Earnings Call Transcript - ESLT Q2 2023

Operator, Operator

Ladies and gentlemen, thank you for standing by. Welcome to Elbit Systems Second Quarter 2023 Results Conference Call. 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 at 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, Investor Relations Director

Thank you, Nathan. Good day, everyone, and welcome to our second-quarter 2023 earnings call. On the call with me today are Butzi Machlis, 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 in the company's 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 better understand the performance of the ongoing business. You can find all the detailed GAAP financial data as well as the non-GAAP financial information and the reconciliation 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 now like to turn the call over to Kobi. Kobi, please.

Kobi Kagan, CFO

Thank you, Rami. Hello, everyone, and thank you for joining us today. The financial results of the second quarter of 2023 reflect sustained demand for our solutions, increased production capacity, and gradual easing of supply chain pressures that supported the revenue growth. The sequential increase in operating profitability provides an encouraging initial indication of the successful implementation of the operational improvement plan. We continue our efforts across the company to improve profitability and cash generation and realize our potential. Before I discuss some of the key figures and trends in our financial results, I would note that the sale of Ashot Ashkelon to FIMI Opportunity Funds was completed at the end of the second quarter of 2022. Our results in the second quarter of 2023 do not include a contribution from Ashot Ashkelon. Second-quarter revenues increased by 12% to $1.454 billion compared to $1.303 billion in the second quarter of 2022, with growth across all business segments. In terms of quarterly revenue by segment, aerospace revenue increased by 19% in the second quarter of 2023 compared to the second quarter of 2022, mainly due to training and simulation sales in Europe. C4I and cyber revenues increased by 1% year-over-year. ISTAR and EW revenues increased by 21%, mainly due to European Electronic Warfare sales. Land revenues increased by 3%, mainly due to armored vehicle upgrades and ammunition sales. Elbit Systems of America revenues increased by 7% in the second quarter due to growth in night vision sales. Elbit Systems benefits from a diverse geographic revenue base that reduces revenue volatility and supports the long-term sustainability of our business. In the second quarter, Europe was our largest market, contributing 32% of group revenues. North America was 23%, Asia Pacific 22%; and Israel contributed 17% of revenues. European revenues increased mainly due to growth in training and simulation sales. Asia Pacific revenues declined primarily due to lower precision-guided munition sales. The non-GAAP gross margin for the second quarter was 26.1% compared to the second quarter of 2022 at 26.5%. GAAP gross margin in the second quarter was 25.6% of revenues compared to 26.1% in the second quarter of 2022. Second-quarter non-GAAP operating income was $112 million or 7.7% of revenues compared with $103 million or 7.9% of revenues last year. The sequential improvement in non-GAAP operating profitability is an encouraging indication of the tangible benefits of the operational transformation plan. GAAP operating income for the second quarter was $102 million or 7% of revenues versus $115 million or 8.8% of revenues in the second quarter of 2022. GAAP operating income in the second quarter of 2022 included a capital gain related to the sale of our subsidiary, Ashot Ashkelon Industries, as well as the sale of a building in Israel. The operating expenses breakdown in the second quarter was as follows: Net R&D expenses were 6.4% of revenues versus 7.4% in 2022. Marketing and selling expenses were 7% of revenues versus 6.4% last year. The positive inflection in global defense budget growth has created multiple opportunities, and the increase in marketing and sales spending will help to realize the potential this creates. G&A expenses were 5.2% of revenues compared to 5.6% last year. Financial expenses were $32 million in the second quarter compared to $9 million in 2022. Financial expenses in the second quarter were higher as a result of the significant increase in interest rates and higher debt. Operating cash flow in the second quarter was a $138 million outflow compared to a $169 million outflow in the same quarter last year. Operating cash flows in the first half of 2023 reflect an increase in inventories to support revenue growth and delays of payments from the Israeli Ministry of Defense. We do not believe there is a risk to receiving these outstanding payments, and we continue to work with our customers to expedite these payments. Our operational improvement plans should also support our efforts to improve cash generation in the medium term. We recorded a tax expense of $9 million in the second quarter compared to $13 million in 2022. The effective tax rate in the second quarter was 13.6%, a similar level to the tax rate in 2022. Our non-GAAP diluted EPS was $1.57 in the second quarter compared with $1.73 in 2022. GAAP diluted EPS was $1.40 for the second quarter compared with $1.82 in 2022. Our backlog of orders as of June 30, 2023, was $16.1 billion, a $2 billion higher than the backlog at the end of the second quarter of 2022. Approximately 49% of the current backlog is scheduled to be performed during the remainder of 2023 and 2024, and the rest is scheduled for 2025 and beyond. The Board of Directors declared a dividend of $0.50 per share. I will now turn the call over to Mr. Machlis, Elbit CEO. Butzi, please go ahead.

Bezhalel Machlis, CEO

Thank you, Kobi. The second-quarter results demonstrate the successful implementation of Elbit Systems' long-term strategy. Revenue growth accelerated in the quarter as we started to benefit from increased capacity, alleviation of supply chain bottlenecks, and continued demand for our portfolio of solutions from customers around the world. The operational improvement plan that we discussed with you in the past is starting to deliver tangible results with a sequential increase in our operating profitability. Financial expenses in the first half reflect the increase in interest rates and higher debt due to delayed payments from customers. In recent years, we have leveraged a strong balance sheet to overcome the challenges presented by COVID-19 and supply chain disruption to sustain deliveries to our customers. The increased interest rate environment has raised our cost of financing. As part of our operational improvement plan, we are working to improve cash generation and reduce financial leverage. This should contribute to a reduction in financial expenses over time. I would like to review how the financial results in the second quarter reflect the successful implementation of Elbit Systems' long-term strategy. The growth in European revenue in recent quarters is a direct result of our multi-year investment in building a multi-domestic footprint across Europe. Elbit Systems identified the long-term potential across the European market as part of our strategic planning. Many European governments had significantly reduced the scale of military forces following the end of the Cold War. This also resulted in reduced procurement from the domestic defense industrial base and the investment in defense-related research and development. At Elbit Systems, we identified the opportunity to supply our advanced solutions to customers across Europe by building domestic subsidiaries with engineering, manufacturing, and support capabilities, transferring our cutting-edge IP and solutions, and adapting them to the requirements of different European customers. We established domestic subsidiaries and partnerships with local companies across Europe from Sweden to Greece and from the UK to Romania. When we were ramping up our investments across Europe, other defense companies were shrinking their exposure and reducing investments. The Russian invasion of Ukraine was a wake-up call for many European countries that have substantially decided to ramp up their defense spending, strengthening military forces and domestic industrial bases. Following years of investment in our multi-domestic presence across Europe and our portfolio of leading and relevant solutions, Elbit Systems has started to benefit from the growth in European defense spending as demonstrated by the growth in recent quarters as well as the orders we announced for Watchkeeper X UAV in Romania and airborne EW systems from Germany in recent months. In 2018, we acquired IMI from the Israeli government and integrated it into our Land segment. IMI has two major product areas, active protection systems for armed vehicles and a broad portfolio of munitions. The strategic rationale recognized the potential for significant value creation we could generate by combining our legacy technology with IMI's munition portfolio to develop a range of air and ground launch precision-guided munitions. As part of the acquisition, we committed to building a brand new mission production development and testing facility in the southern part of Israel. The Russian and Ukrainian militaries are consuming thousands of rounds of ammunition every day in the current conflict. Militaries around the world have realized the critical importance of munition production capacity and stockpiles. We are benefiting from the strong demand for our portfolio of munitions and launchers from customers around the world. In July, we announced a $60 million contract to supply artillery shells to the Israeli MOD. These orders follow multiple orders for our PULS rocket launchers, precision rockets, artillery solutions, and tank munitions. Demand for platform protection solutions has also increased, and we have received significant interest from customers around the world in our Iron Fist active protection system. The strong demand for the Land segment solutions validates the strategic rationale for the acquisition of IMI and our M&A processes. As part of our strategic processes, we regularly review our portfolio to identify capability or technology gaps that we can fill through M&A. We have spent more than $1 billion in recent years on a series of acquisitions that are delivering tangible returns like IMI and NICE. We also review our existing portfolio to identify the business units that are no longer relevant to our strategy and could be more successful under different ownership. When we identify these businesses, we explore opportunities to sell them. In 2022, we sold Ashot Ashkelon to FIMI Opportunity Funds and Ferranti Technologies' Power and Control business in the UK to TT Electronics. This is the preferred option, but if we are not able to find a buyer, we close the business as part of our strategy to optimize our business portfolio. Last week, following our AGM, David Federmann was appointed chair of Elbit Systems' Board of Directors, replacing Michael Mickey Federmann, who will remain on the Board as a director. Mickey was appointed as the Chair of the Board in July 2000, following the merger between El-Op and Elbit Systems. In 2000, Elbit Systems reported annual revenues of $591 million and a backlog of $1.4 billion. In 2022, Elbit reported annual revenues of $5.5 billion, a 900% increase, and a backlog of $50.1 billion that increased to $6.1 billion at the end of the second quarter. Revenues and order backlog growth during Mickey's tenure have outstripped global defense budget growth, and Elbit Systems has become one of the leading defense companies in the world. Elbit Systems was ranked 21st in the first news top 100 global defense companies. On behalf of Elbit's employees, I would like to thank Mickey for his leadership and wish David Federmann success in his role as the Chair of the Board of Directors. And with that, I will be happy to take your questions. Operator?

Operator, Operator

The first question is from Sheila Kahyaoglu from Jefferies.

Sheila Kahyaoglu, Analyst

I just wanted to ask a few questions, if that's okay. You talked about it in the prepared remarks a little bit, but obviously, Europe was really strong in the quarter. And Israel and North America were weaker. How should we think about the cadence of growth across geographies from here? And any color on the regional mix in the backlog?

Bezhalel Machlis, CEO

Sheila, we see a big potential ahead of us, the funnel of opportunities we deal with is quite large. And we see many opportunities in all domains, actually. We expect to see growth in Europe, and we also expect to see growth in Asia Pacific, as well as in the U.S. In Israel, we are waiting for a five-year planning with the Israeli MOD, which should take place around the end of this year. After it takes place, I believe that we'll be able to get more orders from the MOD, and Latin America is shrinking. I don't expect big orders from this region in the near future. After the Abraham Accords, there are more opportunities for us in the Middle East. We have a subsidiary in the UAE, and we believe that there is quite a big potential for us in this market as well. Our diverse presence acts as a stabilizing factor for future growth. I believe that the strategy of Elbit, which includes two main pillars: one is the very wide portfolio, and the other one is being a global company with many subsidiaries around the globe, is proving itself, and I expect to see additional growth in revenues as well as in backlog.

Sheila Kahyaoglu, Analyst

Great. And I may ask one or two more if that's okay. When we think about the European market, obviously, it's been really good again. Is there a different strategy there? You mentioned your coverages in your prepared remarks, how you sell in Europe versus how you sell in North America and Asia?

Bezhalel Machlis, CEO

No, I don't expect a different strategy. We continue to enhance our local presence in Europe. We have many subsidiaries. We have subsidiaries in the UK. We just inaugurated another facility for Elbit in the UK a month ago; we are enhancing our position in Germany as well. We inaugurated another facility in Germany. We have subsidiaries in Sweden, Belgium, Switzerland, Austria, and Romania. We are working hard with our customers to improve our local position in the continent because that's our strategy. Regarding the U.S., as you know, we acquired two companies in the U.S. recently: Sparton and Night Vision. We are very happy with these acquisitions. We see a lot of interest in our portfolio in the U.S. market, and we expect additional growth for us in the U.S. market.

Sheila Kahyaoglu, Analyst

Great. And then one more, if you don't mind. On the free cash flow, continued usage, how much of that $300 million or so of usage in the first half will reverse in the second? And how much is tied to Israel specifically in the working capital?

Kobi Kagan, CFO

Sheila, this is Kobi. We expect that the second half will be a positive one. We see some delays in payments from the Ministry of Defense here in Israel, but we don't expect those delays to extend past the year-end. So we expect that in the second half, the Ministry of Defense will pay all the outstanding receivables that we are currently missing in our cash flow position.

Operator, Operator

The next question is from Pete Skibitski of Alembic Global.

Peter Skibitski, Analyst

Butzi, I wanted to follow up on Sheila's question regarding Europe because the revenue there has been incredible, right, up 40% last year and roughly 60% here through the first half. Very impressive. From the perspective of playing the role of the devil's advocate, how much concern do you have about the willingness of European governments to continue funding defense budget increases in light of inflationary pressures and macroeconomic concerns? Do you think the governments will follow through with budget increases in the next few years given the current macroeconomic backdrop?

Bezhalel Machlis, CEO

Thank you, Pete. From what I understand, all European countries understand right now that they need to spend 2% of GDP on defense, and some countries are really investing more than that. This emphasis is not just for the short term, but more for the long term. Many countries also understand that they need to build local capabilities and want to reduce their dependency on external sources, and this aligns perfectly with Elbit's strategy. Thus, I do not foresee a decline in defense spending in the near or medium term in Europe. Additionally, I want to highlight the huge demand to increase inventories for munitions and supplementary products in Europe. Many countries have faced significant shortages of critical munitions, tanks, artillery pieces, UAVs, and communication equipment. It will take years to replenish these stocks to the required quantities. So I don't foresee a shift or change in demand in the market. I also want to add that the backlog we have in Europe, as well as in other places, is not confined to just the coming quarters; it's a long-term backlog, and I am confident it will yield additional revenues in Europe. We are seeing increasing demand for guided munitions, UAVs, electronic warfare systems, communication solutions, and anti-drone systems throughout the continent as a result of the conflict with Ukraine, and I don't expect this trend to change in the near future.

Peter Skibitski, Analyst

That's very helpful. I appreciate the insight. Let me switch to Israel now, and without steering the conversation into politics from thousands of miles away, can you give us a sense of the recent social unrest? Do you expect that to impact the MOD's budget processes or contracting activities?

Bezhalel Machlis, CEO

No. Without entering into politics, as you indicated, I don't expect the situation in Israel to impact matters. There is a budget in the country, and a process is currently underway to build a five-year plan for the IDF. This plan should be concluded around the end of this year, and we expect to receive orders afterward. So far, I do not see any changes.

Peter Skibitski, Analyst

Okay, appreciate that. Last one for me: Earlier this year, we moved away from discussing Phantom stock options expenses because the shares had retreated a bit. But now the shares are up about 25% year-to-date. Should we start being concerned again about stock option expenses as a possible headwind to margins? Can you provide some insight there?

Kobi Kagan, CFO

Thank you, Pete, for the question. The Phantom stock option plan has specific terms, and all payments concerning this option plan are scheduled to be concluded this year. We do not expect any further costs on the P&L from stock options either this year or in coming years.

Operator, Operator

The next question is from Ella Fried of Bank Leumi.

Ella Fried, Analyst

Well, it seems that you managed to tackle the supply chain challenges, but also the cost of increasing inventories. Correct me if I'm wrong. This increase in demand brings me to my follow-up question on cash flow: How do you plan to address the challenge of inventories with significant growth? When supply isn't as smooth as it used to be?

Bezhalel Machlis, CEO

First, I must point out that, as we predicted, most of the obstacles we faced during COVID regarding the supply chain are mostly over. While not all are resolved, it's considerably better than it was a year ago or even a quarter ago. Therefore, we don't face the same supply chain hindrances as before. This should positively affect inventory levels. During COVID, due to uncertainty, we were required to purchase more inventories to ensure deliveries to our customers. Today, we can revert to our previous procedures, and there is no longer a need to maintain large stocks due to supply chain constraints. The company is growing significantly, as you've observed. To meet the demand and fulfill our commitments, we need to acquire more stocks to deliver goods to customers. That's what you see reflected in the results. We continue to work diligently to reduce inventories. As I mentioned, the normalization of the supply chain will assist us in doing so, which is an important effort within the company currently.

Ella Fried, Analyst

It seems that the headwind of the supply chain has shifted toward increasing costs of labor and delays. Do you believe this trend will continue into 2024? How are you managing it?

Bezhalel Machlis, CEO

No, regarding the workforce situation, it's contrary to what you mentioned. The company has grown significantly, and there is still a demand for additional staffing. Recruiting good talent was quite challenging during COVID. However, it is now easier to find capable individuals in the country, and salary expectations are more reasonable. Thus, I don't see major challenges in acquiring good talent in the country at reasonable costs compared to a year ago, which was quite different.

Ella Fried, Analyst

So I suppose my next question is for Kobi. How should we assess 2024's profitability compared to this quarter? Are we expecting a substantial increase? I recall you mentioning that we should anticipate quarter-over-quarter improvement. However, looking at this quarter, the financial expense impact concerns me. What should we expect for 2024 in relation to this quarter?

Kobi Kagan, CFO

So Ella, thank you for your question. As you know, we typically do not provide specific guidance. However, as Butzi previously stated, we are targeting sequential improvement in non-GAAP operational profitability. We've endeavored to honor that commitment, and we have observed a gradual improvement in non-GAAP operational profitability. The company is actively working towards achieving this improvement. Regarding financial costs, we see a dramatically increased neighborhood of interest rates, and we are facing higher interest rates. Our risk rating is excellent; however, the base interest rates, the SOFR, are now at 5.5% compared to almost zero a year ago. So while we maintain almost the same debt levels, we are encountering increased financial costs, which represents the new reality. As we previously stated, improving cash generation will help reduce our financial debt.

Bezhalel Machlis, CEO

We are also committed, as mentioned earlier, to continue to improve our operational profit, our non-GAAP operational profit, as you’ve seen in the last few quarters, and we will continue this trend into the future.

Ella Fried, Analyst

And perhaps an unpolitically correct question, but can you clarify what happened with Denmark? There have been numerous publications about it. Does it impact Elbit's orders, if at all? Is it relevant to Elbit's position in any way?

Bezhalel Machlis, CEO

The answer is very clear and simple. It has nothing to do with Elbit. There was an urgent requirement, and the Danish MOD came here and decided to acquire our products. We secured an order which is valid. The criticism occurring in Denmark currently does not pertain to Elbit but is rather about internal processes within Denmark. We have already delivered some equipment to them, and this program is active. We believe we will receive additional orders from them in the future. Moreover, we have won contracts for rocket launchers not only in Denmark but also in the Netherlands and just recently secured a $300 million contract, with significant opportunities for guided munitions in Europe.

Operator, Operator

The next question is from Elad Kraus of Meitav.

Elad Kraus, Analyst

Well, you've answered most of my questions, but I do have one leftover. Do you notice any changes in the competitive landscape that could affect the company's margins in 2024 or 2025, possibly leading to higher or lower margins than today?

Bezhalel Machlis, CEO

Of course, competition exists in the market, but our substantial portfolio depth and global presence give us a unique advantage. Customers are increasingly looking for mature equipment, rapid access to it, and local providers, which makes us distinctive in our offerings. Of course, this competitive landscape varies by segment, each having its type of competition; however, not many companies possess the extensive portfolio and market position that we have.

Elad Kraus, Analyst

Based on this, should we expect the same margins we’ve experienced over the last few years?

Bezhalel Machlis, CEO

I can tell you that the gross profit profitability of our backlog is higher than the gross profit from the revenues reflected in our quarterly results. Therefore, I am confident that our future revenues will exceed past figures and that our profit margins will improve.

Operator, Operator

The next question is from Boaz Ben-Shitrit of Altshuler Shaham.

Boaz Ben-Shitrit, Analyst

I have three brief references that I would like to address. First, regarding the delays in payments from the Israeli Defense Force, are you receiving any compensation due to incurring costs? Secondly, looking forward, I see higher interest rates; can we expect similar conditions to the past six months? Finally, concerning your future contracts, mainly regarding the backlog, is it linked to interest rates or inflation since the world has changed significantly over the past year? Your backlog spans about two to three years, so how will we witness this in the coming quarters?

Kobi Kagan, CFO

In response to your first question, we are negotiating with the Ministry of Defense, but I would prefer not to disclose the details of our negotiations. As I mentioned earlier, we expect all payments to be settled by the end of the year. Regarding financial expenses, we anticipate them remaining at levels similar to this quarter. Our analysis indicates that interest rates have reached their peak; we do not foresee further increases in rates and expect improvements in cash generation that will reduce our debt level. Lastly, concerning price-adjusted contracts, we have a mix of contracts; some are price-adjusted while others are fixed. We are subject to competition, which influences our contract terms.

Operator, Operator

The next question is from Pete Skibitski of Alembic Global.

Peter Skibitski, Analyst

Yes, I had one follow-up, but it seems much of it has already been addressed by Kobi. Kobi, if cash collections do improve in the second half, it sounds like you plan to pay down some of the short-term debt you incurred this quarter. Would you prioritize debt paydown over M&A if an attractive deal arises, or is your capital deployment flexible in that regard?

Kobi Kagan, CFO

We are known for our strict capital deployment protocols, and we approach capital allocation very diligently. Regarding specifics on major M&A transactions, we don’t have any specific announcements at this time; however, we continuously monitor opportunities for M&A that could enhance our portfolio or increase market share. So there remains an ongoing search for improved capital deployment. Of course, if positive cash generation occurs, we will prioritize reducing our short-term debt, which remains a certainty, Pete.

Operator, Operator

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 1 (888) 782-4291. In Israel, please call (03) 925-5900. And internationally, please call 972-3-925-5900. A replay of the call will also be available on the company's website at www.elbitsystems.com. Mr. Machlis, would you like to make your concluding statement?

Bezhalel Machlis, CEO

I would like to thank all 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.

Operator, Operator

Thank you. This concludes the Elbit Systems' Second Quarter 2023 Results Conference Call. Thank you for your participation. You may now go ahead and disconnect.