Elbit Systems Ltd Q2 FY2021 Earnings Call

Ladies and gentlemen, thank you for standing by. Welcome to Elbit Systems' Second Quarter 2021 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 Rami Myerson, Elbit Systems' Investor Relations Director. Rami, please go ahead.

Thank you, Misha. Good day, everyone and welcome to our second quarter 2021 earnings call. On the call with me today are Butzi Machlis, President and CEO, and Joseph Gaspar, our Chief Financial Officer. Before we begin, I would like to point out that the safe harbor statement and the company's press release issued earlier today also refer 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 details of GAAP financial data as well as the non-GAAP financial information and the reconciliation in today's press release. 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'd like to turn the call over to Yossi. Yossi please.

Thank you, Rami. Good day everyone and thank you for joining us today. The results of our second quarter reflect sustained demand for Elbit Systems solutions and services from our customers around the world, as reflected in the growth in revenues and the backlog and encouraging operational improvement. Second quarter results include the results of Sparton and Rokar acquired in the beginning of April. At the beginning of July, we completed public tenders for three series of notes raising approximately $600 million. S&P global rating agency and Israeli rating agency assigned each Israeli AA rating with a stable outlook to the notes, which are traded on the Tel Aviv stock exchange. The significant participation by investors in the tenders provides a strong vote of confidence in the company. I will now highlight and discuss some of the key figures and trends in our financial results. Second quarter revenues were $1.302 billion, increased 21% year over year. A major part of the growth was organic in addition to the contribution from Sparton. In terms of annual revenue breakdown across our areas of operation, Elbit Systems accounted for 40% of total quarterly revenues and increased year over year mainly due to the airborne precision guided ammunition sales. Land systems accounted for 22% of total revenues, showing a similar level of revenues to the second quarter of 2020. C4ISR at 26% of revenues increased year over year, primarily due to the acquisition of Sparton and Electro-optics accounted for 8% of total revenue and declined year over year, mainly due to the phasing of Elbit Night Vision recent programs in the US. I would like to note that significant volumes of electro-optics equipment are included on solutions that we report as part of our airborne, land and C4I systems for operation. Other sales were 4% of revenues and increased significantly year over year due to growth at the US medical device subsidiary. Our diverse geographic revenue base is important to the long-term sustainability of our business. In the second quarter, North America was the largest contributing 34% of our revenues, Israel was 21%, Asia Pacific 46% and Europe 16%. The growth in the US was mainly due to the Sparton acquisition and the revenues from non-defense medical device sales. Asia Pacific revenues increased mainly due to the sales of precision-guided munitions. The non-GAAP gross margin for the second quarter was 26.6% compared to 26.5% in the second quarter of 2020. GAAP gross margin in the second quarter of 2021 was 26% of revenues in line with the second quarter of 2020. The sequential improvement in gross margin compared to the first quarter of 2021 is encouraging and reflects the initial benefits of cost control measures we adopted to help mitigate the financial impact of the stronger shekel and the COVID-19 situation that we discussed with you previously. The second quarter non-GAAP operating income was $114.9 million or 8.8% of revenues compared with $92.7 million or 8.6% of revenues last year. GAAP operating income for the second quarter was $117 million, similar to the second quarter last year. GAAP operating income in the quarter included the profit from the sale of a business in Israel recorded under other operating income. GAAP operating income in the second quarter of 2020 included a profit from the sale and leaseback of two of Elbit systems of America specifically. The operating breakdown in the second quarter was as follows: Net R&D expenses were 7.3% of revenues, similar to the second quarter of 2020. Marketing and selling expenses were 5.8% of revenue versus 6.2% last year. G&A expenses were 5.1% of revenues compared to 4.8% last year, due to acquisition-related expenses in the quarter. Financial expenses were $7.1 million in the second quarter, compared with $16.5 million in 2020. The lower level of financial expenses was mainly a result of gains from changes in fair value of financial assets and liabilities. We recorded a tax expense of $20.1 million in the second quarter, compared with $23.6 million in 2020. The effective tax rate in the second quarter was 18.5% compared with 20.8% in 2020. Our non-GAAP diluted earnings per share was $2.11 in the second quarter compared with $1.56 last year. The GAAP diluted EPS was $2.30 compared with $2.20 last year. Our backlog of orders as of June 30, 2021 was approximately $13.6 billion, which is $2.8 billion higher than the backlog at the end of June 2020, and $1.8 billion higher than that at the end of March 2021. Approximately 51% of the current backlog is scheduled to be performed during 2021 and 2022 and the rest is scheduled for 2023 and beyond. This ratio is lower than that in the second quarter of last year following a number of multi-year contracts awarded recently. The order backlog is equivalent to more than 2.5 years of revenues and provides good visibility for future revenue. Cash flow from operating activities for the second quarter was $170 million inflow compared with $179 million inflow in the same quarter last year. The net proceeds from the recent bond offering will be included in our third quarter. Following the review of capital structure and cash requirements, the board of directors declared a dividend of $0.46 per share for the second quarter of 2021. I will now turn the call over to Mr. Machlis. Please Butzi.

Thank you, Yossi. I would like to begin by thanking the investors that participated in the tender for Elbit Systems notes in July for this strong vote of confidence in the company. We have a record $13.6 billion backlog at the end of the second quarter, which included the $1.65 billion 20-years contract from the Hellenic Ministry of National Defense to establish and operate the international flight of the Hellenic air force signed in Elbit. Elbit Systems has developed a broad portfolio of market-leading training and simulation solutions for militaries around the world that are expanding those simulator and training capabilities. These solutions provide more realistic training that better prepares the forces for a wide range of scenarios at a low cost. Firefighting squadron in Greece: Elbit Systems operated an Israeli firefighting squadron on behalf of the Israeli fire and rescue authorities. This week, the Israeli Government sent two firefighting aircraft from this squadron, as well as an air force transport aircraft to Greece to assist the efforts of the Greek firefighters who are battling wildfires across the country. The delegation includes Elbit Systems' employees that will provide logistical support. I am proud that Elbit Systems is taking part in this critical mission as part of our commitment to protecting the environment in this world and around the globe. As we indicated in April, we highlighted three medium-term growth engines; network position munition, maritime systems, and high-powered lasers. I am pleased with the progress that these growth engines demonstrated during the second quarter. Precision guided ammunition was one of the revenue growth drivers in the quarter, as Yossi mentioned. The recent conflict in the south of Israel highlighted the growing rockets and missiles directed at civilian populations and military installations around the world, increasing urgency to develop more efficient and cost-effective solutions. In June, Elbit Systems together with the Israeli MOD and Israeli Air Force successfully carried out a series of tests to intercept and shoot down drones using an airborne high-powered laser installed on our system. The successful interceptions were an important milestone in our development of airborne high-powered laser systems that will be capable of defending large areas by intercepting multiple threats at high altitude. Elbit Systems has made significant investments in recent years to develop and acquire comprehensive solutions for the increasingly contested maritime domain. In April, we completed the acquisition of Sparton in the US and received an $80 million contract in June to supply AI-powered SPECTRO XR electro-optical systems for maritime forces of Asia Pacific countries. Elbit Systems SPECTRO XR is a multi-spectral long-range electro-optical systems that provides naval, air, and land forces with visibility capabilities in both day and night and under low visibility conditions. SPECTRO utilizes artificial intelligence to continuously scan for targets, extract the position, and reduce human error. In June, our UK subsidiary Elbit Systems in the UK received a $60 million contract to supply exact night vision goggles to UK armed forces. Systems from the exact family have accumulated significant experience and have been selected by a number of NATO countries, including Germany and the Netherlands. In June, our US subsidiary Elbit Systems of America was awarded two orders with a combined value of $20 million to upgrade US Army night vision systems. In June, Elbit Systems' German subsidiary was awarded a $20 million contract to supply software deployment for multi-channel radios to the Swedish army. Under the contract, Elbit Systems will supply additional software as part of the Sweden tactical radio program. Our radios have been selected by several armed forces across Europe, including Switzerland, Spain, and other NATO countries. In summary, our broad-based backlog continues to provide us with good visibility, and we continue to see significant potential for our advanced high-technology solutions. And with that, I will be happy to take your questions.

The first question is from Greg Konrad of Jefferies. Please go ahead.

Hey, how's it going? Just, to start first on airborne sensors or systems that you mentioned, the strengths and precision munitions, how lumpy is that or does this business reset at a higher level? Let me just think about it going forward.

Well the basis of this product line, there are several of those coming from the acquired subsidiary IMI that we did in 2018. Now there is a big variety of products that are in that category, that means airborne-launched precision guided munitions. When we bought IMI, we had about 20% or less of international business at IMI which included very low level of revenues from this kind of product lines. With our geographic spread of our marketing and contacts with various customers, we were able to promote significantly the interest of customers in this kind of precision guided munitions. And we do see significant growth over the years for this kind of family of products. Our estimate is that this growth will continue into the future as well, particularly because we also introduce some significant upgrades in this kind of munition for improvement of launching capabilities on one side and improvement of precision guidance on the other side. By the way, the acquisition that we did, the smaller acquisition that we did this quarter, a company by the name of Roca that we bought from BAE, today does have the capability and the technology to improve the precision guidance of this kind of munitions. Therefore, looking forward, we do see, we are very optimistic of continuous growth in this area.

That's helpful. And I mean, you brought up IMI, which I think you've done a good job kind of improving the margins. Margins stood out in the quarter, good sequential progression and some of the highest over the past several years. How much does mix play into that or have you been able to drive productivity where we kind of think about a step up for margins as we go forward?

Well, we have a multi-year plan going out for covering over five years. We are somewhere in the middle of performing and achieving the goals of this plan. We had another two years to go. I think we are ahead of what we initially planned. We are improving at a nice rate, the margins, and it looks like that there is still room for improvement for the following two to three years. A major milestone that we will be achieving towards the end of '23, beginning of '24 is the movement of the manufacturing/production facilities to the Southern part of Israel into a new modern production facility. Through that, we also expect to lower the cost of labor, and that will give another boost for improvement of profitability for the production of these products.

Okay. And then just last one for me, strong free cash flow in the quarter, you had a nice tailwind from working capital. Any changes or thoughts around your assumptions for working capital as you kind of move through the year given the good conversion in Q2?

Over the years, we did have some delay in payment from one of our major customers, which is the Ministry of Defense here in Israel. During the second quarter, they did pay some of their billings. However, these are fluctuating a little bit. There may be some fluctuations in the next quarter. We are very optimistic that everything will be settled by year-end because the delays were caused by the approval of the overall budget for Israel, including the budget of the Ministry of Defense. This will be solved somewhere in November and therefore it looks like every outstanding billing will be paid by the year end.

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

Hi guys, how are you and congratulations on your great results? And I have a couple of questions. I think the first one and the most interesting is what are the main segments that contributed to the big increase in revenue this quarter? Can you tell, do you think it's sustainable for some kind of amount or something?

Growth in revenues is not related just to one line of business. We see it all over the portfolio, and the strategies that we have chosen are starting to bring results. The strategy uses a wide portfolio, a very advanced wide portfolio on one hand and being global as much as we can with local subsidiaries around the globe. We see a growing demand, on one hand, for this portfolio because of tensions around the globe and for the interest to increase different budgets. On the other hand, we also see a trend to support local economies and create more jobs. The fact that we have many subsidiaries around the world is certainly helping us to get contracts. So the answer is we see a growing demand for the whole portfolio all around the globe and you'll see it in the backlog, and this backlog should be converted into revenues and profits in the near future. As you saw in these results, and I believe that this trend of growth in revenues and in profitability will continue. Talking about profitability, we invested a lot in platforms to increase effectiveness, efficiency, and to create synergies between the different activities we have in the company, and that's why we are successful in gaining more profit, and I believe that this trend will continue.

I understand. Great! Does the high revenue volume contribute to the increase in the profitability in the quarter, or just...

No, it's two different. The high revenues are related to backlog, which is transformed into revenues, and the reason for the growth in profit is the big efforts and a very detailed plan that we have implemented quite a long time ago and is starting to bring results to increase effectiveness and efficiency in the company.

Understand, right. And last question. Do you expect some kind of decline in results next quarters if there will be an acceleration in COVID-19 restrictions in the world?

I think that we've proven that we know how to operate and how to be successful also under restrictions because of COVID-19. We understand that the different dynamics will not disappear in the future, and we're ready to continue to operate in the future also under new restrictions. The fact again that we have so many subsidiaries around the globe is certainly helping us. I think that we are ready to handle new assumptions if they happen in the future.

Okay, great. Thank you, guys.

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

Yes, good afternoon, Butzi and Yossi and Rami. Very nice quarter all around, guys. First question: The large cash advance that you guys received in the quarter was pretty sizable. Was that related to the Greek contract being signed, or is that related to something else?

It's a combination of various contracts. The Greek contract is definitely a significant contributor to that.

Okay. And, Butzi, I think you guys have been alluding to the implementation of the new ERP system. Is that completed at this point? Is that an ongoing process, and has that been pretty important to the margin strength?

Well, it's an ongoing effort. The plan and the implementation started about three years ago; it was a very detailed plan, and we are on plan, give or take some changes. Right now, by the end of this year, we will probably be completed around 70% of the implementation. By the end of 2022, we expect to be close to 90% of implementation, maybe a little bit higher than that. Our financial report statement includes all the capital investments that we did in that ERP system. They include all the expenses related to the implementation, but unfortunately, so far we did not see yet the benefits coming through because not the whole organization is on the same system. We are starting right now to see some very small savings, but I think it looks like somewhere in 2023, we'll be facing some more material improvements in costs due to reduction in inventory because of the commonality of items and shorter turnaround times and other benefits that will improve the operational performance of the company, hopefully including cash flow.

That's great. I appreciate the color. A couple more from me. I want to ask about the F35 program because I know you guys have a good amount of content on the F35. And the reason I ask is because we've heard from other suppliers that there were some revenue headwinds over the last couple of quarters, maybe two or three conference calls on the F35, because they kind of slowed things down a little bit and needed to wind down inventory. Have you guys kind of been through that where you've had maybe some revenue headwinds on the F35 for maybe the last couple of quarters, but maybe that shouldn't start to grow again, maybe later this year into 2022? I don't know if you could provide any color on that.

On the F35, we have significant content. The helmet system is one of them; the full display info of the cockpit is another one and some other parts as well. So far we're working with Lockheed Martin hand-in-hand, and our production plans are very closely related to their requirements. They give us some forecasts, and according to that, we work and of course, according to the purchase orders that we get from them. So far, I wouldn't say that we have experienced material headwinds, but we definitely work hand in hand with them to see that we adapt our engineering and production performance according to what they need. As I said so far, nothing material yet.

Okay, I appreciate that. Last one for me: With the large capital raise, I guess I'm just curious in terms of how you're approaching M&A going forward, how active you are, and also just kind of do you see gaps in the portfolio that you'd like to fill? How do you see your desire to reshape the company going forward?

M&A has been our strategy. It wasn't, it has been, it will continue to be. The rationale behind that is to expand the opportunity on one hand and also gain additional global positioning in the market. We continue to look for opportunities. We are monitoring the market; we see some opportunities which are relevant to us, and based on what you said, we have the right capital right now to continue doing it. I think we also proved to the market that we know how to make acquisitions and how to manage these activities and how to gain synergies from those transactions. It will continue to be part of our future strategy as well.

That's great. I appreciate the color. I'll get back in the queue. Thanks, guys.

There was a follow-up from Pete Skibitski of Alembic Global. Please go ahead.

Yes, thanks. Butzi, there was some press out there in the quarter about your ground mobile artillery system. I think it's called Sigma. I think James had an article, and I think it's still in development, but I think maybe it's nearing the end of development, perhaps. Could you give us a sense of what kind of market and international opportunities are out there for that system, because I think it's maybe the most modern mobile system that's out there right now since it's finishing up development, so?

Thank you. It's in the middle of development; we have a big contract tune as well for this Sigma 155 artillery gun, which is diverse, sophisticated, and difficult equipment to be viable and which can reach ranges of more than 40 kilometers with a limited amount of core members. It can fire guided munitions as well. We are in the middle of the development, focusing well with our local customers in Israel, and we will start performing live shooting next year. The first system should be completed around the end of next year. We see a lot of demand for it. You see, I agree with you that it is one of the most, if not the most advanced solution in the market right now. We see growing demand in several countries for that, and we are promoting it already in several countries. One of the technologies and one of the assets they have is a guidance fuse, which can be added to a regular projectile to make it guided, which will actually enable us to provide a complete solution for our customers, which includes the system itself along with all the automation embedded in it if file control system embedded with reconnaissance capabilities collected, which can create thousands for the hub itself. This includes all types of ammunition that can be fired, including guided munitions as well. We can provide a full solution for our customers, and there is a growing demand for that.

Okay, that's great. I appreciate all that color. I guess last one for me: It seems like in terms of the government in Israel, things are progressing and are pretty stable. Could you give us an update in terms of whether the government has made all of its appointments to the Israeli MOD? Is the budget outlook fairly stable at this point? Just things like that that maybe people like me internationally don't have as much visibility into?

Of course there was an understanding in the government about the size of the different budgets for the coming years. There is an agreement which has been made between the Minister of Finance and the Minister of Defense which presents a growth in defense spending in Israel. This budget, titled the national budget deal, is now under the approval process in the country, and it should be concluded by the beginning of November. It should then be implemented. This is after more than two years of not having a national budget, and when the budget is finally implemented, it will provide many additional opportunities for us which I expect to happen. This budget is bigger and it opens up many opportunities with embedded funds for new technologies to support these forces. It's also important to mention here that the budget will cover 2021 and 2022.

Okay, so much more visibility at this point than you've had in a while. That's great. Thanks so much for the color, guys. Have a great day.

The next question is from Elad Kraus of Excellence. Please go ahead.

Hi Butzi and Rami. First of all, regarding the new businesses, do you see any change in the margins that you're selling compared to the past? Is it higher, lower, or more of the same?

No. I just want to clarify a little bit of how we work so that you all understand. First of all, of course, the prices are set by the market, and that is where we compete. There might be some movements because of changes in economies in various parts of the world, but the prices are set by market competition. The cost elements are set, of course, by our estimates of costs for the various programs and on a multi-year basis. We definitely take into account anything for the future economic environment that could affect the cost of materials and labor. If we look at what we are getting from new businesses that we acquire, then definitely we can see that there are some movements, but not major movements in the prices that we are getting. On one hand, on the other hand, there is movement in the cost structure of our company, which on a multi-year basis, we have a significant effort to reduce overheads, increase productivity, and centralize production and acquisition operations, and that will lead to improved profitability. By the end of the day, the market is what defines the prices in competition. I also want to add that we have much more to offer to the market than we had a few years ago because of the acquisitions we made and due to the synergies between the different parts of the portfolio. We have many more solutions to provide, and the fact that we control most of the technology in-house creates many opportunities for us.

Okay. I see. And another thing, if you see any major changes in the CapEx of the company, is it due to the fact that you're moving out from the central region?

Well, the CapEx I would split into two parts. The part which I would call ongoing supports the ongoing operation of the overall company; in that, we do not see significant changes. There are two elements in the CapEx, which do affect the numbers that I would say are one-time. One of them is the investment in the ERP system, which is a significant investment over the years that affects our CapEx to the tune of, I would say, 10 to 20 million dollars per year. The other element, which is extraordinary, is the movement of the production facilities of IMI to the Southern part of the country, which also affects our CapEx. I don't foresee a significant step-up in that part for the following two years, but it's a one-time effort. If you look at what's been happening in the CapEx in the last five years, let's say in the last three years versus what’s coming in the next two years, it supports both these major efforts which are not recurring. The other CapEx is essentially stable; maybe we’ll see some minor increases in some advanced technologies that require specific engineering capabilities, but nothing outstanding.

Alright, thank you very much. Great quarter. Thanks.

There are no further questions at this time. Before I ask Mr. Machlis to go ahead with his closing statement, I would like to remind participants that a replay of this call will be available two hours after the conference ends. In the US please call 1-888-782-4291. In Israel, please call 03-925-5900, and internationally please call 972-3-925-5900. A replay of this call will also be available on the company's website at www.elbitsystems.com. Mr. Machlis, would you like to make your concluding statement?

I would like to thank all employees again for their continued hard work, particularly in these challenging times, and thank everyone on the call 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 2021 results conference call. Thank you for your participation. You may go ahead and disconnect.