FLIR Systems: What The Market Is Missing

Summary

• The market's sentiment around FLIR has been driven more by surface-level negative internal and external news than by deeper, evidence-based arguments and indicators.
• At this level, you're basically looking at investing in the company at 2016 prices, when the upsides mentioned here were absent.
• The analysis here shows why FLIR is an attractive investment at these depressed levels, and outlines the upsides the market seems to be ignoring or, at best, downplaying.

Since the start of the year, FLIR Systems, Inc. (NASDAQ:FLIR) has seen its stock go from around $52 to the current price of around $35, trading at a discount of 35% as of this writing. Heading into the Q4-19 earnings announcement at the end of February 2020, the stock hit highs near the $59 mark, only to drop dramatically to near the $25 level a month later. Since then, positive sentiment leading up to the Q1-20 earnings call pushed the stock back up near the $50 mark, eventually settling in the low $40s. After the Q2-20 call, however, the market again wiped out more than 10% of FLIR's market cap, with the stock now trading significantly below that level.

Source: Seeking Alpha

I believe the market's sentiment around FLIR has been driven more by surface-level negative internal and external news than by deeper, evidence-based arguments and indicators.

Thesis: The analysis below shows why FLIR is an attractive investment at these depressed levels, and outlines the upsides the market seems to be ignoring or, at best, downplaying. I believe investors are being excessively cautious about this stock and not seeing the long-term potential.

A Brief Look at Events Around FLIR's Q4-19 Earnings

When the Q4-19 earnings were released, the continued headwinds in the Commercial Business Unit played a major role in pushing the stock down in an unprecedented manner.

Source: FY-19 Annual Report - 10-K

Revenues from the unit had been on the decline since 2018, primarily due to the divestiture of the Consumer and SMB Security business. As of FY-2019, the unit posted a revenue decline on the back of "volume declines in the OTS business and Maritime product lines during fiscal 2019."

This was compounded by a continued less-than-optimal outlook for the unit through the end of FY-2020:

We expect the financial and operational trends we experienced in 2019 to persist into the coming year which is reflected in our 2020 outlook. In fact we view 2020 as a year of evolution in many respects. First we've reached end-of-life on large multiyear programs that provided solid revenue contributions over the past several years. Second the significant new franchise program wins we've recently announced are not expected to begin a meaningful ramp until 2021 and beyond.

The 1.5% decline in organic revenue growth and 51% decline in gross margins in FY-19 further exacerbated the problem. Furthermore, per CFO Carol Lowe:

Despite productivity gains achieved through The FLIR Method across all business units, margin was impacted by weaker end markets in our Commercial Business Unit coupled with the ongoing ramp of recent acquisitions.

So, the combined effect weighed heavily on the stock even prior to the full force of COVID-19 hitting global markets. The subsequent onset of the pandemic in the West was the straw that broke the camel's back, sending FLIR shares plummeting down to lows not seen since 2016.

Enter COVID-19

The cataclysm that is COVID-19 hit the western hemisphere hard and fast, but it was a godsend for FLIR. At a time when the company was reeling from revenue and profitability issues and its investments in autonomous and unmanned technologies weren't mature enough to have a material positive impact, the pandemic provided the perfect platform for top and bottom line growth.

As COVID-19 went on its initial rampage, the demand for FLIR's EST-related applications surged, putting it in the driver's seat for revenue growth in Q1-20.

EST products make it possible to rapidly screen people in high traffic areas. As the company noted at the Q1-20 earnings call:

Although these thermal cameras cannot detect or diagnose COVID-19, the cameras do serve as an effective tool to measure the skin surface temperature of people entering public areas such as hospitals, airports, train terminals, businesses and factories. In fact, we've been using our own technology to screen employees for EST when they enter our facilities. FLIR cameras have a history dating back to the SARS virus in 2003 and then H1N1 in 2009 of detecting elevated skin temperatures through screening.

In terms of revenues, it meant being able to post a 1.4% YoY growth rate at the top. Moreover, the resulting shift to a high-margin mix in the Industrial Technologies segment had only just started showing up at the end of the first quarter, when stay-at-home orders were being implemented in the U.S. and scaled-up EST testing was the need of the hour. The best was yet to come.

The timing was perfect for FLIR, and the stock gained as much as 70% between the post-Q4-19-earnings lows and Q1-20 earnings. It was now trading at a mere 15% discount to the highs set before Q4-19 earnings.

Unfortunately, the market thought it had overcompensated because of expectations around EST products. Soon after Q1-20 earnings were announced, the stock started declining again, eventually losing more than 12%.

At this point, we're at the beginning of June, and calls for defense budget cuts that started coming in a month before are getting louder. While it is historically factual that a dent in defense budgets only tends to come years after a crisis, the markets in general do not appreciate this "stickiness" of defense budgets:

... the 2008 financial crisis. Lehman Brothers collapsed just a couple weeks before fiscal year 2009 started, leaving that $666 billion defense budget largely beyond recall. The following years’ budgets were $691 billion, $687 billion, $646 billion and then finally in FY13 a more precipitous 10 percent fall to $578 billion. It took four years for the Pentagon to really feel the squeeze of the financial downturn.

Regardless, any news of potential budget cuts itself significantly impacts the stock performance of companies that rely heavily on defense contracts.

Data by YCharts

Of course, I recognize that news of budget cuts isn't the only thing moving these stocks, but it is nevertheless an important factor.

For FLIR, it was compounded by the not-forgotten problem of the Commercial Business Unit rearing its ugly head again despite the number of reportable segments changing from three to two when 'Project Be Ready' came into effect in Q1-20.

In the first quarter of 2020, the Company completed a business reorganization as part of its "Project Be Ready" restructuring plan which resulted in identification of two reportable segments (Industrial Technologies and Defense Technologies). The Company commenced operating and reporting under the new organization structure effective January 1, 2020.

Despite the commercial business now being embedded within Industrial Technologies, the negative effect of weak demand in the commercial segment made itself known:

Beginning with Industrial Technologies, second quarter revenue was $300 million, up 6% year-over-year, due primarily to the increased demand for thermal cameras for EST screening applications. Revenues were partially offset by lower volumes in commercial end markets, such as maritime and security products as a result of COVID-19.

The effect of low demand in commercial end markets was not able to fully offset the gains from EST products, but there were also other factors that affected the company's overall performance in Q2-20:

• "administrative-related process delays in securing customer sign-offs and licenses for foreign sales" in the Defense Technologies segment having impacted segment revenues by -8% for Q2-20.
• The withdrawal of guidance for FY-20
• The decision to not reinitiate share repurchases "for the foreseeable future"
• Lower demand expectations for EST products and solutions through H2-20

These factors put significant downward pressure on the stock since Q2-20 earnings, pushing it down nearly 10% to where it's trading as of this writing.

That's how I see investor sentiment having played out over the course of H1-20. However, at the current price point, I believe some significant upside factors may have been ignored or downplayed by the market. That's the next section of this article.

What FLIR has Done Right

In addition to the obvious move of maximizing its gains on the EST front, FLIR has also made some good moves that bode well for the future of the company, and, more immediately, of the stock. The problem is, the market is not buying it. Literally. And this is where the opportunity lies.

1. Deepening and Widening the EST Portfolio

In the absence of a vaccine for the novel coronavirus or a cure for COVID-19, rapid and accurate screening at high traffic points will remain a necessity. Admittedly, this is a short-term upside, but FLIR is doing everything to widen the scope and reach of its EST products, including releasing software updates, enhancing the hardware, launching new products, and even promoting the installation of its technologies at the Pentagon Visitor Center.

CEO Jim Cannon has already revealed that EST-related sales have slowed down since the initial surge, and that he expects demand levels moving forward to be lower than surge levels and more stable:

Towards the second half of the quarter, certain customers began shifting their behavior, opting instead to first implement our technology on a smaller scale to test their approach in advance of eventual large-scale enterprise-wide deployments. This more measured approach to deployment led to a deceleration of EST demand as the quarter progressed. As we look ahead to the second half of the year, we expect demand for EST applications to stabilize, likely at levels below what we experienced in the second quarter.

EST-centric revenues will remain an upside through H2-20, but there's also a hidden downside here that can only be mitigated if the situation with commercial end markets improve over the next two quarters:

The demand for our EST products in the first half of the year helped offset headwinds driven by the pandemic. Within the Industrial Technologies segment, we experienced weaker demand compared to prior year levels for our commercially centric businesses. However, we are cautiously optimistic about signs for those businesses that may indicate the start to a recovery in the second half of the year.

The improvement was hinted at by both the CEO and the CFO, Carol Lowe:

...we are cautiously optimistic about signs for those businesses that may indicate the start to a recovery in the second half of the year. - Mr. Cannon

...in the second half of 2020, as product mix begins to normalize with the recovery of commercially centric businesses and the slowdown of EST demand. - Ms. Lowe

Due to the restructuring of reportable operating segments, it will be hard to quantify the extent to which EST revenues will offset prolonged downward pressure in commercial, but what's clear is that EST revenues will continue to play a major role in driving growth over the next two quarters, possibly beyond.

One positive takeaway is that, as EST-centric revenues stabilize and gradually reduce over the next year or so, it could simultaneously indicate a recovery in commercial end markets, especially across FLIR's maritime and security products portfolios. The "significant order from a large OEM customer" for what is presumably the company's Neutrino QX or SX12 thermal imaging camera core (as shown in the image on Slide 6 of the Q2 presentation), could be one of the signs Mr. Cannon alluded to in the call.

As such, the risk of revenues declining in the Industrial Technologies segment is low, but margins will shrink again as the product mix retraces its pre-COVID-19 patterns, as indicated by the CFO. Overall, there's still an upside in terms of elevated demand for EST products in the near term. The market has clearly looked past the gains from EST and focused on weaknesses that the quarter has revealed.

2. Investments in Forward-looking Businesses that Represent Long-term Upsides

Unmanned

FLIR's unmanned products are relatively new to the mix. As such, while a few of them, like the Soldier-borne Black Hornet and the SkyRaider lines, are already accretive to line average gross margins, others like the ground robots are still dilutive. However, recent orders from the U.S. Army, Navy, and Marine Corps for Centaur UGVs totaling over $42 million for 300 units will help move FLIR toward the desired scale in ground robots as well.

Per several estimates, the UAV and UAS (Unmanned Aerial Vehicle and Unmanned Aircraft System) markets are expected to grow at CAGRs of between 15% and 25% to reach a combined size of nearly $50 billion over the next three to five years.

These segments are key drivers of growth for the thermal imaging market, which is expected to grow at a CAGR of over 6% between 2020 and 2025. FLIR, being one of the major players in this market with a large client base comprising military, industrial, and commercial customers, stands to gain significantly from this growth.

Autonomous

FLIR's second area of strength is thermal sensors for autonomous vehicles as well as the broader auto market in general. For vehicles that have ADAS or Advanced Driver Assistance Systems, thermal imaging has a strong use case for triggering AEB or Automatic Emergency Braking. Features like these all depend on imaging technologies, and FLIR is a market frontrunner in a lot of these segments.

If you look at autonomous vehicle technology, it's really nothing more than a composite of various ADAS 'building blocks', and as a Tier 1 provider of imaging technologies to some of the world's largest auto manufacturers, FLIR stands to gain from the rapid development of vehicular autonomy over a long-term horizon. From the Q2-20 call; Mr. Cannon answering an analyst's question regarding ADAS initiatives over a 2- to 3-year time frame:

Longer term, through the second quarter, we saw a lot of continued and very aggressive R&D efforts across the board, whether it's with some of the larger autonomous driving customers, we can't name by name, but we formally signed partnerships with to be their thermal provider, studying how thermal is integrated with other sensor solutions and such, whether it be with robo taxi companies or as I mentioned earlier, what I'm really excited about is current auto manufacturers looking at things like automatic emergency braking. And all of the conditions, whether it be sun glare, low light conditions, et cetera, where existing technologies and sensors to initiate AEB are not effective, but thermal very much is. So we're really encouraged by the kind of R&D effort and customer engagement we've had through the second quarter on that front.

Positioning itself as one of the strongest Tier 1 suppliers to autonomous vehicles is, in and of itself, a high-potential upside for FLIR in the long term.

3. Maintaining an Adequate Liquidity Position

As far as the books are concerned, FLIR is in good shape. Total debt as at the end of the second quarter was reported at $847 million, while the current liquidity position comprises $333 in cash and cash equivalents and an additional $365 million in available credit facilities. The interest coverage ratio stands at around +9x and, as at June 30, 2020, the company has complied with the credit agreement financial covenant that requires maintaining a consolidated total leverage ratio.

In terms of cash flows, net cash provided by operating activities was down by $4.6 million to $63 million for Q2-20, "primarily due to less favorable timing of working capital changes partially offset by higher net earnings after adding back non-cash adjustments."

Investor's Angle

As for revenue recovery, the company has already seen signs of it during the second quarter and remains confident that it will continue through the remainder of the year. Per Ms. Lowe:

As Jim noted, we believe our core Industrial and Defense Technologies businesses are showing signs of recovery. We anticipate this recovery will continue during the balance of the year and we are experiencing record backlog as we move forward in the second half of 2020.

The current portion of the $913 million backlog is about 80%, or $731 million, which is 9% up from the prior period. While this alone doesn't indicate a revenue turnaround in the short term, of note is the fact that bookings are up nearly 20% YoY to $546 million, which pushed the Defense Technologies segment's book-to-bill ratio up to 1.17. The backlog in defense is marginally down for the quarter but up by nearly 50% in Industrial Technologies.

Unmanned volumes are growing at a steady rate, adjusted gross margins will remain at elevated levels, albeit marginally lower than during Q2, and share repurchases, although suspended for now, have contributed significantly to the +23% increase in EPS for Q2-20.

A Brief Note on Broader Economic Recovery

While FLIR has already started seeing signs of recovery, a broader resumption to normal levels of economic activity could take much longer.

It's certain that recovery will come, as it does after every major financial crisis in the past; the point of uncertainty is the time frame and shape of that recovery.

Various recovery models have been proposed, with the V-shaped recovery being the best-case scenario and the L-shaped one being the worst. But some experts like Dr. Tenpao Lee, Professor of Economics at Niagara University, feel that recovery from the pandemic will be quick if appropriate action is taken to deal with it now:

Once we are in recovery mode, the recovery will be very fast as global supply chains could be reconnected instantly.

If we are able to contain COVID-19 quickly, we will have a V-shaped recession. If we are not able to contain COVID-19 in the near future, we will have a U-shaped recession.

Others, such as Robert Johnson, professor of finance at Creighton University, aren't that optimistic:

Americans may end social distancing prematurely and that a secondary outbreak of coronavirus could force another round of social distancing, stalling the recovery.

The recent rise in the equity indices appears based more on FOMO (fear of missing out) than on medical developments for dealing with the pandemic.

What's of immediate concern is that nearly all experts point to dealing with the pandemic as the key determining factor for what shape the actual recovery may take. And the scenario in the U.S. is less than encouraging. An opinion piece in Time magazine this month talks about America's failed response to the pandemic:

At this point, we can start to see more clearly why the nation has foundered so miserably. A failure of political leadership at all levels; a distrust of scientists, the media and expertise in general; and deeply ingrained cultural attitudes about individuality and the values placed on life have all combined to result in a horrifically inadequate pandemic response compared to what are traditionally considered the U.S.’s peer nations.

At the risk of being optimistic, even in the midst of this crisis, FLIR appears to have a solid foundation for long-term growth while having the financial strength to withstand a prolonged contraction on the commercial side of its business. Besides, at this level, you're basically looking at investing in the company at 2016 prices, when the upsides mentioned here were absent. For a not-insignificant player in the sensor and imaging market, this is probably as good as it will get.

The general trend of the stock since Q1-20 results were announced has been downward, which indicates that a further decline may be on the books. The stock seems to be sensitive to news right now. For that reason, add to your position in several tranches. Do this in order to take advantage of any further declines, while still getting in at a significant discount to pre-COVID-19 levels to maximize future total returns. The dividend looks safe for now, and it is in the company's best interest to keep returning cash to shareholders through this channel in the absence of share repurchases for the foreseeable future.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.