Earnings Call Transcript - ESLT Q2 2022

Operator, Operator

Welcome to Elbit Systems Second Quarter 2022 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, www.elbitsystems.com. I would now like to hand over the call to Rami Myerson, Elbit Systems Investor Relations Director. Rami, please go ahead.

Rami Myerson, Investor Relations Director

Thank you, Joni. Good day, everyone, and welcome to our second 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 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 both with 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 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 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 second quarter results reflect a pickup in demand with a series of significant contracts awarded for our solutions in the quarter as our customers start to implement the lessons learned from the Russian invasion of Ukraine. Second quarter revenues were similar to 2021. This growth in Europe and Egypt offset the decline in the U.S. Our revenues by geography tend to fluctuate on a quarterly basis based on the specific programs and project performance as well as milestones reached in a particular quarter. We believe the long-term revenue trend supported by the growth in the order backlog is more representative and encouraging in most of Elbit Systems' geographical end markets. I will now highlight and discuss some of the key figures and trends in our financial results. Second quarter revenues were $1.303 billion, similar to the second quarter of 2021. In terms of the revenue breakdown across our areas of operation, airborne systems accounted for 39% and land systems was 21% of total revenues. C4ISR at 30% of revenues increased year over year, mainly due to U.S. to Asia Pacific customers. Electrooptics accounted for 9% of revenues, increasing year over year mainly due to night vision sales. Other sales accounted for 2% of revenues and declined year over year due to lower medical device sales. The second quarter highlighted the strategic importance of our diverse geographic revenue base. In the second quarter, Asia Pacific contributed 29% of our revenues; North America, 26%; and Israel and Europe, each 20% of revenues. Asia Pacific revenues increased mainly due to UAS sales. The growth in European revenues was broad-based and included growth in training and simulation, precision guided munitions, and night vision sales. Growth in European and Asia Pacific revenues helped offset lower North American sales. The non-GAAP gross margin for the second quarter was 26.5% compared to the second quarter of 2021 at 26.6%. GAAP gross margin in the second quarter was 26.1% of revenues compared to 26% in the second quarter of 2021. Second quarter non-GAAP operating income was $103.3 million or 7.9% of revenues compared with $114.9 million or 8.8% of revenues last year. GAAP operating income for the second quarter was $115.1 million versus $117.1 million in the second quarter of 2021. The operating expense breakdown in the second quarter was as follows: Net R&D expenses were 7.5% of revenues versus 7.3% in 2021. The recent conflict has highlighted the alignment of Elbit Systems’ product portfolio to the priority areas of our customers, demonstrating the return on our historic investments in research and development. The current investments in R&D will help upgrade existing and develop new products and solutions and ensure that we continue to supply a range of market-leading solutions for our customers in the future. Marketing and selling expenses increased to 6.4% of revenues from 5.8% last year. We continue to invest in sales and marketing to take advantage of the positive inflection in global defense budgets and the new opportunities this creates. G&A expenses were 5.6% of revenues compared to 5.1% last year. Other operating income of $27.2 million included capital gain related to the sale of our subsidiary Ashot Ashkelon industry in the second quarter and the sale of a building in Israel. I will note the significant increase in the share price since the beginning of the third quarter. We would expect a significant impact in compensation expenses related to our stock price linked compensation plans to employees if the shares remain at current levels or increase further. As we discussed at our first quarter results, we believe these plans help align employee compensation with share price performance incentivizing our employees to generate long-term value for all of Elbit Systems stakeholders. Financial expenses were $9.3 million in the second quarter compared to $7.1 million in 2021. Other expenses of $12.1 million includes a $10.6 million nonrecurring pension adjustment expense related to the sale of our subsidiary. We recorded a tax expense of $12.8 million in the second quarter compared to $20.1 million in 2021. The effective tax rate in the second quarter was 13.6% compared to 18.5% in 2021. Our non-GAAP diluted EPS was $1.73 in the second quarter compared with $2.11 last year. The GAAP diluted EPS was $1.82 compared with $2.30 last year. Our backlog of orders as of 30th of June 2022 was $14.1 billion, approximately $0.5 billion higher than the backlog at the end of June 2021. Approximately 52% of the current backlog is scheduled to be performed during '22 and '23, and the rest is scheduled for '24 and beyond. Operating cash flow for the second quarter was a $169 million outflow compared to a $170 million inflow in the same quarter last year. The cash flow in the quarter includes the payment of $73 million following the company’s decision to release exempt earnings from approval of privileged enterprises in Israel. The cash outflow also includes an inventory build related to our effort to mitigate supply chain challenges and the timing of receiving payments from various customers. We expect to receive these payments over the coming quarters. The Board of Directors declared a dividend of $0.50 per share for the second quarter of '22. I will now turn the call over to Mr. Machlis, Elbit's CEO. Butzi, please go ahead.

Butzi Machlis, President & CEO

Thank you, Kobi. Orders in the second quarter reflect good demand for our solutions from customers around the world. A series of significant orders in recent months have validated the alignment between Elbit Systems' portfolio and our customers' priority areas of defense spending and mission-critical requirements. I believe that we are at the beginning of a period of global defense budget growth driven by the escalation in geopolitical tensions. We are encouraged by the order intake in the second quarter and have learned from decades of experience that the conversion of defense budget growth to our fees and then into orders and revenues can take time, particularly when militaries are adjusting procurement processes and structures for a new era. The Abraham Accords have also helped open new markets and new opportunities for strategic partnerships with the nations that are party to this historical agreement. We opened Elbit Systems operations in the UAE at the end of 2021 and announced our first order for DIRCM systems in March 2022. Governments and militaries are analyzing the Russian invasion of Ukraine and the evolving conflict to prepare for the next one as they have done in the past with other conflicts. We have identified five areas that should benefit from increased defense spending over the coming years. These are platform protection, command and control systems, electronic warfare, unmanned systems, and network precision munitions. During the second quarter, we announced significant contracts for four of these five priority areas from customers in Europe and other parts of the world who are implementing the lessons learned. I would like to provide an overview of these priority areas, starting with platform protection. The conflict in Ukraine has demonstrated the vulnerability of platforms across all domains and the critical need to protect both platforms and their occupants. Elbit Systems provides systems and solutions that enable the protection of air, ground platforms from a range of threats. Our telecom systems are installed on more than 25 different types of military and commercial aircraft and have accumulated hundreds of thousands of flight hours protecting them from ground-to-air missiles. In July, we received an $80 million contract to supply C-MUSIC DIRCM systems, an airborne EW solution to an Asia Pacific country. And we were selected to supply a J-MUSIC DIRCM system for a Gulfstream G650 for the Netherlands Ministry of Defense. Our platform protection system includes infrared missile warning systems, chaff and flare systems for a range of aircraft, Iron Fist Active Protection Systems for armed vehicles, and EW systems that protect ships and submarines. The second area of priority spending is advanced command and control systems. These C2 systems are the critical enabler of combined force and multi-domain operations. Elbit Systems' Torch-X C2 solution provides visibility and connectivity to commanders and soldiers, utilizing intelligence collected from a multitude of sensors across the battlefield, identifying adverse situations enabling fast decision-making and the ability to convert insight into action. Our C2 systems help shorten the sensor-to-shooter loop and support logistics. In June, we received a $548 million, four-year contract to upgrade the multi-domain combat network capabilities for the armed forces of an Asia Pacific country. As part of this contract, Elbit will provide a range of networking and command and control systems as well as software-defined radios for air, ground, and naval platforms. The third priority area is electronic warfare that provides our armed forces with the capability to utilize the electromagnetic spectrum to protect, attack, and exploit communications and other enemy activities. Elbit Systems is the Israeli MOD's prime supplier of EW capabilities for aerial and ground-enabled platforms across various domains. In recent years, we received a number of prestigious EW contracts from the U.S. and German air forces among others. In May, we received a $69 million contract to supply electric warfare systems to a country in Asia Pacific. And in June, we were awarded a $70 million contract to supply ground-based EW and signal intelligence solutions to international customers. The fourth priority area is unmanned systems. Elbit Systems has decades of experience developing and manufacturing a broad portfolio of unmanned air, ground, and maritime solutions. Elbit also provides the command and control systems to connect and operate them as well as a range of advanced payloads. These unmanned solutions can execute a broad range of missions, reducing risks to forces and increasing their effectiveness. At the Eurosatory in June, we demonstrated Legion-X, a multi-domain autonomous network solution for swarms of unmanned platforms in the air, on land, and at sea. Legion-X enables the command and control of a range of unmanned platforms of various sizes and capabilities in a cohesive swarm, helping soldiers perform their missions in complex environments such as open areas. The fifth priority area is network precision munitions that enable armed forces to engage time-sensitive targets with power, precision, and minimum collateral damage. Elbit Systems has combined a portfolio of munitions acquired with IMI, our legacy precision guidance capabilities with the technological technologies we acquired last year to develop a range of precision munitions from a 120-millimeter mortar round to a supersonic air-to-ground missile. In June, we received a $220 million contract to supply precision-guidance kits for airborne munitions of an Asia Pacific country. In July, the German defense company KMW signed a cooperation agreement with Elbit Systems Land and Elbit Systems Deutschland in the area of rocket artillery. We believe this agreement will leverage the leading expertise these companies have in rocket artillery and will enable both companies to address the growing potential in the European market for these solutions. These are just five areas of Elbit's broad portfolio. We believe that each one has the potential to generate billions of dollars of revenue over the medium term. At the end of June, we closed the sale of our 84.9% stake in Ashot Ashkelon industry to FIMI Opportunity Funds for $84 million. We regularly review our portfolio to ensure that we remain focused on the core areas of our business. As part of this review, we decided to sell Ashot Ashkelon that we acquired with IMI in 2018 and was not considered a core business of Elbit. I would like to take this opportunity to thank the hundreds of Ashot Ashkelon employees for their hard work and dedication and to wish them success in the future. Elbit Systems' strategy is to focus on the global defense market, and I do not expect this to change. I believe it is important to remain focused on the market and technology and to reduce disruption for a market that may appear attractive but often requires different skill sets. That said, we continue to explore opportunities to leverage our technology and solutions to develop and formulate applications in adjacent and new markets. In July, our U.S. subsidiary Universal Avionics received a $33 million order from AerSale for ClearVision, enhanced flight vision systems for Boeing 737NG. As part of this contract, Universal will supply ClearVision EFVS systems featuring the SkyLens head-mounted display and EVS-5000 cameras. The ClearVision system enables commercial pilots to fly in regulated visibility situations both day and night, to take off and land faster while saving time and increasing operational effectiveness and safety. In August, Opgal, our thermal imaging subsidiary, and the Sheba Medical Center in Israel signed an MOU to explore opportunities to utilize thermal imaging technology to improve the efficiency and effectiveness of surgery and treatment in four key areas: heart surgery, diabetic foot treatment, surgical incision infections, and respiratory monitoring. I'm proud of our engineers who are looking for additional opportunities to utilize Elbit technologies to protect and save lives. And with that, I will be happy to take your questions.

Operator, Operator

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

Ellen Page, Analyst

Hi, guys. Thank you for the question. Can we talk about C4ISR which has grown double digits for years now in the first half? How do we think about a normalized growth rate in that business? And is there anything chunky in there that might start to anniversary and moderate growth?

Rami Myerson, Investor Relations Director

Ellen, can you please repeat the question? Your line is a little bit disrupted.

Ellen Page, Analyst

Is that better?

Butzi Machlis, President & CEO

Yes. Much better.

Ellen Page, Analyst

Just at C4ISR, you've posted double-digit growth two years in a row in the second quarter. And just how do we think about a normalized growth rate in that business and the sustainability of this demand?

Butzi Machlis, President & CEO

We see a growing demand for C4ISR solutions, which includes communication systems, networking systems, applications, UAVs, and thermal solutions. These are all included in the C4ISR. As was mentioned earlier, U.S. UAVs and ground unmanned systems, they all fall under this definition. And as I mentioned earlier, we see a growing demand for such solutions. We have experience using unmanned systems in Israel as well as in other markets, and we have delivered them to many customers with full interoperability to different forces. We own all the technology, and we see growing demand for this segment. So, I believe that the growth will continue.

Ellen Page, Analyst

Great. And just on cash. You mentioned that there's a build of inventory related to supply chain disruptions and timing of collections was an impact in the quarter. But can you just walk through working capital in the back half? And just go over that $76 million cash tax payment again and how it relates to future tax planning?

Kobi Kagan, CFO

This is Kobi Kagan. Thank you, Ellen, for your question. During the quarter, we made a one-time payment of $73 million, which is connected to the company's choice to release exempt earnings from approved and privileged enterprises in Israel. This payment was made to resolve matters with the tax authority in Israel. Since this is a one-time expense, it will not impact the second half of the year. We are viewing cash flow on an annual basis rather than quarterly. We expect to receive payments from various customers in the upcoming quarters.

Ellen Page, Analyst

Okay. Thanks. Thanks a lot.

Operator, Operator

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

Pete Skibitski, Analyst

Hey. Good afternoon, everyone. Yes. Let me start with, I guess, maybe Butzi. You had good sequential backlog growth this quarter, Butzi, but I think that didn't include the pretty large intelligence systems contract that you booked in Europe. I think it was $660 million that closed after the quarter. So that was a nice win. And I'm curious because I haven't seen an Intel contract that large booked by Elbit. And so it raises the question, I think. Do you see other opportunities out there to sell a contract of this magnitude to other countries in the Intel area?

Butzi Machlis, President & CEO

Thank you for the question. As we all see, the company is transforming in the midst of confirmation. We are getting big contracts, and that's on top of the small and medium-sized contracts we used to get in the past. The contract actually includes the entire portfolio of the company. One of the main advantages of Elbit is that we are unique; we have EW solutions, radar, optic solutions, networking systems, command and control, UAVs, and other platforms with a lot of AI and data analytic capabilities in applications. So we are quite unique, and we have such a wide portfolio. This enables us to win mega projects and adapt the technology to the required needs of our customers. So the answer is yes. We see more demand for end-to-end solutions for mega projects. We got two very big contracts in the second quarter with the networking digitization program we got in Asia Pacific for $550 million and the $650 million we got in Europe. We see more and more demand for mega projects which is on top of the medium-sized and small projects we continue to get. The whole company is transforming to perform and to get more contracts like these and perform them accordingly. We have more production capabilities. We are working in several places, three shifts. If you remember last year, the company was organized in a new way. We now have four main divisions in Israel instead of five to prepare ourselves better for these megaprojects, which we hope to continue to get. The simple answer is yes, we see more and more demand for combined mega projects which involve many technologies from the group.

Pete Skibitski, Analyst

That's great. I really appreciate all the color and the context that it's great. If I could now maybe shift the conversation to margins. Could you guys give us an update on where you're at with implementation of the ERP system as well as how construction is coming along on the new IMI facility? Because I think those two initiatives are important to kind of the midterm margin expansion outlook is my recollection.

Butzi Machlis, President & CEO

I will start with IMI activity, and then Yossi will continue with ERP. We are progressing according to the plan with IMI to shift the main production facility of IMI from the central part of the country to the south. We are investing a lot of money in the new infrastructure, which is much more modern and efficient to increase yields and productivity, which will enable us to deliver bigger quantities with better quality and lower cost to our customers. Our plan is being achieved. The first phase to shift some of the activities to a new facility will happen by the end of this year. The majority of the plan will be concluded around the end of 2024, according to the plan.

Kobi Kagan, CFO

In addition to that, regarding the ERP system, we are on track with that. Actually, we have now about 60% of the organization implementing the new ERP system. The next major milestone will be by the end of this year, when we will probably reach somewhere in the 80-plus percent, probably 85%. By mid of next year, the whole organization will be operating on that one-year system. We expect that the benefits from these activities will start to come toward the second half of next year and definitely much stronger into the beginning of '24.

Pete Skibitski, Analyst

Let me ask one more along these lines also with regard to pricing. Because obviously, we're in kind of a global inflationary environment, labor, materials. And I'm wondering, I guess, mainly with the ERP system coming along, do you feel like you're getting the pricing that you need to offset the impact of inflation? Are you getting net pricing gains? Or will that take more time? And strategically, do you feel like you're getting the prices that you need given the value you're providing to clients?

Kobi Kagan, CFO

Well, as you probably know, Pete, prices are defined by the market. However, we have in our contracts linkage to indexes of labor and material costs in many of our contracts. So to some extent, we compensate for the increase in cost. I must say we cannot compensate for everything. We do see in some of the integrated circuits significant changes in the short term, but we expect this to change in the longer term and return to what we call normal. Regarding our bill of materials, what they are composed of, I must say that the basic impact is not material on costs. But we are not immune to increases, especially in electronic components that we all see as challenges. The bottom line is that, yes, we are affected, but it is not material from the point of view of the impact on profitability, and part is compensated by our contracts, which include indexing to material costs.

Pete Skibitski, Analyst

Okay. That's very helpful. That's very helpful. Let me ask one last one and I'll be completely done. Butzi, on the MOU signed with KMW Krauss-Maffei on rocket artillery, are there anything near term in Europe along the lines of rocket sales that you expect to book in the second half of 2022 or maybe it won't be until 2023?

Butzi Machlis, President & CEO

Pete, the answer is yes. I cannot go into the details, as you can imagine, but the answer is yes. We see the potential for new orders in Europe for guided rockets.

Pete Skibitski, Analyst

Right. Thanks so much, everyone.

Butzi Machlis, President & CEO

Thank you, Pete.

Operator, Operator

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

Ella Fried, Analyst

Well, I have a few follow-up questions. But before if you don't mind, I really would appreciate you repeating the answer to the first question about double-digit growth. The line was really distorted and there were some people on for the sake of two people, please tell what you told?

Butzi Machlis, President & CEO

Yes. So, Ella, it's Butzi. The question was regarding C4ISR solutions. If I believe that the growth will continue, the answer was yes. We see a growing demand for C4ISR solutions, which includes UAVs, USVs, UGVs, different sensors, different payloads, different command and control systems, and thermal solutions. So there's growing demand for that. We just announced a contract for intelligent solutions, which is part of this segment as well. It's a mega project, and we see growing demand for this solution as a result of the last conflict in Ukraine.

Ella Fried, Analyst

Okay. Sorry, another follow-up question. You seem to perform much better in terms of growth than many companies in your peer group. We don't have results for everybody, but on the annual level, you have the best results for growth in this and the wider group as well. How do you explain it? What is it that some companies are decreasing and Elbit is really outperforming?

Butzi Machlis, President & CEO

I think the answer to that is our strategy. Our strategy is composed of two main pillars. The first one is a very wide and deep portfolio. There are not many companies that have such a portfolio, which includes UAVs, electro-optics, simulators, avionics, helmets, communication, EW, electro-optics, lasers, guided munitions, UAVs, USVs, UGVs, and artillery sensors. So we have a very wide and deep portfolio, which enables us to tailor solutions to the specific needs of customers. That's number one. Most of the portfolio is mature and combat-proven. That's the first pillar. The second pillar is our international position, our global footprint. We have dozens of subsidiaries all around the globe. Many customers prefer to buy locally today due to growing demand for defense solutions. Companies prefer to buy local solutions and we gain from previous investments and previous strategy to build local subsidiaries. We win most of the programs via these subsidiaries. The combination of growing demand in the market, a large portfolio, and a global footprint brings us success in the market.

Ella Fried, Analyst

The challenge of profitability is heightened by our versatility as a relatively smaller player among leading global companies. Are you considering developing larger hubs? The costs associated with operations and this versatility are significant.

Butzi Machlis, President & CEO

It's true that it's costly to maintain such an operation and to protect the portfolio we have. That's the reason why we invest 7.4% in R&D, which I believe is double the nominal number in this market. This is to support this portfolio and to bring new innovation and new capabilities to the market. Although we are a big company with many subsidiaries, the Board works to avoid duplicating capabilities between the different facilities. Some activities, some IP are coming from Israel, and some capabilities come from our subsidiaries. For instance, in the U.S., we have central night vision capabilities that serve the entire group. Similarly, we have sonar capabilities in Canada, and they serve the whole group for sonars. HF radios are produced in Germany, and they serve the entire group for communications. We also have Centers of Excellence for different production capabilities, which enable us to leverage talent and facilities globally. We have reorganized the way we are working with our subsidiaries to ensure we gain maximum efficiency from them.

Yossi Gaspar, Senior EVP, Business Management

I would like to add one more aspect. In the past, we emphasized our international spread that helps us reduce the risk in the business. We are almost immune to changes in various geographies of defense budgets. While one is declining, the other is growing. What we are seeing in recent quarters reflects this. The fundamental strategy that Butzi explained before, having a widespread business, both geographically and product-wise, is proving beneficial.

Ella Fried, Analyst

I have a few more questions. One is in the same direction. You mentioned on the previous call that this quarter would show the impact of the Ukraine war. While we didn't see as much as expected, the company is performing well. Should we expect to see more impact from this interest that you mentioned last quarter?

Butzi Machlis, President & CEO

Talking about all the new business we got. For example, we got a $660 million contract for Intelligence Solutions in Europe. That's one example of the impact of the conflict in Ukraine. The first phase of the impact is getting business. It takes some time for it to reflect in revenue and profit levels.

Ella Fried, Analyst

But most of it is not in the backlog yet, right? Or is it?

Butzi Machlis, President & CEO

Part of it is in the backlog. The $660 million contract we received is in the backlog. But you're right, there are many opportunities. We see the result of the Russian invasion of Ukraine, and while there are growing demand not just in Europe, but also in our region. The Abraham Accord has opened new horizons for us against different threats. We've opened a company in the UAE and already secured some business there. There is a lot of potential in our region, and the conflict between the Western World and China continues to shape demand. We see growing opportunities and more potential for our company both in the near and long-term future.

Ella Fried, Analyst

I have one more technical question. You mentioned in the press release that the stock price linked plan will lay effective next quarter as well. Regarding the scale of this impact, is it going to be more like the first quarter or—?

Kobi Kagan, CFO

Well, Ella, you know what we explained in the first quarter. You have seen the increase in the stock price and the effect on our results. We can't know yet how it will end this quarter. There is a formula we use according to the plan we have with our employees on how to calculate the impact. You can deduce some general estimates based on growth in the first quarter and then compare it with what's happening in the second quarter. It's a rough estimate. However, we really believe in the upward trajectory of the stock.

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 at the company's website, www.elbitsystems.com. Mr. Machlis, would you like to make your concluding statement?

Butzi Machlis, President & 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, everybody.