Elbit Systems Ltd Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by. Welcome to Elbit Systems Second Quarter 2020 Results Conference Call. All participants are 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 new section of the company's website www.elbitsystems.com. I would now like to hand over the call to Rami Myerson, Elbit Systems Investor Relations Director. Rami, please go ahead.

Thank you, Yoni. Good day, everyone, and welcome to our second quarter 2020 earnings call. On the call with me today are Butzi Machlis, our President and CEO; and Yossi Gaspar, our Chief Financial Officer. Before we begin, I would like to point out that the Safe Harbor statement in the company's press release issued earlier today also refers to the contents of this conference call. Yossi 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 Yossi. Yossi, please.

Thank you, Rami. Hello, everyone, and thank you for joining us today. The results of our second quarter reflect the resilience of Elbit Systems and the actions we are taking to address and mitigate the impact of the COVID-19 pandemic on our activities, as we discussed in our earnings call for our first quarter results. Government-directed safety measures, supply chain delays, and travel restrictions continue to cause some disruptions to our business, including the ability to attend in person except for inspections. Our subsidiaries around the world have helped support these inspections where possible. We continue to monitor the situation closely and are adhering to the instructions of the governments of the various countries in which we operate. The extent of the impact of COVID-19 on the company's performance will depend on future developments, including the duration and the spread of the pandemic, the measures adopted by governments to limit the spread of the pandemic, and the resulting actions that may be taken by our customers and our supply chain. Turning now to our results, 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 their reconciliation in today's press release. Overall, we are satisfied with our performance in a challenging environment. Revenues and backlog increased year-over-year and slightly in comparison to the previous quarter. The improvements in profitability and cash flow reflect the increased focus on operations, including the cost-control measures that we implemented to mitigate the financial impact of the COVID-19 pandemic. Our backlog of $10.8 billion provides good visibility and reflects the long-term nature of our business. It generally takes time to finalize contracts in our industry, but once we book, they often provide many years of revenues. I would like to note three events that impacted our results in the quarter. On May 19, we announced a $70 million investment by Charlesbank Capital Partners in Cyberbit, our commercial cyber subsidiary, and we received $48 million for a portion of our share in Cyberbit and the balance of $22 million was invested in Cyberbit. Following the investment and the sale of our holdings, Elbit Systems is now a minority shareholder. This transaction generated a healthy profit that we reported in other income. I know that we have retained all our military cyber activities within Elbit Systems, and the revenues are important under the C4ISR systems line. In May, we completed the sale and leaseback of two of Elbit Systems of America facilities. The profit from these transactions was reported in the other operating income line. During the quarter, we restructured an Israeli joint venture that we had formed with a foreign company and recorded a $4.4 million noncash write-off reported in earnings of affiliated companies and partnerships. The remaining assets and employees have been incorporated into Elbit and going forward will be reported as part of Elbit Systems ongoing activities. The impact of all three of these transactions was excluded from our non-GAAP results due to the nonrecurring nature. I should also note that the acquisition of Elbit Night Vision from L3 Harris closed on September 15, 2019 and was therefore consolidated into our income statement commencing the date of their acquisition. I will now highlight and discuss some of the key figures and trends of our financial results. Our second quarter 2020 revenues were $1.79 billion. In terms of revenue breakdown across our areas of operation, LAN system sales accounted for 27% of the total sales and increased year-over-year mainly from the sales of artillery systems and precision munitions to U.S. customers. Electro-optics accounted for 12% of total sales and increased year-over-year mainly due to the acquisition of Elbit Night Vision. Airborne systems at 36% of sales declined year-over-year primarily due to lower commercial avionics sales in the U.S. Our diverse geographic revenue base is important to the long-term sustainability of our business. In the quarter, North America, at 34% of total revenues, was the largest geographic area followed by Israel at 25%, Asia Pacific at 21%, and Europe at 15%. Growth in North America was primarily due to LAN systems sales as mentioned in the acquisition of Night Vision in the U.S. For the second quarter, the non-GAAP gross margin was 26.7%, down from 27.7% in the second quarter of last year. The decline reflects the business mix as well as additional pandemic-related costs we incurred during the quarter to facilitate the safety of our employees and maintain business continuity. GAAP gross margin was 26% compared with 27.1% for the second quarter of last year. Second quarter non-GAAP operating income was $92.7 million or 8.6% of revenues compared with $89.6 million or 8.4% of revenues in the second quarter of last year, as cost control measures helped to offset the impact of the COVID-19 on gross profit. GAAP operating income for the quarter was $117.1 million versus $80.3 million in the quarter last year and includes a profit from the sale and leaseback of Elbit Systems of America facilities, as mentioned previously. The operating expense breakdown in the quarter was as follows. Net R&D expenses at 7.3% of revenue were similar to the second quarter last year. Our investment in R&D enables us to maintain and build our technological leadership and underpins our long-term prospects, and therefore we increased our investment in R&D in absolute terms during the quarter. Marketing and selling expenses declined to 6.2% of revenues versus 6.9% last year due to reduced travel and participation in trade exhibitions. G&A expenses were 4.8% of revenues versus 5.4% last year. The lower G&A expenses reflect some of the cost control measures we implemented to mitigate the impact of COVID-19. Financial expenses for the second quarter of 2020 were $16.5 million compared with $20.3 million last year. Other income of $13 million includes the profit generated by the sale of Elbit shares in Cyberbit, and equity in net earnings of affiliated companies and partnerships was a loss of $0.4 million following the write-off of a $4.4 million investment in an affiliated company in Israel, as mentioned previously. The effective tax rate in the second quarter of 2020 was 20.8%, higher than the 17.6% tax rate in the second quarter of 2019 due to the higher tax rate on capital gains we booked in the quarter. During the second quarter of 2019, Elbit Systems raised $185 million through the sale of Treasury shares to institutional investors in Israel. This increased our share count by about 3% to 44.2 million shares, having a small corresponding impact on our earnings per share relative to the second quarter of 2019. Our non-GAAP diluted earnings per share was $1.56 in the second quarter compared with $1.46 in the second quarter of last year. GAAP EPS was $2.02 versus $1.22 last year. Our backlog of orders as of June 30, 2020, was $10.8 billion, $1 billion higher than the backlog at the end of the second quarter of 2019, and $14 million higher than at the end of the first quarter of 2020. Approximately, 55% of the current backlog is scheduled to be performed during the remainder of 2020 and 2021, and the remainder is scheduled for 2022 and beyond. This ratio is broadly similar to that of the second quarter last year. Operating cash flow for the quarter was a positive of $179 million compared to the negative of $138 million in the same quarter of last year. Our cash flow in the quarter reflects the increased focus on working capital management, including improved collection from our Israeli and international customers, as well as more disciplined inventory management. Lower capital expenditure also supported total cash flow in the quarter. On June 30, we paid the final interest and principal payments for the Series A notes. Elbit Systems continues to manage its balance sheet conservatively. Besides our cash, we have access to multiple credit lines that can provide us with additional liquidity. The Board of Directors declared a dividend of $0.44 per share for the second quarter of 2020.

Thank you, Yossi. I would like to start by thanking Elbit Systems employees around the world for their continued hard work during these challenging times. We continue to monitor the evaluation of the COVID-19 pandemic. Our priorities remain to protect the safety of our employees, to maintain business continuity in our supply chain, and leverage our ability to assist and protect our communities. The actions we initiated to address COVID-19 and mitigate the impact are ongoing. Moving to the business and the quarterly results, the second quarter included a number of strategic milestones and important developments across different areas of our operation. Space is a relatively small but strategically important part of our business with large potential. Space-related R&D also contributes to the development of additional capabilities and applications, including airborne weather systems, advanced electro-optic sensors, and communications systems. In July, Israel launched into orbit the Ofek 16 electro-optical reconnaissance satellite, with an advanced camera on the satellite developed and manufactured by Elbit Systems. Elbit is the world leader in developing high-performing space cameras that are smaller and lighter than our competitors. We have sold our advanced space cameras to government and commercial customers around the world. At the end of 2019, Elbit’s first nanosatellite, NANOVA, was successfully launched into orbit, with a commercial communication payload. The nanosatellite built on our experience in developing and capturing and deploying space electro-optic payload and satellite communication. Maritime is an additional area where Elbit Systems has a broad portfolio of capabilities. In July, we received a $53 million contract from a Navy in Southeast Asia to equip the ship with integrated intelligence suite capabilities that enable them to perform complex reconnaissance missions, generating an operational picture for the earth's surface and underwater domain. Under this program, Elbit Systems will supply an array of systems including electronic intelligence systems, naval tactical communication, intelligence systems, jamming capabilities, electro-optical payloads, hull-mounted, and towed active and passive sonars, underwater communication systems, and combat management systems. This contract provides a good indication of the breadth of Elbit's portfolio of maritime capabilities that are based on decades of operational experience with the Israeli Navy. This includes the Seagull, an operational unmanned surface vehicle that recently participated in 12 exercises conducted for the U.K. MoD to examine the possible use of an unmanned surface vessel for anti-submarine activities, as well as advanced sonar and underwater acoustic communication systems from our Canadian subsidiary, GeoSpectrum Technologies. The contract also highlights the growing demand for our naval and other defense capabilities for customers in Asia-Pacific due to elevated geographical tensions in the area. The U.S. is our largest market, and in 2019, we reported more than $1.2 billion of sales in the U.S. In recent months, we have seen sustained momentum across the portfolio. We supply advanced avionics in helmet-mounted displays for most of the U.S. airborne platforms including the F-35, F-16, F-15, C-17, C-130 transport aircraft as well as Blackhawks, Chinook, and Apache helicopters. The larger orders announced by the U.S. DOD in recent months for a number of these programs should provide Elbit with multiyear revenue streams that are not currently included in our backlog. We continue to upgrade our systems on these platforms with new technologies. The next generation of JHMCS II Helmet Mounted Display System for the F-16V and F-16 Blocks 70 and 72 is currently undergoing flight tests following selection by a number of international customers. We continue to provide a range of advanced border protection solutions for the U.S. Department of Homeland Security. Our autonomous solutions include special relocatable and mobile surveillance tower systems and ground detection systems. These systems, which are fielded along the U.S. border, include command and control, electro-optics and eye sensors, radars, and communication systems, and provide autonomous artificial intelligence and machine learning technologies. In our U.S. medical equipment subsidiary, KMC, develops and manufactures advanced medical instruments in collaboration with many of the leading medical device companies in life sciences. KMC partners with its customers to develop and manufacture innovative medical devices, leveraging a multi-disciplined engineering team with broad expertise in areas including hardware and software design, robotics, optics, fluidics, and stimulus integration under contract manufacturing and developing labeling agreements. The COVID-19 pandemic has increased demand for KMC’s automated diagnostic products and its engineering capabilities as the medical equipment companies mobilize to fight the pandemic. We supply a broad range of training equipment and services to customers around the world. Elbit is a leading supplier of training simulators for air, naval, and ground platforms to the Israel Defense Forces. In June, we received a $38 million contract from the Israeli Minister of Defense to provide operational maintenance and logistic services for the Israeli Air Force Flight Academy Textron T-6 trainer aircraft fleet. This contract follows a decade during which Elbit Systems provided these services to the Israeli Air Force. Elbit Systems provides a range of training and logistic services for the Israeli Air Force Flight Academy. This includes an interconnected multi-cockpit mission training center for cadets flying the M-346 trainer jet that provides realistic simulated battlefield training as well as emergency training on the ground. In the air, the cadets train with Elbit’s Embedded Virtual Avionics or EVA. The EVA enables advanced mission operation training on a trainer aircraft by generating a simulation suite that provides virtual avionics, weapons, and sensors, and a synthetic environment to increase training effectiveness while significantly reducing costs. Elbit Systems provide comprehensive training solutions, systems, and logistic services to customers around the world. Our Affinity joint venture with KBR in the U.K. provides procurement operations and maintenance services for three aircraft fleets of the U.K. Royal Air Force Flight Academy as part of the military flight training system. Affinity supports a training pipeline that is more effective and efficient so that U.K. military air crews are better prepared for their duties. Elbit’s selection by Boeing to provide avionics and training capabilities for the U.S. Air Force C-17 trainer was an important validation of our training and simulation capabilities. We believe that militaries worldwide are keen to expand their simulator and training capabilities to provide more realistic training that better prepares soldiers for a wide range of scenarios at a lower cost. In summary, Elbit Systems has continued to work hard in recent months to maintain deliveries to our customers and protect our employees. Our backlog continues to provide us with significant visibility, and we continue to see significant potential around the world for our leading high-technology solutions as we work to generate value for all of our stakeholders: our employees, customers, suppliers, and of course, for you, our shareholders. And with that, I will be happy to take your questions.

The first question is from Sheila Kahyaoglu of Jefferies. Please go ahead.

This is actually Ellen on for Sheila. Thank you for this question. You raised the dividend back to $0.44 in the quarter after lowering it last quarter. So, how do you think about free cash flow in the second half? How comfortable are you with it and how much of the about $150 million generated in the quarter was from Israeli government payments versus core operations?

Hi, well actually, as you have seen, we have experienced quite a lot of fluctuations in our cash flow during the past quarters, some related to the payment from the Ministry of Defense here in Israel. Fortunately, we were successful in securing the payments in the second quarter, and we're looking forward to generate cash flow in the second half of the year as well. Having said all of that, we are all aware of the pandemic around the world and the fact that in Israel, the budget for 2020 is not yet finalized, but we are optimistic that we'll be able to handle that.

Okay. Thank you, that's helpful.

The next question is from Pete Skibitski of Alembic Global. Please go ahead.

One question I had - I had a question on the revenue by regions. I just noticed the Asia Pacific revenue down sharply this quarter, which I thought was a little surprising because you've won a lot of fairly sizable contracts in the Asia Pacific region. So, I was just wondering if this is maybe a timing issue where the new contracts haven't ramped up yet, but the old ones have ramped down, or if there is some impact of COVID-19 in particular in the Asia Pacific region? I guess I was wondering if you could clarify that?

Yes, I would say the following: First of all, yes, we did suffer, to some extent, not materially, from disruptions in this area - acceptance testing by customers of our equipment and so on, but this was not a material impact. Regarding the major contract that we got in the first quarter, it does take some ramp-up to prepare for production, and we will start delivering that part towards the end of this year and during the next year and the following year. So, this is something that takes time until we see the transformation from new business to revenues. The third element is that one or two programs that we had last year have finished delivery during the first quarter. So, we did not have their impact during the second quarter of this year. I should in general recommend looking at our multi-quarter performance, as one quarter shouldn't be very characteristic of how we operate.

Okay that's very helpful. I appreciate that, Yossi. And then separately, revenue-wise, on commercial avionics, obviously we've seen Boeing and Airbus take rates down going forward and COVID has impacted to a lesser degree, but so does your business in general aviation as well. I’m just wondering if you could quantify for us the decline you saw in the quarter from commercial avionics versus business and general avionics?

I would say the following: I mean, the defense avionics did perform well and in line with the general trend of the business of the company. The commercial part is not a huge part of our business yet. We did see, during this quarter, some lower revenues in commercial avionics deliveries compared to the previous quarter. We did see some upside coming back in the beginning of the third quarter; however, this is very fluid, and I would not dare to make any expectations on this part. Our commercial avionics are mainly focused on business jets and not that much on wide-body airplanes. Therefore, we are affected, but not at the level that the general industry is affected.

Okay. Very helpful. Thank you. I'll ask one more and then I'll get back in queue. I'm not sure if there are others in queue. But I guess, I want to think about the timing of margins in the back half of the year. If we look at the second half of 2019, you had a decline in margin rate in the third quarter and then a sharp ramp-up in the fourth quarter. I'm just wondering if you were expecting that similar kind of dynamic in the back half of 2020?

Well, as you know, we do not give guidance. However, I think that we do expect to have some recovery on the gross profit level for the second half. I think that the performance on the operating profit this quarter and in general for the first half was quite good. We do not expect any significant change on that part.

The next question is from Dina Korshunov of Leader Capital Markets. Please go ahead.

My question is, do you feel that generally, the risk in the defense market is rising in the last quarter or the last couple of months due to the pandemic and economic risks?

It depends. As you probably know, there is no defense budget and no budget. So, there are some delays in new orders. However, in the U.S. as well as in the UK and in Western Europe, as well as in Australia, we see a growing demand, and we'll see more contracts. This is mainly to support the local economy to create more jobs. And just to remind all of us, we have dozens of subsidiaries all over the globe which help us right now to communicate with our customers but also help the local governments to create more jobs and support their local economies. In some areas, we see some cuts because of budget priorities, but relatively, it is not occurring in many places. There is also growing security tension in several places around the globe, which generates more demand for our products. Overall, we have a wide portfolio with many technologies and solutions. We are spread across many countries with dozens of subsidiaries, all together creating stability. We also have a strong backlog of almost $11 billion, which helps us take the right measures and adapt to changes in the market.

The next question is from Ella Fried of Bank Leumi. Please go ahead.

Thank you for taking my question. The question is actually about the next backlog cycle mix. I think we know from experience that post-crisis, the mix is often driven by upgrades and budgets shrink, and airborne systems upgrades and maybe some land upgrades? Are you preparing for this trend? Do you think it's going to happen? If so, what steps do you need to take because that has been less the focus of recent years?

As you know, our portfolio can support new platforms as well as upgrading existing platforms. We continue to provide the avionics for new fighters in the U.S. as well as in other countries. We are also actively upgrading existing platforms worldwide. The same is true for land applications; we will continue to provide new electronics and new systems to new ground platforms and upgrade existing platforms in the market as well. We already outperform the full support and are ready for any decision that our customers will make. I also want to mention that our portfolio can help customers save costs. For example, command control applications and autonomous systems bring more operational value with fewer personnel and do so much more efficiently. That's one example. Another example is our online training systems. Instead of using a real flight and real hours in the field, we provide simulators and training scenarios to replace active hours in the air and on the ground. Once again, it helps our customers prepare themselves with lower associated costs. We have a wide portfolio capable of supporting most of the demand in the market. We follow the demand and requests of our customers closely, adapting ourselves to the changing requirements in the market.

I've not seen your doing great, and I think you will do even better as time goes on. The question is, if we see some shrinkage of budgets—which is almost inevitable at least in some countries—do you think the targets that you marked for IMI growth have to be reconsidered and softened a bit? Or do you still think that it will be the same through 2020 and into the beginning of 2023?

On the contrary, Ella, we see growing demand for our land portfolio. Just to remind everyone, we have combined capabilities for IMI with Elbit capabilities. By combining these capabilities, we can provide guided munitions to our customers for different air forces, as well as for land forces and navies worldwide. There is a growing demand for that, and we have state-of-the-art solutions. I see a lot of potential there. Talking about upgrading existing platforms, that's an area where the IMI portfolio is relevant for protection systems, armor, and additional technologies that are very pertinent for upgrade programs. We see a growing demand for our IMI offerings. Just to illustrate, when we acquired IMI about three years ago, they held around 15% of the international market. Today, they are doing more than 40% of our earlier brought, and we are working on improving efficiency as well. We are bringing more business to IMI, combining capabilities between Elbit and IMI, increasing exports, and enhancing profitability at IMI. We are very pleased with this acquisition.

That's great to hear. Another question that I think refers to both of you. You raised quite a lot of cash in this quarter. Is this just being prudent and conservative facing the COVID crisis, or do you have some acquisition targets or are you preparing for future opportunities—as you may find something more interesting for acquisition in the next year or couple of years?

Cash is a very important target for us, reducing working capital, increasing cash balance, and improving our cash position. This is very important during all times, specifically during the times we are currently living in amid COVID-19. We want to ensure that we have enough cash and liquidity to run our business, and that is what we are doing. We had several quarters in the past that were quite low in our cash performance. I believe we have caught up very nicely this quarter and continue to emphasize the importance of cash performance for the organization. In general, I would also address the second part. Our strategy for many years does include acquisitions. We have executed several successfully. Most essentially, all of these have been done with cash. If we have some specific target for the next months, I would say no. However, that remains part of our overall strategy to acquire and grow the business through M&A.

Yes, thank you. Just one sort of two-part follow-up on cash flow. Advances—it looked like there were advances that were really strong this quarter and for the whole first half. That was great to see. I don't know if that was related to a couple of programs in particular, maybe the Asia Pacific that we talked about earlier. I was wondering if you could give us any color on those strong advances? And then the second part is it looks like receivables continue to build. Do you have any expectation for the second half of the year on receivables declining? Thanks.

Regarding the cash, I think during previous calls, we explained that we moved from a situation where we saw increased working capital in the company. We changed some of our policies to improve cash generation. This change in policy has resulted in working with our customers for improved payment terms that include advances, down payments for the various contracts that we have been awarded. I think that we are now seeing the actual result of this strategy, which has resulted in a significant growth in the advances of new contracts. Going forward, we continue to place emphasis on cash elements, and hopefully that trend will continue for the future as well. It, of course, depends on the business environment and the capabilities of the customers to provide us these advances. This quarter was very promising in that aspect. The receivables have grown, which is related to the progress in the various programs and the various contracts that we have. I would like to remind you that some of these receivables are what we call unbilled receivables. According to the new accounting rules, we recognize revenues on the cost input method. Therefore, as we progress on the program, we recognize the revenues. They will ultimately be converted into cash in response to the payment milestones of the various contracts with our customers.

There are no further questions at this time. Before I ask Mr. Machlis to proceed with his concluding statement, I would like to remind participants that a replay of this call will be available two hours after the conference ends. In the U.S., please call 1-888-782-4291; in Israel, please call 03-925-5900; and internationally, please call 9723-925-5900. A replay of this call will also be accessible at the company's website, www.elbitsystems.com. Mr. Machlis, would you like to make your concluding statement?

Thank you. I would like to thank all of our employees again for their continued hard work, particularly in discouraging times. To everyone on the call, thank you for joining us today and for your continued support and interest in our company. Have a good day and goodbye.

Thank you. This concludes the Elbit Systems Ltd second quarter 2020 results conference call. Thank you for your participation. You may go ahead and disconnect.