Elbit Systems Ltd. (NASDAQ:ESLT) Q3 2022 Earnings Call Transcript

Elbit Systems Ltd. (NASDAQ:ESLT) Q3 2022 Earnings Call Transcript November 29, 2022

Elbit Systems Ltd. misses on earnings expectations. Reported EPS is $1.4 EPS, expectations were $2.11.

Operator: Ladies and gentlemen, thank you for standing by. Welcome to Elbit Systems’ third quarter 2022 results conference call. All participants are at present in listen-only mode. Following management’s formal presentation, instructions will be given for the question and answer session. As a reminder, this conference is being recorded. You should have all received by now the company’s press release that is available in the News section of the company’s website, www.elbitsystems.com. I would now like to hand over the call to Mr. Rami Myerson, Elbit Systems Investor Relations Director. Rami, please go ahead.

Rami Myerson: Thank you Michal. Good day everyone and welcome to our third quarter 2022 earnings call. On the call with me today are Butzi Machlis, our President and CEO; Kobi Kagan, our CFO, and Yossi Gaspar, Senior EVP, Business Management. Before we begin, I would like to point out that the Safe Harbor statement regarding the press release issued earlier today also refers to the contents of this conference call. As we do every quarter, we will provide you with both our regular GAAP financial data as well as certain supplemental non-GAAP information. We believe that this non-GAAP information provides additional detail to help understand the performance of the ongoing business. You can find all the detailed GAAP financial data as well as the non-GAAP information and the reconciliations in today’s press release.

Kobi will begin by providing a discussion of the financial results followed by Butzi, who will talk about some of the significant events during the quarter and beyond. We will then turn the call over to a question and answer session. With that, I would like now to turn the call over to Kobi. Kobi, please.

Kobi Kagan: Thank you Rami. Hello everyone and thank you for joining us today. The third quarter results reflect the strong demand for our solutions and the investments we are making to realize the growing potential presented by increased geopolitical tensions and growing defense budgets. Third quarter revenues were similar to 2021 as growth in Europe offset lower Asia Pacific revenues. Our revenues by geography tend to fluctuate on a quarterly basis based on specific programs and project performance, as well as milestones reached in a particular quarter. We believe the longer term revenue trends supported by the growth in the order backlog are more representative, as we have discussed with you in the past. I would note the sale of Ashot Ashkelon Industries to FIMI was completed at the end of the second quarter of 2022 and our results in the third quarter of 2022 do not include a contribution from Ashot.

The current operational environment is challenging due to supply chain disruptions and labor cost inflation. Profitability in the third quarter includes expenses related to stock price-linked compensation plan. This plan helps align employee compensation with share price performance, incentivizing our employees to generate long term value for all of Elbit Systems stakeholders. Our GAAP and non-GAAP results have always included these expenses, but this year they are higher than in recent years following the share price appreciation. Our conservative balance sheet management policies have enabled us to increase inventories and partially offset the supply chain disruptions to maintain deliveries to our customers on schedule. Our budget and longer term planning assume that the global economic trends of supply chain and wage inflation headwinds will gradually subside from the second half of 2023.

We continue to invest in R&D to enhance our portfolio and maintain our competitive edge. We invest in sales and marketing to expand our customer base and also continue to invest in CapEx to improve and expand our manufacturing footprint. The rollout of the new ERP system and the construction of the new facility in the south of Israel are progressing, and we expect these and other efforts to support and improve the operational performance. I will now highlight and discuss some of the key figures and trends in our financial results. Third quarter revenues were $1,349,000,000 compared to $1,364,000,000 in the third quarter of 2021. In terms of revenue breakdown across our relevant areas of operations, C4ISR at 30% of revenues increased year-over-year mainly due to UAS and command control system sales.

Land systems was 26% of total revenues and increased year-over-year due to artillery system sales. Airborne systems accounted for 32% and declined year-over-year due to lower airborne precision guided munitions sales. Electro-optics accounted for 10%, and other sales accounted for 2% of revenues, similar to third quarter of 2021. The geographic revenue breakdown in the third quarter reflects our diverse geographic revenue base. In the third quarter, North America contributed 29%, Europe 26%, and Asia Pacific and Israel each contributed 19% of revenues. European revenues increased due to growth in training and simulation sales. Asia Pacific revenues declined mainly to lower precision guided munitions sales. North American revenues were lower due to a decline in medical device sales.

The non-GAAP gross margin for the third quarter was 25% compared to third quarter of 2021 at 27.2%. GAAP gross margin in third quarter was 24.2% of revenues compared to 26.6% in the third quarter of 2021. Gross margin in the third quarter reflects a combination of unfavorable program mix, wage inflation, and supply disruptions. GAAP and non-GAAP gross profit in the third quarter includes approximately $30 million of expenses related to stock price-linked compensation plans. Third quarter non-GAAP operating income was $84.3 million or 6.3% of revenues compared with $123 million or 9% of revenues last year. GAAP operating income for the third quarter was $73.4 million versus $110.3 million in the third quarter of 2021. Operating profit in the third quarter includes expenses of approximately $22 million related to the stock price-linked compensation plans.

The operating expense breakdown in the third quarter was as follows: net R&D expenses were 8.4% of revenues versus 7.4% of revenues in 2021; marketing and selling expenses were 5.1% of revenue, down from 6.2% of revenues last year; and G&A expenses were 5.9% of revenues compared to 4.9% of revenues last year due to stock price-linked compensation expenses. Other operating income of $9.4 million included the capital gain related to the sale of the building in Israel which was included in our GAAP and non-GAAP results. Financial expenses were $16.4 million in the third quarter compared to $13.5 million in 2021. Other income of $4.8 million included approximately $4.6 million which related to the re-measurement of an affiliate following an investment .

We recorded a tax expense of $7.9 million in the third quarter compared to $8.3 million in 2021. The effective tax rate in the second quarter was 12.8% compared to 8.6% in 2021. The non-GAAP diluted EPS was $1.40 in the third quarter compared with $2.33 last year. The GAAP diluted EPS was $1.26 compared with $2.08 last year. The stock price-linked compensation expenses in the quarter were equivalent to approximately $0.45 on an EPS basis. Our backlog of orders as of September 30, 2022 was $14.7 billion, approximately $1.1 billion higher than the backlog at the end of September 2021. Approximately 40% of the current backlog is scheduled to be performed during ’22 and 2023, and the rest is scheduled for 2024 and beyond. Operating cash flow for the third quarter was a $178 million inflow compared to no inflow in the same quarter last year.

The cash outflow also included an inventory build related to our efforts to mitigate supply chain challenges as we have leveraged our solid balance sheet to support deliveries to our customers. Cash flow from investing activities includes the higher CapEx related to the new facilities in the south of Israel, Charleston, South Carolina, as well as the rollout of the new ERP system. The board of directors declared a dividend of $0.50 per share for the third quarter of 2022. I will now turn the call over to Mr. Machlis, Elbit’s CEO. Butzi, please go ahead.

Butzi Machlis: Thank you Kobi. Firstly, I would like to thank the investors on the call and all our shareholders for their continued support. In a volatile world, we, Elbit’s management team have to make hard choices and decisions as we strive to create value for all our stakeholders and ensure we find the right balance between long term value creation and short term performance. We are fortunate that Elbit System shareholders understand the strategy, the potential, and the long term investment horizon that has supported the growth and the success of the company for decades. We are also aware that you expect a better operational performance, including higher profitability than what we delivered in the third quarter. We are working to improve the short term performance while maintaining the balance with the long term success of Elbit Systems by investing in our people, our portfolio and our customers.

This year, we increased investment in our people. Elbit’s employees are the most critical contributor to our long term success. We invested to retain talent in a competitive labor market in Israel and around the world, including stock price-linked compensation plans that had a material impact on the profitability in 2022. I would like to remind you that our executives and employees come to work at Elbit for more than just a salary. They joined Elbit because we are an attractive employer that provides them with an opportunity to work on some of the world’s most advanced technologies and to support those responsible for the protection of our loved ones and our countries. Our business is growing and we continue to recruit around the world to deliver our record backlog and support our customers.

We continue to invest in R&D to develop leading solutions that provide our customers with valuable competitive edge leveraging the operational experience of our employees and the proximity and short feedback loop with our customers. We are investing in new facilities. Elbit is building new advanced facilities in Israel, the U.K., Germany and the U.S., and we continue to gradually upgrade existing facilities. These facilities will include the latest manufacturing technologies and processes that should support operational improvements. We are also investing in creating value for our customers by providing them with advanced capabilities, investing in our multiple subsidiaries around the world and by utilizing our balance sheet to build inventories and maintain deliveries on schedule.

We know that our customers appreciate our efforts and we expect these investments to deliver good returns in the future. Elbit Systems’ long term growth has been driven by a health combination of both organic growth and acquisitions. These include Elbit night vision in 2019 and Sparton in 2021 that enhanced our technology portfolio and strengthened our position in the U.S. Sparton and Elbit Night Vision reported significant milestones in recent months. In October, Sparton was one of three suppliers awarded a joint five-year, US $5.1 billion ID/IQ contract to supply sonobuoys to the U.S. Navy. This follows selection of Sparton as a qualified vendor for the multiple award delivery order contract, or MADOC in July. The ID/IQ is significantly larger than the previous five-year ID/IQ.

This illustrates the importance of anti-submarine warfare as tensions escalate and the growing demand for next-generation sonobuoys. U.S. naval force’s Central Command is currently conducting a three-week digital horizon exercise in the Middle East focused on employing and integrating unmanned and artificial intelligence systems. Elbit Systems of America together with our Israeli based maritime business unit are showcasing Elbit Systems’ Seagull unmanned surface vessel as part of this exercise. This event validates the investment Elbit has made to build its maritime capabilities and the growing importance of the maritime domain. In October, Elbit Night Vision received a US $107 million order to supply night vision systems to the U.S. Army as part of the OTA contract received in 2020.

In September, Elbit Night Vision received a contract to develop an advanced night vision sensor for the U.S. Army’s IVAS system. Militaries around the world continue to invest to equip their soldiers with capabilities that enable operations at night or in dark environments. Recent conflicts have highlighted the importance of these capabilities. Elbit is a leading provider of night vision capabilities for soldiers thanks to the acquisition of Elbit Night Vision and our legacy solution. We are working to realize the synergies between our Night Vision capabilities and additional technologies in Elbit’s portfolio, like the integration of our command and control systems that can project information on the night vision display. At the second quarter results conference call, we discussed five capability areas that we identified should benefit from increased defense spending over the coming years following the lessons learned from the Russian invasion of Ukraine.

These are platform protections, command and control systems, electronic warfare, unmanned systems, and network precision munitions. We believe that each one has the potential to generate significant revenue over the medium term. During the third quarter, we announced additional contracts across these five areas. Starting with platform protection, in November we announced a US $200 million contract for a military helicopter self-protection suite for an Asia Pacific customer. The conflict in Ukraine has highlighted that only ground forces equipped with tanks and can maneuver and execute large-scale operations. The conflict has also demonstrated the vulnerability of platforms across all domains and the critical need to protect both platforms and their occupants.

This highlights the importance of active protection systems to protect maneuvering ground platforms. The Iron Fist active protection system development is on track for platforms in Israel, the Netherlands, Australia and the U.S. I believe there is significant potential for this unique solution that can protect armed personnel carriers and a range of military platforms. Helicopters provide physical support to maneuvering ground forces, and our DIRCM system protects helicopters and fixed from a range of threats. Another area of priority spend is autonomous and unmanned systems in the air, on the ground and at sea. The effectiveness of munitions on an armed UAV is limited when operated as a single platform. Armed forces require a comprehensive solution that generates targets and a sensor to shoot the load quickly and efficiently.

Elbit can supply our customers with a multi-layered solution of autonomous aerial intelligence capabilities and UAVs. We can connect these platforms with our command and control solutions and equip them with a range of electro-optical sensors and payloads, all developed in house at Elbit. The vertical integration of our internal supply chain enhances our ability to tailor unmanned and autonomous solutions to customer requirements, increasing effectiveness by maximizing the performance of each part of the solution and reducing costs. In September, we were awarded a $120 million contract to supply Hermes 900 maritime UAS to the Royal Thai Navy. This UAS will configurate for maritime missions and will be equipped with maritime radar, satellite communication, droppable inflatable life rafts, and other capabilities.

In November, we received a $72 million contract to supply Hermes 900 UAS to an international customer. The Hermes 900 UAS has been selected by more than 16 customers around the world. The third area of priority spend are advanced radios and command and control systems. To maneuver efficiently and effectively and combine multi-domain operations, modern armies have to be equipped with advanced . In October, we were awarded a $65 million contract to supply the first fully networked maintenance solution to an army in Latin America. This solution includes armed vehicles equipped with software-defined radios, a battle management system, and mini unmanned aerial systems. In October, we received a $25 million contract from the Finnish Ministry of Defense to supply radio communication systems to the Finnish Army.

Our military radio communication system has been selected by several northern European and NATO countries, including Sweden, Germany, the Netherlands, Switzerland, Spain and others. With that, I will be happy to take your questions. Operator?

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Q&A Session

Operator: The first question is from Pete Skibitski of Alembic Global. Please go ahead.

Pete Skibitski: Yes, good afternoon everyone. Hope everyone is doing well.

Rami Myerson: Hey Pete.

Pete Skibitski: Guys, I had a question about the airborne systems unit. Revenue was down quite a bit this quarter – I think, Kobi, you mentioned it was on airborne precision guided munitions. It was also down a little bit in the second quarter. I’m just wondering if there was maybe one large program that’s ending that’s driving that weakness and that maybe as we get into the fourth quarter or first quarter, we’ll see easier comps there and a return to growth.

Kobi Kagan: Thank you, Peter, for the question. This is Kobi. You are right – it is a large program that we announced early last year that we had concluded in the previous quarter, and in this quarter we don’t have any sales from this large program. We announced a new airborne precision munitions sale that we got this year, so we expect that next quarter, we will continue to sell on this issue.

Pete Skibitski: Okay, that’s helpful. Thanks so much for that. Then I just wanted to switch now to maybe underlying gross margin issues, in particular pricing. I’m just wondering–you know, as we’ve heard the U.S. defense contractors, worked our way through the third quarter, they are also experiencing, of course, higher labor rates and there’s sort of a delay effect in terms of not being able to pass on the higher labor rates through updated pricing until they start new contracts, essentially, and so you’ve got this mix of current contracts with higher labor rates but pricing that reflects labor rates from maybe a year or two ago. I’m just wondering, have you–has Elbit had success in terms of the ability to pass on the cost of higher labor rates through pricing on new contracts, and so maybe ignoring for you stock-linked compensation but just in terms of base labor rates, are you getting better pricing on new contracts as opposed to the contracts that maybe were awarded a year ago when labor rates were a bit lower?

Yossi Gaspar: Hi Pete, this is Yossi. I would address it in the following way. First of all, the extraordinary costs related with our stock option plan, that is something kind of one-time and it goes away, and it’s not something of the baseline of cost of the company, so that should be neutralized. It does impact present year, but that is not something that we’re continuing to witness. On the baseline cost, I would say the following. Some of our contracts with customers do have economic price adjustments and therefore we are getting compensation because of the growth in the cost of the labor, and also to some extent growth in the cost of basic materials which is also price adjusted according to what happens in the market. However, we don’t have that in all of our contracts and therefore we are suffering to some extent because of that.

We definitely take all these changes into consideration when we bid for new contracts, and I would say that even in the recent growth of backlog that we have experienced, that already include backlog that takes into account these economic adjustments and we hopefully will–these contracts will result in improved profitability in the future.

Pete Skibitski: Okay, that’s very helpful. Great color there, I appreciate it. I’ll just ask one last one and then get out of the queue there. On the backlog growth – that’s a good transition, Yossi, it was very strong this quarter, year-to-date backlog growth has been strong. I’m just wondering, can you bifurcate it a little bit by region for us? Is there any one region that’s been very, very strong and maybe some laggards? I’m sure a lot of people are wondering if Europe, and even Eastern Europe is driving that growth, or if you’re seeing strength kind of across the board. Appreciate any color on that topic.