Elbit Systems Ltd. (ESLT) Earnings Call Transcript & Summary

Ladies and gentlemen, thank you for standing by. Welcome to Elbit Systems' Fourth Quarter 2022 Results Conference Call. [Operator Instructions] 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, Joni. 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 in the company's press release issued earlier today also refers to the content of this conference call. As we do every quarter, we will provide you with both our regular cash and 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 our question-and-answer session. Earlier today, we hosted an investor conference at the Tel Aviv Stock Exchange. A recording of the event is available on the Investors section -- Investor Relations section of our website at www.elbitsystems.com. Investors and analysts who wish to ask questions related to the topics discussed 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, please?

Thank you, Rami. Hello, everyone, and thank you for joining us today. The 2022 annual results reflect a healthy business environment supported by a growing defense budget 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 plan 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 budget and longer-term planning assumes that the global economic trends, supply chain and wage inflation headwind will 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 expand our customer base and also continue to invest in CapEx to improve and expand our manufacturing footprint. 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 our results in the second half of 2022 do not include a contribution from Ashot Ashkelon. I will now highlight and discuss some of the key figures and trends in our financial results. Fourth quarter revenues were $1.506 billion compared to $1.494 billion 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 operation, C4ISR is 29% of revenues 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's 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 to 3% and declined year-over-year, mainly due to lower sales in 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 to the decline in medical device sales. Asia Pacific revenue declined mainly due to lower precision-guided munitions and C4I sales. The non-GAAP gross margin for the fourth quarter was 25.7% compared to the fourth quarter of 2021 at 25.5%. For the full year of 2022, non-GAAP gross 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 reflects an unfavorable problem mix, wage inflation and supply chain disruption. GAAP and non-GAAP gross profit in 2022 include expenses related to soft price-linked compensation plans. The fourth quarter non-GAAP operating income was $103 million or 6.8% of revenue 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 margin 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 facility relocation grant of $28.6 million received by a subsidiary in Israel in the fourth quarter. Operating profit in 2022 include expenses of approximately $62 million related to stock price-linked compensation plan and an additional $10 million of retention bonus. 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 reflects the higher interest rate environment. Other expenses were $24 million in 2022 and resulted mainly from the reevaluation of holding in affiliated companies and expenses related to nonservice 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 onetime 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 that extraordinary expense. 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 '22 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, a $1.4 billion higher than the backlog at the end of 2021. Approximately 60% of the current backlog is scheduled to be performed during '23 and during 2024 and the rest is scheduled for '25 and beyond. Operating cash flow for the fourth quarter was $195 million inflow compared to $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 the higher CapEx related to the new facilities in Israel and in Charleston, South Carolina as well as the rollout of ERP system. The Board of Directors declared a dividend of $0.50 per share. I will now turn the call over to Mr. Machlis, our CEO. Butzi, please go ahead.

Thank you, Kobi. 2022 was another good year for Elbit Systems with sustained growth and record order backlog. We continued the strategic transformation of Elbit Systems moving up the value chain from the system provider into a company that provides comprehensive and relevant solutions to its growing global customer base. We initiated this transformation during the previous decade. And you have seen the successful implementation as the order book and revenue growth accelerated in recent deals. We have also seen a step-up in the number of large 3-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 adopting new technologies and implementing processes to increase the throughput and efficiency of our production facilities. For example, we have increased the capacity of our Tel Hai radio production factory in Northern Israel by 60% or 10,000 additional radios a 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 from 2024. This new state-of-the-art facility should benefit ongoing 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 this 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 2022. 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 close to $200 million. Approximately 2/3 of this investment is the cost of the system that will be amortized over the coming years, approximately 1/3 of the investments are the expense cost related to the implementation that 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 cost base. To mitigate the impact of this disruption and maintain timely deliveries to our customers, we increased inventories. Our working assumption is that global supply chain pressure gradually eased over 2023 with the most significant improvement for the second half of 2022. In 2022, we increased our investment in R&D to sustained development of leading solutions that provide our customers with a valuable comprehensive advantage. A significant awards we received in 2022 and in recent months have validated the alignment between Elbit Systems portfolio and our customers' priority areas for defense spending and the mission-critical requirements. The potential for orders from European countries have come up often during investor call and meeting over the last year. Following the announcement of defense budget increases by most European governments. We described the noticeable increase in customer interest across Europe and told you that we expect this increase to gradually convert into same orders. In the recent months, we announced a series of European customer contracts across a range of capability areas, including artillery and rocket artillery, UAVs, C4I and armed vehicles. We also reported strong growth in European revenues in 2022. We expect this trend to continue over the coming years as the European government increased defense spending and recapitalized both the military forces and the domestic defense industrial base. Elbit Systems is well positioned to benefit on these trends following significant investments 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 business. We have also partnered with most of the large European defense companies. In 2022, we announced a joint venture with KMW, the German armed vehicle manufacturer to cooperate on the Euro-PULS, the next generation of rocket of 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 highlights both the demand for rocket artilleries in Europe and Elbit's leading position in this market. UAV is the second capability area where we are benefiting from increased demand. In December 2022, U-TacS, our U.K. subsidiary was awarded a $400 million 5-year framework contract by the Romanian Ministry of Defense for Watchkeeper X tactical unmanned aero systems. In December, we also received the 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 development and the judicial legislation proposed by the government have not impacted our business until now. However, sustained political instability has implication for the local defense industry as we have seen in the past and would also increase economic uncertainty. I am confident that Israeli leadership will act responsibly to stabilize the situation and ensure Israeli's long-term security and prosperity. In recent months, we were awarded significant long-term contract by the Israeli MoD. In January, we received the $180 million contract to provide and operate a new mission training centers to train the Israeli Air Force's F15 and F16 aircrafts. In January, we received $107 million contract to provide an operating advanced armor training center for the Israeli Defense. 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 a significant potential in this market for solutions that provide more realistic planning that better prepare shoulders for wide range of scenarios at a lower cost. And with that, I will be happy to take your questions.

[Operator Instructions] The first question is from Ellen Page of Jefferies.

Just looking at Europe, a slight growth through 2022. Obviously, there's a lot of higher defense expense 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?

This is Yossi. I'm not sure I got the 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 we -- 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. were also a very nice growth of the backlog. We do not provide the exact breakdown, but you are right that Europe is a significant contributor to that. From a point of view of the spread of the backlog, we do indicate how much of our backlog is going to be transformed in revenues in the '23 and '24 period and then the rest of that during '25 and on. Usually, it stands about 60% roughly of our backlog and this percentage did not change a lot over the years. It's quite stable.

Okay. Helpful. And just on land systems, it's been pretty lumpy through 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 us that the short numbers were deducted from the revenues from the second quarter of 2022. We see a growing demand for land 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.

The next question is from Pete Skibitski of Alembic Global.

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 I don't know, 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 had grown significantly, much more than our revenue numbers. Then from that, it is just natural that during '23, we are going to be able to realize some of that growth in revenues as well.

Right. Okay. Fair enough. And then maybe Yossi, on the $62 million employee share linked comp in 2022, do you guys have the numbers for what that was in 2021, so we could just judge the magnitude of the increase and maybe factor in our expectation for '23?

Pete, this is Kobi. Actually, the $62 million is the difference between the numbers that we saw in 2021 and 2022. So this is actually a onetime expense, which is higher in that totality from the numbers in 2021. And in addition, we had some -- mostly for engineers, some retention-linked price programs that cost us additional onetime $10 million. So it's $72 million of additional expenses that we are not expecting to have a 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 in that given hopefully, the likelihood that employee linked comp will decline in '23. And I don't know if there are other mix issues or net pricing has improved, but is it reasonable for us to expect margins to improve in '23 by some amount? I don't know if you want to put any kind of a range around it or not, but -- or add color, 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 '23.

Okay. Okay. And then any -- just on net pricing, just in terms of base labor rates, are you guys able to cover the inflation from base labor rates in your pricing in 2023? Or are you expecting improvements or a deterioration of that situation? Could you add some color there?

Well, you know that Pete 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 currency exchange rate between the shekel and the U.S. dollar of roughly about 3.3 shekels to the dollar in general, on an average. This number is going to improve in 2023. It is still to be calculated, but we expect an improvement in this cost labor in dollar currency.

[Operator Instructions] The next question is from Atinc Ozkan of Wood & Company.

This is Atinc from Wood & Company. Sorry if my questions are repeated. I was not able to join earlier part of the conference, but 2 questions for you, please. The first one is regarding your recent strategic MoU in Japan. You signed it with 2 local aerospace companies, and we know that Japan is rearming and they will be spending roughly, I guess, $300 million over the next 5 years. Where do you see the strategic opportunities for your products in Japan? Should we assume that you start with the needs of Japanese air defense force given that they are an operator of F15 and F35? That's the first question. And second one is, could you please provide some update regarding percentage of completion of your ongoing investment programs, whether it's the OneERP, the ongoing production line in South Carolina and the state of plant in Southern Israel or IMI?

Butzi, hello. With regards to the first question, we all see that there is a growing investments in Japan in defense. We find that our portfolio is very relevant to the growing needs -- growing requirements in this market. We see there is a lot of interest for our portfolio. And I'm talking about training solutions, I'm talking about avionics, I'm talking about UAVs and others. For that, we have teamed with several companies in the country. As you noticed, we are -- we presented in the last exhibition 2 weeks back. This is not the first time we are in this market. And we certainly see a growing opportunity in these areas as well as in others, in the Japanese market. It's a new market for us. We feel very welcomed in this market, and we have a very good relationship with the local industry and the customers -- the customers, the Minister of Defense is well aware of our technologies and capabilities. With regards to our new facilities, our new facility in the South in Ramat Beka, we started 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 this year, 2023, and I think you talked about another -- the OneERP system, we have invested a lot in our OneERP solution. The system that we are deploying right now will replace 11 different all the ERP systems that were used in the company. The final implementation stage will take place mid this year. When we are going to implement the system in the old IMI cooperation. And this will be the final implementation phase. The rest of the company is already on the system, and we start seeing many benefits coming from this new ERP solution.

The next question is from Pete Skibitski of Alembic Global.

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 were implying that R&D was kind of a part of that overall. And 2022, I think you spent the most on R&D in probably a decade, and I know FX is an impact, et cetera. But kind of going forward, should we expect that R&D spend will remain elevated so that you can kind of take advantage of these very active markets over the next few years? Or have we reached a plateau there? Just was wondering if you had any color to add.

We have -- as you know, our strategy is to be a leader in the defense market. And for that, we have to invest in R&D. And we are investing in several areas. Just to give you an example, high-power lasers. We have a unique position in this market. We have a unique technology, and we are providing the lasers for usually lenses -- usually high-power lens solution, and we are a front contractor for the airborne Israeli high-powered lasers. It is just one area where we invest. And another -- some other areas of guided munition. After the acquisition of IMI, we took a strategic decision to combine our guidance capabilities with the munition portfolio of IMI and I think we have a new really advanced line of business, which is very successful in Israel as well as abroad. Another area where we invested quite a lot is autonomy. We see autonomy in AI and big data. In this area, we believe we are a world leader, 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 the number in the future. And so that's more or less the area where we will continue to invest in the future around the world.

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 2 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 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 our employees for the 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.