeyBanc Capital Markets Inc., Research Division

Can you maybe elaborate on, I guess, 2 points? Maybe what could happen under sequestration, and what your contingency plans are. And we've been hearing anecdotally that maybe contracting officials are rushing right now to spend any money they have not knowing what the fiscal '13 environment will hold. So is that -- are you seeing a meaningful uptick in bookings? Like, down the pipe, I guess, over the next quarter or 2?

William A. Sundermeier

I really haven't heard of any procurement folks rushing to spend their money other than Q3 is typically a big rush to spend. So I'm not sure that's going to happen. I think that it's probably wise for them to get their programs in place. Sequestration brings the total budget down another 10%, if you will, roughly, and it's more about Oconus, funding and kind of supplementals being reduced. We do a lot of quick book and bill because our company is really focused on quick delivery and not long-term programs. Some of the programs that we're focused on this year will be long-term, around [ph] the record, and that should carry us into the future. So sequestration, to us, means that we need to focus more internationally, and we've been good at that. And we'll see that resurgence happening here in Q1 in the bookings for the remainder of the year. So we try to be focus abroad to try and fill in some of that 10%, if that happens. Although I've met with my military advisory board just last week, and it could go either way. There's a lot of folks out there that think it's going to happen. It's inevitable. But the military is just not planning on it. If anything, it would seem to go into more of a slowing of procurement if sequestration happens. What's going to get cut and what's going to happen in that it might slowdown spending. But I'm hoping that, if that gets resolved, end of this year, we don't see a sequestration. I think that's what the military is hoping as well.

Operator

Your next question comes from Josephine Millward.

Josephine Lin Millward - The Benchmark Company, LLC, Research Division

Bill, what is your expectation of the U.S. and international mix with Government Systems this year?

William A. Sundermeier

The mix, I think, will trend towards 50:50. And I think we've been kind of 60:40 in the last 4. But I'm hopeful we'll quite make 50-50 international and the U.S., but we might [ph] be shy of that.

Josephine Lin Millward - The Benchmark Company, LLC, Research Division

Okay. Can you give us an update on the Air Force A29 contract, since it was successfully protested and canceled? Did you take that out of your backlog? And when do you expect to recompete decision on that?

William A. Sundermeier

Sure, Josephine. We have never received an order for the A29, so it wasn't in our backlog. Embraer has been a great partner for us in the long time. [indiscernible] bright star Super Tucano. So it was a great -- it was the right choice. Unfortunately, Beechcraft's [ph] delegation got a hold of that program, and Air Force cut it up. But anyway, it was never in our backlog. We never did receive an order for that.

Operator

Your next question comes from Jeremy Devaney.

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

A couple of questions for you on assumptions underlying guidance here. What would you say your base macro case is that's supporting the current guidance? Is it for global GDP improvement or is it for EMEA strengthening? Or what sort of are you seeing there?

Earl R. Lewis

Macro case. I'm not sure we could say we have a macro case. We look at each division. We talk to each division manager, review all of the forecasts that they put together. And I mean, will the euro go to hell? It's probably not in our forecast. Will the economy improve slightly in the U.S.? That's probably in our thinking. Will we improve our operating cost? Yes, that's in our thinking. I don't think I can give you a 40,000-foot macro guidance, I guess.

Andrew C. Teich

Jeremy, I guess, I would say that from the standpoint of what has to happen in the economy for us to meet our plan, certainly not expecting a huge recovery. I think there's still a fair bit of concern across our commercial division about what's going on in Europe. I think our Raymarine team, Tom Surran's, got some caution about recovery in Europe in there. You just saw today that the U.S. economy grew a little slower in Q4. I don't think there's a lot of optimism, expectation that -- I think there's an expectation that there's a lot of improvement. But as Earl said, we really tend to -- when we're testing our guidance, we tend to look more at what we see as our opportunity landscape and, frankly, our customer.

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

Earl, at the Investor Day, you'd commented that a 25% EBIT margin on a consolidated basis was definitely a possibility. Is that still within plan considering where we see EBIT margins posted today?

Earl R. Lewis

Yes. I think by the end of the year we'll be in that range.

Anthony L. Trunzo

Probably tough to get there for the totality of the year.

Earl R. Lewis

Exactly, yes. But each quarter, we suspect right now we should improve slightly.

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

All right. And then if I can get one more in there. Directionally, next quarter, do you expect weaker or stronger, and particularly looking at Raymarine with the extreme seasonality that we see between the first half and second half?

Earl R. Lewis

Raymarine will have a very strong Q2. And then they will taper off Q3 and Q4. And that's very much historical in -- way before we owned them.

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

And across the rest of the segments?

Earl R. Lewis

Across the rest of the segments, we're not forecasting great growth in Q2. We think Q3 and Q4 will be stronger in all the other areas. Q3, for example, is always very strong when it comes to government orders, and that's been historical. If you look at the Thermography business, that's always been very strong in Q4. When you average all these together, we see an improving landscape, Q3 and Q4, and with Q2 slightly better than Q1.

Operator

Your next question comes from Tim Quillin.

Timothy J. Quillin - Stephens Inc., Research Division

Just a couple quick questions. One, Andy, you'd -- I think maybe a couple years ago, had talked about what percent of the then commercial division systems consisted of government end markets. I'm wondering if you could say what percent of TVM revenue is exposed to government end markets. And then, Tony, what's the capital expenditure plans for the year?

Andrew C. Teich

So on the ratio, if I look at it, I don't have the number for all of TVM. If I just look within the Cores business, that number hasn't changed much, Tim. So that's been running fairly level. It runs at about a 70% level. And we look at that quarterly, and it, well, ticked down a bit in Q4. It kind of ticked back up to historical levels in Q1. And I don't expect that it's going to change a lot. We see some mixed shift between that between cooled and uncooled, which we saw this quarter, so we actually saw uncooled becoming more dominant.

Earl R. Lewis

Tim, I'll be a little careful there. Andy was referring that 70% to a subset, a very small subset of the total so...

Anthony L. Trunzo

Q1 U.S. government revenue, as you guys know, U.S. government revenue, teasing it out for us can sometimes be -- take a fair bit of focus because we're trying to trace through to the end customer. But it was less than 10% of Commercial Systems' total revenue in Q1. The vast majority of that, less than 10%, came out of the TVM business. And the vast majority of that would've come out of the old Commercial Systems business.

Earl R. Lewis

Commercial vision.

Anthony L. Trunzo

I'm sorry, Commercial Vision systems.

Earl R. Lewis

And then Even another level deeper is in Cores.

Anthony L. Trunzo

Right. So it comes out of Cores. But in the totality of the Commercial Systems business, it's less than 10% of revenue, Tim.

Timothy J. Quillin - Stephens Inc., Research Division

And CapEx, Tony?

Anthony L. Trunzo

CapEx? Well, we've scaled back our CapEx plan for the year, but it'll probably still be in that $12 million to $15 million a quarter range for the totality of the year.

Operator

Your next question comes from Michael Lewis.

Michael S. Lewis - Lazard Capital Markets LLC, Research Division

Totally lost me on that last question on the TVM.

Anthony L. Trunzo

Let's try it again. Let me try it, if I can. So in Q1, the total Commercial Systems business, you look at the Commercial Systems division, less than 10% of their revenue came from the U.S. government, okay? The vast majority of that 10%, the vast majority of that U.S. government revenue, came from a segment inside of TVM, which is our Cores business. We don't have very much U.S. government revenue in the old Thermography business. We don't have very much in the system side of our old Commercial Vision Systems business. And we don't have very much in Raymarine. It's focused -- it's really focused on a couple of customers in the Cores business.

Michael S. Lewis - Lazard Capital Markets LLC, Research Division

Okay, that's helpful. But my actual questions were going to be -- I missed the detection backlog number, Tony. And then just one more follow-up for Bill.

Anthony L. Trunzo

I don't think I gave you a detection backlog number, but we have one.

Earl R. Lewis

Yes, it was basically flat.

Michael S. Lewis - Lazard Capital Markets LLC, Research Division

Flat with year-over-year?

Earl R. Lewis

Quarter-to-quarter. Book-to-bill it's attached to [ph] was one. That's a nice way to look at it, Mike.

Michael S. Lewis - Lazard Capital Markets LLC, Research Division

Got you, okay. And then, Bill, just to close the loop on government services and the weakness in the quarter, were there any product deliveries that slipped from Q1 due to some POs that did not hit by the end of the quarter that may have hit and you've already delivered out in the second quarter? Or was this a scenario that do not play – it was not part of the issues that we saw in Q1?

William A. Sundermeier

That wasn't part of the issues in Q1. No.

Earl R. Lewis

Operator, I think we're actually a little past our time. Is there a large queue of questions or not?

Operator

No, sir.

Earl R. Lewis

Then I think we'll end. And thank you all for calling in this morning. We look forward to talking to you about Q2 in 3 months.

Operator

This concludes today's conference. You may now disconnect.

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