TheSecurityAnalyst

We know most industry (and all financial) observers’ eyes glaze over when we talk about standards.  But there is something going on in the video industry that may just be very important.  Yesterday May 12, a consortium of Axis Communications, Sony and privately-held Bosch – three of the leading names in video surveillance, formed a group aimed at developing a standard for the interface of network video products. Currently, while there are video compression standards (MPEG-4, and the new H.264), there is no global standard defining how network video products such as cameras, video encoders and video management systems should communicate with each other.

This is potentially huge for the growth of the video market, even though it may cost some manufacturing companies with proprietary technologies some well-guarded revenues.  Yes, we have seen the Government begin to create “standards” with the HSPD-12 program and its related FIPS 201 standard.  And perhaps more important, the Security Industry Association (SIA) is actively promulgating a set of standards (OSIPS) for video and access control.  However, it is one thing to have government and industry groups saying what should be done, and it is another for the very companies that usually fight standards in the security industry – the manufacturers – to get together to push them through. 

The big winners – if these standards are accepted – are (1) “the market,” which can be expanded just as the IT market was with standards, (2) the video-access software platform companies, like Lenel, DVTel, On-Net Security, and Milestone who have been screaming for a standard communication interface, and (3) the more IT-savvy security systems integrators who would now be able to plan a system with enterprise end users and not have to create multiple custom projects within one installation like they have to now.  Congrats to Axis, Sony and Bosch – now let’s just hope the other manufacturers with an axe to grind will support this initiative.

Axis Communications (Axis AB, based in Lund, Sweden) and U.S. based FLIR Systems are the two leading companies in their respective technological niches in the $7 billion video surveillance industry.  Axis is the leading provider of IP network video cameras, while FLIR is the leading provider of infrared cameras for surveillance and thermographic (temperature control) use.  While the video industry is growing at nearly 13-15% annually these two companies have been growing at 2x-3x that rate, or slightly faster than their own subsectors.  Both companies traded at similar P/E ratio premiums to the market with 28x-30x forward 12 month ranges and 22-25x forward 18-24 month ranges.

However, those valuations recently diverged dramatically, along with stock performance, and therein lies the tale of two video companies.  Over the last several quarters, FLIR has maintained a 40% revenue growth rate amid gross margins in the mid 50’s% as demand for its Government (usually DoD related) business continued to show contract wins and growth over 40%, and the Thermographic division (used for monitoring industrial processes) maintained 15%-plus growth, even into a declining industrial market.  However, in our opinion, the big winner for FLIR has been its relatively new Commercial Vision Systems division (17% of revenues, growing over 50%), covering everything from commercial and homeland security, to maritime and commercial airplane vision, as well as building inspections.  The explosion in end user possibilities appears only limited by FLIR’s ability to find the right channel partners and market the products effectively – which is no slam dunk.  But FLIR has been helped by dramatic cost price drops in its infrared sensor costs.  So, despite the economic slowdown, the company has maintained its operating margins at 22%-23%, and the 2008 consensus P/E of 28.7x the estimates of $1.18 appear quite fair.

If Axis were only so insulated from the economy!  Axis as a brand is rapidly becoming to the world of IP camera end users what Pelco (now owned by Schneider Electric) has been to the legacy analog market.  But the economy doesn’t care about that.  With both U.S. and Western European sales slowing just a bit, top line growth has slowed from the mid-40% range down to the “tortoise-like” 35% range.  This should not be a problem were it not for a major operating expense program the company has undertaken over the last six months to dramatically increase its admired “two-channel” go-to-market strategy and to pioneer the H.264 compression technology (80% faster and more storage than JPEG and about 25% faster and more storage than current MPEG-4).  In the middle of slowing growth, this has lifted S,G&A to 26% from 24% of revenues and R&D to 15% from 13% within one year, resulting in an operating margin hit of 400 basis points to 15.7% from 19.7%, and relatively flat operating income growth.  The cause is all for the good, but we won’t see the first returns on these investments until at least later in the second half of 2008.  The effect on the stock has been predicable – a forward P/E of 28-30 has shrunk to 23.5x on consensus earnings estimates that have shrunk by 10%-15%, leaving the stock down 40% from its 52-week high, and at one point, 50% off its high.

So there rests the tale of two video companies:  one with a high, but not outrageous valuation in a niche business that seemingly is finding new uses every day, and one company continuing to invest heavily – even at the cost of its stock price – in driving a leading marketing and technology strategy that probably will work, but is not certainty.

Both companies face enormous competition from large players – FLIR from the likes of Raytheon and L-3, and Axis from Sony and Panasonic.  However, in their given niches, both companies have proven to be the leaders, with better product and better management.  We like them both.