FLIR is the world market leader in thermal imaging. The company was founded in 1978, and designs, manufactures, and markets sensors capable of reading and measuring infrared energy or heat signatures across a variety of applications. The technology is not new, but FLIR has been on the leading edge of expanding its uses and reducing its cost. Whereas once it was limited to “thermagraphers” who owned devices costing tens and even hundreds of thousands of dollars and did contract work for those needing it, the technology is now cheap enough to allow mass adoption. This mass adoption has led to impressive growth at FLIR.

So, why would one want to measure the heat signature of an object? The technology has a multitude of applications from preventative industrial maintenance to veterinary science. For example, an engineer can measure and record the heat signature of a piece of industrial equipment, and note changes over time that indicate a weakening or degrading of performance of various components within the machine in question. An architect can measure the efficiency of insulation or the growth of mold within a building. A farmer can quickly scan a herd of cattle to check for sick animals. In short, the scanning of heat signatures can lead to cost savings for users.

While commercial applications have been growing, historically the most prevalent use of this technology has been in military/defense applications, and the US Government is FLIR’s largest customer. Again, historically these systems were large and expensive and thus limited to aerial or nautical platforms, but recent advances in the technology and reductions in cost have led to uses such as night vision (more effective than traditional night vision which relies on magnifying ambient light, heat based night vision can see through fog or smoke, and even through walls). Additionally, FLIR’s products can be integrated with other technologies like radar in order to add a level of intelligence to the operators experience.

Unfortunately for those who have owned the stock over the last year the growing federal budget deficit, the winding down of operations in Iraq and Afghanistan, and uncertainty surrounding future defense spending have led to a more than 40% decline in share price. Fortunately for potential new share holders, this may be a case of the baby being thrown out with the bath water as FLIR’s non government business continues to thrive.

High margins and ROEs show that FLIR is a good company.

However, the recent down turn in returns and margins begs the question is FLIR in a permanent decline or just the victim of a cyclical decline in military spending?

The runway for growth in use of FLIR’s commercial products remains long, and while they are not the only manufacturer of this technology, FLIR has a moat strong enough to ensure that they will continue to meet this need. While the usual moat associated with devices is present – ie users become accustomed to the interface etc and do not want to switch to a new product – the real moat comes from FLIR’s status as the market leader and the culture of the company.

As the market leader, FLIR is aware of how and why their customer’s are using their products, how these products can be improved, and how future needs can be met. FLIR’s integrated manufacturing capability can then be employed to develop the next generation of products to meet customer’s changing needs in a cost effective and time efficient manner. Competitors who do not have access to the same level of market intelligence and who are reliant on external partners for their manufacturing process cannot meet changing customer needs as effectively as FLIR.

The company further benefits from a cultural attitude which is encapsulated in the phrase, “Commercially Developed, Military Qualified.” In other words, the company does not produce goods that only have a military application – substantially everything they make is designed for use in civilian applications. They do not build products simply because the military has a contract out for bids and thus hamstring themselves with a “cost plus” payment model and government funded R&D as most defense contractors do. Rather they develop projects with civilian uses in mind and then apply them to military needs.

Current competitors in the space are defense contractors first, and only think of commercial uses as an after thought. As such, they do not have a distribution network on par with that of FLIR, and their culture is not geared toward cost efficient production as they typically put in a bid on a project and then build in a capped margin on top of the bid. Any production efficiencies that would ordinarily lead to a widening of this margin and increased profitability would lead to tax payer claims of government waste and a re-narrowing of the margin. Essentially, competitors are not incentivized to work as efficiently as FLIR is.

While critics point to the slow down in government related growth, commercial sales continue to grow, and the impact of government sales has been steadily declining.

While defense spending is cyclical and will surely come back at some point, for the near to mid term investment case the key questions become is FLIR a good company outside of defense applications, and are current prices over selling the decline in defense spending.

FLIR has recently been written up on both VIC and gurufocus.com so I will take a different less conventional approach to valuation. I suggest you follow up with the aforementioned articles for a view at a more traditional valuation.

With a long growth horizon in front of civilian applications and 18% CAGR in Non Government Revenues, it is fair (but not cheap) to put an 18x PE multiple on the non government earnings. Unfortunately non government earnings are not split out explicitly, so we will have to back into them by applying the company wide net margin to non government revs. As a margin of safety I will use a current net margin of 14% which reflects both the impact of reduced sales of high margin government projects, as well as the impact of low margin businesses that have recently been acquired such as RayMarine.

A P/E of 18% is equivalent to a yield of ~5.5%. If we are using this as our required rate of return, we can divide the 14% margin by 5.5% to back into a price / sales ratio that would be equivalent to a yield of 5.5%.

In other words, if $1 of sales leads to .14 of earnings, but I only need .055 of earnings, I would divide .14 by .055 to find out how much I would pay for $1 of earnings to get .055 in yield.

In this case, .14 / .055 = 2.52, so I would be willing to pay 2.52x revenues to get a .055 yield.

Applying the 2.52x price/sales ratio to 2011 non government revenues of $1,099,180, gives an estimate of intrinsic value estimate for the non government business of $2,770,000. I believe this to be a conservative estimate given that we used a lower than average margin that is impacted by low margin recent acquisitions in the midst of credible turn arounds and a multiple that fairly (not aggressively) values the companies growth runway.

As of today, the market cap is ~$3,300,000, which implies the government business is worth a touch over $500M, or a bit over 1x sales. If we assume that the excess net cash that the company has on the balance sheet is all attached to government business and we back it out, the government business is valued at more like .5x sales.

At .5x sales the government business is valued at only around $225M – this is a very cheap price to pay for a segment that is seeing a cyclical decline, but is surely not going away. Additionally, i believe that many of the company’s products will not be as affected by a decline in defense spending as one might think. It is clear that the future of the US military will be in line with the “Rumsfeld Doctrine” of a smaller, more technology advanced and highly trained force. Applications such as night vision, heat scopes, and other FLIR products that are small ticket items on the individual level will be less impacted by defense cuts than big ticket items like planes and tanks.

In summary, at current prices investors are paying a fair price for a growing commercial business, and a cheap price for a government business that is in cyclical decline, but is not going away any time soon. Other kickers include a history of share buybacks, and management owning a significant chunk of the business.

Disclosure – long FLIR