Elbit Systems Ltd Q4 FY2022 Earnings Call

Ladies and gentlemen, thank you for standing by. Welcome to Elbit Systems’ fourth 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 Rami Myerson, Elbit Systems Investor Relations Director. Rami, please go ahead.

Thank you, Yanni. Good day everyone and welcome to our fourth 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 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 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. Earlier today we hosted an investor conference at the stock exchange. A recording of the event is available in the investor relations section of our website at www.elbitsystems.com. Investors and analysts who wish to ask questions related to this topic at the investor conference are welcome to present their questions during the Q&A session of the call. With that, I would like now to turn the call over to Kobi. Kobi, please.

Thank you, Rami. Hello everyone and thank you for joining us today. The 2022 annual results reflect the business environment supported by growing defense budgets around the world and another year of significant contract awards. We ended the year with a record order backlog of $15.1 billion, up 11% relative to the end of 2021. Our financial performance in 2022 also includes the impact of supply chain disruptions and labor cost inflation. This includes a $62 million expense related to employee stock price-linked compensation plans and an additional $10 million of retention bonuses. Our GAAP and non-GAAP results have always included these expenses but this year they were higher than in recent years following the share price appreciation. Our budgets along the term planning assume that the global economic trends and supply chain and wage inflation headwinds would 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 extend our customer base and also continue to invest in CapEx to improve and expand our manufacturing footprints. I would note that the sale of Ashot Ashkelon to FIMI Opportunity Funds was completed at the end of the second quarter of 2022 and now results in the second half of 2022 do not include a contribution from Ashot Ashkelon. I would now highlight and discuss some of the key figures and trends in our financial results. Fourth quarter revenues were $1.506 million compared to $1.494 million in the fourth quarter of 2021. For 2022 as a whole, our revenues were $5.5 billion versus $5.3 billion last year. In terms of annual revenue breakdown across our areas of operations, C4ISR accounted for 29% of revenues which increased year-over-year mainly due to UAS and anti-submarine warfare sales. Airborne systems accounted for 37% and declined year-over-year. The growth in training and simulation sales helped offset lower airborne precision guided munitions sales. Land systems was 22% of total revenues and the year-over-year decline is mainly due to the sale of Ashot Ashkelon. Electro-optics accounted for 10%, and increased year-over-year due to increased sales of night vision systems. Other sales accounted for 3% and declined year-over-year mainly due to lower sales with our U.S. medical instrumentation subsidiary. Our diverse geographic revenue base is important to the long-term sustainability of our business. In 2022, North America contributed 27%, Europe 23%, Asia-Pacific 26% and Israel contributed 19% of revenues. European revenues increased mainly due to growth in UAS, munitions and training and simulation sales. North America revenues were lower mainly due to the decline in medical devices sales. Asia-Pacific revenue declined mainly due to lower precision guided munitions and C4ISR sales. The non-GAAP growth margin for the fourth quarter was 25.7% compared to the fourth quarter of 2021 at 25.5%. For the full year of 2022, the non-GAAP growth margin was 25.5% compared with 26.2% last year. GAAP gross margin in the fourth quarter was 25.3% of revenues compared to 25.1% in the fourth quarter of 2021. GAAP gross margin in 2022 was 24.9% compared with 25.7% in 2021. Gross margin in 2022 reflected an unfavorable mix with inflation and supply chain disruption. GAAP and non-GAAP gross profit in 2022 include expenses related to stock price-linked compensation plans. The fourth quarter non-GAAP operating income was $103 million or 6.8% of revenues compared with $120 million or 8% of revenues last year. GAAP operating income for the fourth quarter was $120 million versus $107 million in the fourth quarter of 2021. Non-GAAP operating income in 2022 was $357 million or 6.5% of revenues compared with $451 million or 8.5% of revenues last year. GAAP operating income was $368 million versus $419 million last year. Operating margins declined year-over-year due to higher R&D and sales and marketing expenses. The operating expenses breakdown in 2022 was as follows; net R&D expenses were 7.9% of revenues, versus 7.5% in 2021. Marketing and selling expenses were 5.9% of revenues, versus 5.5% last year. G&A expenses were 5.7% of revenues, compared to 5.1% last year. We have increased investment in R&D, and in sales and marketing to realize the potential opportunities provided by defense budget growth and increased demand for our capabilities. Other operating income of $68.9 million in 2022 included capital gains related to the sale of buildings in Israel and the U.K., as well as a facility relocation grant of $28.6 million received by a subsidiary in Israel in the fourth quarter. Operating profit in 2022 includes expenses of approximately $62 million related to stock price-linked compensation plans and an additional $10 million of retention bonuses. Financial expenses were $27 million in the fourth quarter, compared to $20 million in 2021. Financial expenses in 2022 were $51 million, compared to $40 million last year, and reflected the higher interest rate environment. Other expenses were $24 million in 2022 and resulted mainly from the re-evaluation of holdings in affiliated companies and expenses related to non-service costs of pension plans. We recorded a tax benefit of $5 million in the fourth quarter, compared to a tax expense of $92 million in 2021. Taxes on income in the fourth quarter of 2021 included a one-time expense of approximately $80 million related to the amendment of legislation regarding exempt earnings from approved enterprises in Israel. The effective tax rate in 2022 was 8.2% compared to 34.3% in 2021 that included extraordinary expenses. Our non-GAAP diluted EPS was $1.68 in the fourth quarter and $6.03 for the full year of 2022. GAAP diluted EPS was $1.91 for the fourth quarter of 2022 and $6.18 for the full year. The stock price-linked compensation expenses in 2022 were $1.26 on an EPS basis, and an additional $0.20 of retention bonuses on an EPS basis. Our backlog of orders as of December 31, 2022 was $15.1 billion, which is $1.4 billion higher than the backlog at the end of 2021. Approximately 60% of the current backlog is scheduled to be performed during 2023 and during 2024, while the rest is scheduled for 2025 and beyond. Operating cash flow for the fourth quarter was a $195 million inflow compared to a $260 million inflow in the same quarter last year. For 2022, we reported a $240 million operating cash inflow versus a $417 million cash inflow in 2021. Cash flow from investing activities includes high CapEx related to new facilities in Israel and in Charleston, South Carolina, as well as the rollout of the ERP system. The Board of Directors declared a dividend of $0.50 per share. I will now turn the call over to Mr. Machlis. Over to you, Butzi, please go ahead.

Thank you, Kobi. 2022 was another good year for Elbit Systems with sustained growth and record order backlog. We've continued the strategic transformation of Elbit Systems, moving up the value chain from a system provider to a company that provides comprehensive and relevant solutions to the growing global customer base. We initiated this transformation during the previous decades, and you have seen the successful implementation as the order book and revenue growth accelerated in recent years. We have also seen a step up in the number of large three-digit contract awards. As part of the broader transformation of Elbit Systems, we have invested in an operational transformation to improve performance and our ability to deliver the growing backlog. At our 2023 investor conference earlier today, we presented some of these investments. We have increased our investment to upgrade and expand our manufacturing footprint. We have acquired new machines; we are adapting new technologies and implementing processes to increase the throughput and efficiency of our production facilities. For example, we have increased the capacity of our high radio production factory in northern Israel by 60%, or 10,000 additional units per year. We are also building new facilities around the world. Construction of our new ammunition production site in Ramat Beka is progressing on schedule and should be up and running for 2024. This new state-of-the-art facility should benefit from growing demand for munitions. We have invested in new production facilities across Europe, in the U.K., Germany, and Romania. In 2023, we plan to open a new ground combat vehicle assembly and integration center in Charleston, South Carolina. In 2022 and 2021, we increased our CapEx to fund the building of these and other new facilities. We believe this investment will deliver good returns and support growth over the coming years. We plan to complete the implementation of the new ERP system across the company by the second half of 2023. As a reminder, Elbit Systems is moving from 11 different ERP systems we used in the past to a single ERP system. We expect the total investment in the new ERP system to be close to $200 million. Approximately two-thirds of this investment is the cost of the system that will be amortized over the coming years. Approximately a third of the investments are the expense cost related to the implementation that has impacted our profitability in recent years. We expect a successful implementation of the new ERP System to support an improvement in profitability and cash generation. Elbit Systems has been impacted by the global supply chain disruption in recent years that slowed revenue growth and increased our costs to mitigate the impact of this disruption and maintain timely deliveries to our customers as we increased inventory. Our working assumption is that global supply chain pressure will gradually ease over 2023, with the most significant improvement expected in the second half of 2023. In 2022, we increased our investment in R&D to sustain the development of leading solutions that provide our customers with a valuable, comprehensive advantage. A significant award we received in 2022, and in recent months, has validated the alignment between Elbit Systems' portfolio and our customers' priority areas for defense spending and mission-critical requirements. The potential for orders from European countries have been frequently mentioned during investor calls and meetings over the last year following the announcement of defense budget increases by multiple federal governments. We have observed a noticeable increase in customer interest across Europe and expect this interest to gradually convert into orders. In recent months, we announced a series of European customer contracts across a range of capability areas, including artillery and rocket artillery, UAVs, and armed vehicles. We also reported strong growth in European revenues in 2022. We expect this trend to continue over the coming years as European governments increase defense spending and recapitalize both their military forces and the domestic defense industrial base. Elbit Systems is well-positioned to benefit from this trend, following significant investment made to expand our presence across Europe over the last decade. Our subsidiaries across Europe, from the U.K. to Romania, employ hundreds of employees, support the local supply chain, and are an integral part of the domestic defense industrial base. We have also partnered with many large European defense companies. In 2022, we announced a joint venture with KMW, the German armored vehicle manufacturer, to cooperate on the Euro-PULS, the next generation of Rocket Artillery System for European customers. The $17 million contract we received in January 2023 and the €133 million contract announced in March for European countries highlight both the demand for Rocket Artillery in Europe and Elbit’s leading position in this market. UAVs are another capability area where we are benefiting from increased demand. In December 2022, U-TacS, our U.K. subsidiary, was awarded a $400 million, five-year framework contract by the Romanian Ministry of Defense for Watchkeeper X tactical unmanned aerial systems. In December, we also received a contract from the Australian MOD for Skylark UAVs. Elbit Systems is Israel's largest defense contractor and an important part of the Israeli economy. Recent political developments and judicial legislation proposed by the government have not impacted our business so far; however, sustained political instability could have implications for the local defense industry, as we have seen in the past and could also increase economic uncertainty. I am confident that Israeli leadership will act responsibly to stabilize the situation and ensure Israel’s long-term security and prosperity. In recent months, we were awarded significant long-term contracts by the Israeli MOD. In January, we received a $180 million contract to provide and operate a new Mission Training Center to train the Israeli Air Force on F-16 aircraft. In January, we also received a $107 million contract to provide and operate an advanced training center for the Israel Defense Forces. Elbit Systems has developed a broad portfolio of market-leading training and simulation solutions for militaries around the world. Our training and simulation technologies have been selected by a range of customers, including the U.S., U.K., Greece, and Poland. We believe there is significant potential in this market for solutions that provide more realistic training that better prepare soldiers for a wide range of scenarios at a lower cost. And with that, I will be happy to take your questions.

Thank you. The first question is from Ellen Page of Jefferies. Please go ahead.

Good morning, guys. Thanks for the question.

Good morning, Ellen.

Just looking at Europe, post-2022, obviously, there's a lot of higher defense spending. But how much of the 11% backlog growth can be attributed to Europe? And is there any way to think about the mix of long-cycle versus short-cycle demand from the region?

Hi, Ellen, this is Yossi. I'm not sure I got your question properly. Could you repeat it, please?

Sure. So just looking at European demand, how much of the 11% backlog growth was from Europe? And can you talk about the mix of long-cycle versus short-cycle orders in Europe?

Well, I would say a significant part of our backlog growth did come from Europe; however, Asia Pacific and the U.S. also saw nice growth in the backlog. We will provide the exact breakdown. But you are right that Europe is a significant contributor to that. From the point of view of the spread of the backlog, we do indicate how much of our backlog is expected to be transformed into revenues in the 2023 and 2024 period. The rest of it is scheduled for 2025 and onward; usually, about 60%, roughly, of our backlog is expected to be realized in those two years, and this percentage has not changed a lot over the years; it’s quite stable.

Okay, helpful. And just unmanned systems, it's been pretty lumpy throughout 2022. What drove the weakness in the quarter? And how do we think about that business into 2023?

It's Butzi. I just want to remind you that a short number will be deducted from the revenue from the second quarter of 2022. We see a growing demand for that solution in Europe as well as in other places. So I'm quite optimistic that the growth related to land systems will continue in the near future.

Thank you. I'll hop back in the queue.

Thanks, Ellen.

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

Good afternoon, everyone.

Good afternoon.

Guys, maybe to start out, 2022 is a pretty good growth year, weighted to the first half. Is something similar for 2023 reasonable for investors to expect? Something in that 4% to 6% type of a range?

Well, Pete, this is Yossi. You know that we do not provide guidance. However, if you look at our backlog numbers that have grown significantly, much more than our revenue numbers, then from that, it is just natural that during 2023 we're going to be able to realize some of that growth in revenues as well.

Right. Okay, fair enough. Thank you for that. And then maybe you'll see on the $62 million employee stock-based compensation in 2022. Do you guys have the number for what that was in 2021 so we could just, you know, judge the magnitude of the increase and maybe factor in our expectation for 2023?

Hi, good morning. This is Kobi. Actually, the $62 million is the difference between the numbers that we saw on 2021 and 2022. So this is actually a one-time expense, which is higher in total from the numbers in 2021. Additionally, we had mostly for engineers some retention-linked bonus programs that cost us an additional one-time $10 million. So it's $72 million of additional expenses, which we are not expecting to have similar expenses during 2023.

Right. Okay. So I imagine there are people out there thinking that 2022 is probably a trough margin year for Elbit. And given, hopefully, the likelihood that employee-linked compensation will decline in 2023. I don't know if there are other mix issues or if net pricing has improved, but is it reasonable for us to expect margins to improve in 2023 by some amount? I don't know if you want to put any kind of a range around it or not, but I guess I'll stop there.

Again, Pete, we do not give you exact numbers, but definitely the numbers that Kobi mentioned earlier will not repeat themselves in 2023.

Can you provide insights on whether you're able to address the inflation in base labor rates through your pricing in 2023, or do you anticipate changes in that area?

Well, you know Pete, that about, I would say 75% of our labor force is in Israel. The compensation of these people is done in local currency, of course, the shekel. During 2022, we had a currency exchange rate between the shekel and the U.S. dollar of roughly about 3.3 shekels to the dollar. In general, on average, this number is going to improve in 2023. It is still to be calculated, but we expect an improvement in labor costs in dollar currency.

Okay, okay. I appreciate it. Okay, yes, I'll stop there. Thanks so much, guys.

Thank you. Thank you, Pete.

The next question is from Atinc Ozkan of WOOD & Company. Please go ahead.

Thank you. Perfect pronunciation of my name. This is Atinc Ozkan from WOOD & Company. Sorry if my questions are repetitive. I was not able to join earlier in the conference. But two questions for you, please. The first one is regarding your recent strategic MOU in Japan. You signed it with localized space companies. And we know that Japan is rearming; they will be spending roughly, I guess, $300 billion over the next five years. What specific opportunities do you see for your products in Japan? Should we assume that you will start with the needs of the Japanese air defense force, given that they are operators of F-15 and F-35? That's the first question. And second, could you please provide some updates regarding the progress of your ongoing investment programs, whether it's the ERP, the ongoing production line in South Carolina, or the state-of-the-art plant in Southern Israel for IMI? Thank you.

With regards to your first question, we see the ongoing investment in Japan in defense. We find that our portfolio is very relevant to the growing needs in this market. We see there is a lot of interest in our portfolio, and I'm talking about training solutions, and other capabilities. For this, we have teamed with several companies in the country. As you noted, we presented at the last exhibition two weeks ago. It's not the first time we are in this market, and we definitely see a growing opportunity in these areas, as well as in others in the Japanese market. It's a new market for us, and we feel very welcome in this market. We have very good relationships with the local industry, and the customers, especially the Ministry of Defense, are well aware of our technologies and capabilities. Regarding our new facilities, our new facility in the south in Ramat Beka will start being operational in June 2024, and we expect it to be fully operational in 2025. Our production facility in South Carolina will enter into production in 2023. I think we talked about it in another article. The one ERP system we are investing in is significant. The system that we are deploying right now will replace 11 different Elbit Systems systems that we've used in the company, and the final implementation stage will take place in the fourth quarter when we are going to implement the system in the old IMI operation. This will be the final implementation phase; the rest of the company is already on the system, and we are starting to see many benefits from this new ERP solution.

Crystal clear.

Thank you, Atinc.

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

Yes, thanks, guys. Butzi, you talked about increasing defense budgets around the world and how you're spending increased business development money to take advantage of those markets. And I think you are implying that R&D was kind of a part of that overall. In 2022, I think you spent the most on R&D in probably a decade. I know FX has an impact, etc. But going forward, should we expect that R&D spend will remain elevated so that you can take advantage of these very active markets over the next few years, or have we reached a plateau there? Just wondering if you had any color to add.

We have, as you know, our strategy is to be a leader in different markets. For that, we have to invest in R&D. We're investing in several areas just to give you examples: high-power lasers, we have a unique position in this market. We have unique technology and we are providing high-power lens solutions. Today we have a front from Israeli high-power level. This is just one area where we invest. Another area is guided munitions. After the acquisition of IMI, we took a strategic decision to combine our guidance capabilities with the munition portfolio for IMI, and today we have a new and very advanced line of business that is very successful in Israel as well as abroad. Another area where we're investing quite a lot is autonomy. We see autonomy in AI and big data, and these areas. We believe we are world leaders and we would like to continue this investment. This year, we have invested about 7.9% in R&D, and percentage-wise, I don't think we will increase this number in the future. So that’s more or less where we will continue to invest in the future.

Okay, thanks so much.

Thanks, Pete.

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 U.S., please call 1888-782-4291. In Israel, please call 03-925-5900 and internationally, please call 972-3925-5900. A replay of this call will also be available at the company’s website www.elbitsystems.com. Mr. Machlis, would you like to make your concluding statement?

I would like to thank all of our employees for their continued hard work and contribution to Elbit Systems' success. 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 fourth quarter 2022 results conference call. Thank you for your participation. You may go ahead and disconnect.