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Elbit Systems Ltd (NASDAQ:ESLT)
Q2 2018 Earnings Conference Call
Aug. 16, 2018, 9:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Ladies and gentlemen, thank you for standing by. Welcome to Elbit Systems Second Quarter 2018 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. If you have not received it, please contact Elbit's Investor Relations team at GK Investor and Public Relations at 1-646-688-3559, or view it in the News section of the company's website, www.elbitsystems.com.

I would now like to hand over the call to Mr. Kenny Green of GK Investor Relations. Kenny, please go ahead.

Kenny Green -- Managing Partner

Thank you very much. Thank you and good day to everyone. On behalf of all the investors, I would like to thank Elbit Systems' management for hosting this call.

Joining us on the call today are Mr. Bezhalel Butzi Machlis, Elbit's President and CEO, and Mr. Yossi Gaspar, Elbit Systems' Chief Financial Officer. Yossi will begin by providing a discussion of the financial results for the second quarter of 2018, followed by Butzi who will talk about some of the significant events during the quarter and beyond. We will then turn over the call to the question-and-answer session.

Before we begin, I would like to point out the Safe Harbor statement in the company's press release issued earlier today also refers to the content of this conference call.

And with that, I would now like to hand the call over to Yossi. Yossi, please go ahead.

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Thank you, Kenny. Hello, everyone, and thank you for joining us today. As we do every quarter, we will provide you with both our regular GAAP financial data as well as certain supplemental non-GAAP information. You can find all the detailed GAAP financial data as well as the non-GAAP information and the reconciliation in today's press release. This quarter, we saw solid year-over-year revenue growth as well as good generation of cash. There are a number of one-time aspects, which affected our results this quarter, which I will walk through in my summary.

I will now highlight and discuss some of the key figures and trends in our financial results. Our second quarter 2018 revenues were $892 million compared to $818 million reported in the second quarter of 2017, up 9% year-over-year. The growth was driven by sales from our growing backlog as well as the addition of revenues from our acquisition of Universal Avionics Systems in the United States on April 11, which we consolidated for the first time in the second quarter.

In terms of revenue breakdown across our areas of operation in the quarter, Airborne systems was 41%; C4ISR was 32%; land systems was 16%; electro-optics was 8%, and the rest was 3%. Compared with the second quarter of last year, airborne systems made up a larger portion of our sales due to increased sales of these systems in the US and Europe, while there were lower sales of electro-optic systems and a slight decrease in C4ISR sales.

In terms of geographic breakdown for the quarter, North America was 28% of our revenues; Europe at 18%; Israel, 19%; Asia-Pacific, 21%; Latin America, 6%, and the rest of the world was 8%. North America increased partially due to the acquisition of Universal. APAC also increased while there was a slight decrease in Europe.

For the second quarter, the non-GAAP gross margin was 28.6% versus 30.4% last year. Our GAAP gross margin was 28% in the quarter versus 29.6% last year. Our gross margin was affected by a mix of projects sold in the quarter as well as by a less favorable exchange rate environment.

The second quarter non-GAAP operating income declined to $73.1 million or 8.2% of revenues compared with $82.7 million or 10.1% of revenues last year. GAAP operating income in the quarter increased to $111.8 million or 12.5% of revenues compared with $75.3 million or 9.2% of revenues last year.

In terms of our GAAP operating expenses for the quarter, total operating expenses were 15.5% of revenues compared with 20.4% of revenues in the second quarter of last year. The GAAP operating expenses included other income of approximately $45.4 million, which we do not include in our non-GAAP results. This was due to two capital gains from the reevaluation of the investments made by outside investors in two of our commercial venture subsidiaries, Cyberbit and Beyeonics. The primary contribution was the capital gain at Cyberbit, following a $30 million investment from Claridge Israel.

The operating expense breakdown in the quarter was as follows. Net R&D expenses were 8.6% of revenues versus 8.2% last year, the increase partially due to lower participation of externally funded R&D. Marketing and selling expenses were 7.8% of revenues versus 8.1% last year, and G&A expenses were 4.2% of revenues versus 4.1% last year. I know the operating expenses also fully consolidate those of Universal Avionics for the first time.

Financial expenses for the second quarter of 2018 were $10.7 million compared with financial expenses of $6.8 million in the second quarter of last year. The increase was mainly due to higher debt level and increased interest rates. Other income included $5.1 million adjustment to the fair value of our investment in one of our Israeli subsidiaries. Taxes in the second quarter was $7.3 million or 7.6% of pre-tax income versus $10.3 million or 15.1% of pre-tax income in the second quarter of last year.

For the second quarter, non-GAAP net income was $57.5 million or a net margin of 6.5% versus $68.8 million or a net margin of 8.4% last year. Non-GAAP diluted earnings per share were $1.35 compared with $1.61 last year. On a GAAP basis, second quarter consolidated net income was $91.9 million or a net margin of 10.3% versus $63 million or a net margin of 7.6% last year. GAAP diluted earnings per share were $2.12 compared with $1.46 last year.

Our backlog of orders as of June 30, 2018 was $8,065 million, $736 million higher than the backlog at the end of the second quarter of 2017, representing an increase of 10%. Approximately 55% of the current backlog is scheduled to be performed during 2018 and 2019, and 45% of the current backlog is scheduled to be performed for 2020 and beyond. The ratio is similar to that at the same time last year.

Operating cash flow for the quarter was a positive of $146.7 million compared with a positive cash flow of $54 million at the same quarter last year. In the first six months of 2018, the cash flow was just below break even. The Board of Directors declared a dividend of $0.44 per share for the second quarter of 2018.

That ends my summary, and I shall now turn over the call to Mr. Machlis, Elbit's CEO. Butzi, please.

Bezhalel Machlis -- President and Chief Executive Officer

Thank you, Yossi. Elbit Systems again demonstrated another quarter of profitable growth, while continuing to increase the backlog. I would like to take a few minutes to look at an element of our broader strategy. Our long-term growth and development has always been built on both investing in our businesses and growing it on an organic basis, while at the same time, acquiring and adding synergistic businesses to our organization.

As you know, at the start of the second quarter in April, we completed the acquisition of Universal Avionics in the US for approximately $120 million. Universal develops commercial avionics systems for the retrofit and forward-fit market, including flight management systems, displays, communication systems, complete cockpit solutions, and additional advanced commercial avionics systems. We see these products as complementary to our existing commercial avionics systems, our Enhanced Flight Vision System, and our commercial Head-Up Display product line. We believe that the newly combined portfolio creates synergies that will strengthen our competitive position in the commercial avionics market.

I also want to highlight that while Elbit is primarily an electronic defense company, many of our technologies have significant commercial potential beyond purely military. It has been our strategy for many years to look at relevant technologies for the commercial realm and we often partner with strategic investors to aid in the development of our commercial businesses.

This quarter, as Yossi mentioned, we saw two capital gains amounting to $44 million from follow-on external investment rounds in some of our commercial ventures, the largest portion of which was from our holding in Cyberbit in the commercial cybersecurity space. We have been very much encouraged by the technological and business achievement of Cyberbit in recent years, and the company has made much progress.

In June, Claridge Israel partnered with us by investing $30 million in Cyberbit, which will provide the company with increased funding and know-how to expand sales and marketing primarily in North America, boost product development, and enhance its customer and partner support. This is in line with our strategy to bring outside strategic partners whenever we see opportunities in developing commercial applications. We are optimistic that Cyberbit will further develop its commercial businesses for years to come and create further value for Elbit Systems' shareholders.

Also, a few days later, Beyeonics, our subsidiary that develops innovative surgeon-centered visualization technologies, raised $11.5 million from other outside investors. Both these successful investment trends increased shareholder value at the subsidiaries and ultimately to Elbit Systems' shareholders, attesting to the commercial potential of our technologies and the success of this strategy.

Finally, as you know, also in the M&A realm, we are looking to close the acquisition of Israel Military Industries in the coming months, and we are working hard toward this goal. As I already mentioned last quarter, we believe there are many potential synergies between IMI and Elbit, and IMI will bring us access to new market and products, and we can leverage our existing business platform. We hope to bring you an update on this in the coming months.

On an organic basis, our core business continues to perform well. We recently announced two electronic warfare system orders. The most recent one was an $85 million award to supply the Israeli Navy with EW suites after successfully completing intensive sea trials. We were also awarded a $17 million contract from a European country to supply a range of advanced ground-based electronic warfare and signal intelligence systems.

The increasing demand for our solutions are clear indications of the growing operational importance of advanced, incumbent, proven capabilities that Elbit has in all domains of operational engagement, maritime, land and air. Over many years, Elbit has proven over and again that we can build our business successfully on both an organic basis as well as acquiring and assimilating new organizations and technologies successfully into the Elbit family. We will continue to do so over the coming quarters and years.

I will now be happy to take your questions. Operator, please.

Questions and Answers:

Operator

Thank you. Ladies and gentlemen, at this time, we will begin the question-and-answer session. (Operator Instructions) The first question is from Yoav Burgan of Poalim Sahar. Please go ahead.

Yoav Burgan -- Poalim Sahar -- Analyst

Hi, Yossi; hi, Butzi. A couple of questions from me. The first one, looking at your topline, so obviously you are unwilling to quantify the different contributors to this quarter's abnormal growth, but still if I'm trying to fully understand, on the one hand, we have the adoption of the ASC 606 standard, and on the other hand, we have the first time that Universal Avionics is consolidated. And I think there is also -- I assumed at least, there was also a bit of strengthening of the US dollar. So Yossi, could you provide some color, I mean, on the magnitude of the impact of these -- of what's been going on?

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

No, I would say the following. The addition of Universal revenues to our results was definitely positive, but it is relatively minor. So it did contribute several tens of millions, but in the very low tens of millions. This is Universal. The 606, I would say, the more we are getting away from the beginning of the year, we see less and less of contribution related directly to that element, and some were toward the end of the year, and maybe in the first half of next year, it will diminish in total. So we do not quantify that, but it was less of -- percentage wise, an addition compared to the first quarter. All the rest, I would say, was definitely organic growth, pure organic growth even compared to previous years and based on the backlog. I would say the change in the currency does affect to some extent, but it is not a material element.

Yoav Burgan -- Poalim Sahar -- Analyst

Okay. So if -- and this leads to my second question. Looking at your profit margins, looking at your non-GAAP gross margin and your non-GAAP operating margin, it seems they have come out a bit low this quarter and actually in the previous quarter. And I was actually expecting them to be a bit stronger mainly due to the strengthening of the dollar. So Yossi, could you provide color on this as well?

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Yeah. I would say regarding the currency, I would say the following. First of all, the dollar really strengthens more significantly in the third quarter. Second quarter was still not that material, the change. So that is one thing. Regarding the overall margin, I'd say that we have a mix of programs sold in this quarter and last quarter actually, which are, I would say, at a lower profitability. As you might know, programs requiring higher engineering content are sometimes lower in margins than programs -- pure production programs. So, it's a mix of things that on average, over the years, over the quarters and the year, will probably come out more or less as we have seen in the past, but it is very dependent on the actual revenues recognized in the specific quarter.

Yoav Burgan -- Poalim Sahar -- Analyst

Okay. But on a longer-term perspective, you are still confident that you can still reach or stay at your objectives of around plus, minus 30% non-GAAP gross margin and 10% non-GAAP operating margin, correct?

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

These are definitely the goals. As to the time, scale, which we will reach that, I am a little bit hesitant now to give you more detail.

Bezhalel Machlis -- President and Chief Executive Officer

But if I can add, I would like to say that there are many activities we do in the company to make sure that we'll achieve these goals. We are combining business units together. We just recently centralized the entire acquisition, infrastructure of the company we're acquiring right now as one group. We're investing in a new ERP system, which should come -- we should go live mid next year. These activities together with other, of course, the main rationale behind them is to support achieving the goals which were mentioned by you.

Yoav Burgan -- Poalim Sahar -- Analyst

Okay, good. Fair enough. Thank you very much, Yossi and Butzi.

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Thank you.

Operator

The next question is from Michael Klahr of Citibank. Please go ahead.

Michael Klahr -- Citigroup -- Analyst

Yes, thank you. Just related to the legal costs related to the US investigation, especially in the first half there is a big pickup on what was in for full year 2017. Do you expect the current rate of expense to continue during the rest of the year (inaudible) some conclusions for that? Can you comment on those expenses?

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

You are referring, Michael, to what, to the G&A expenses? Michael? Hello? Thank you.

Kenny Green -- Managing Partner

Michael, we didn't hear you. Could you repeat?

Operator

Ladies and gentlemen, it seems the questioner has disconnected. (Operator Instructions) The next question is from Ella Fried of Bank Leumi. Please go ahead.

Ella Fried -- Bank Leumi -- Analyst

Hello and good afternoon. I have two questions regarding the prospects in terms of geographies and developments. Of course, we all expect to the merger, but even before, you mentioned that UK appears to be a prospect and you identified it as a very prospective market. And I saw that the Asia-Pacific region grew in the recent quarter. So, could you give us some color on this -- trends in terms of geographies and product mix, if possible, and especially UK?

Bezhalel Machlis -- President and Chief Executive Officer

Hello, Ella.

Ella Fried -- Bank Leumi -- Analyst

Hello.

Bezhalel Machlis -- President and Chief Executive Officer

As you all know, the increase in defense spending in Europe, the demand to which, a spend of 2% of GDP, and we see growing demand all over the continent. We have subsidiaries in Europe as we have in the US. By the way, we see the same trend in the US as well; we see increase in defense spending in the US as well, and we see many more opportunities in the US as well as in Europe for all different types of solutions, which includes the entire portfolio of the company.

You mentioned UK. UK certainly, we see a lot of potential in the UK, we have hundreds of people in our subsidiaries in the UK. We recently established Elbit Systems UK, which includes -- which is replaced with a customer, which we are combining all the activities we have under Elbit Systems UK. And we see a lot of potential in the airborne domain, in the EW domain, in the C4I domain as well in the land domain. So, there are many opportunities for us in the UK, and we see also a lot of interest in other countries as well, in Germany, and in other places -- in other places in Europe as well. So altogether, defense spending is growing and we see opportunities for us in the US, we see opportunities for us in Europe.

And also Far East, and Asia-Pacific is an important market for us. Just to remember, we have several contracts in Australia. We have a strong subsidiary in Australia, and not just Australia, also other countries in this region are showing more and more interest in our portfolio. So altogether, Asia-Pacific, US, and Europe are spending more. We are well positioned there, and I am optimistic that we'll be able to grow our backlog in the future.

Ella Fried -- Bank Leumi -- Analyst

Okay. Thank you. And I would like to follow up on Yoav's question. Do you expect the profitability in the second half to be higher, knowing the impact of the product mix that is expected in the second half?

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Ella, as you know, we do not provide guidance, but we are working hard to improve the present situation.

Ella Fried -- Bank Leumi -- Analyst

Okay. Thank you for taking my questions.

Bezhalel Machlis -- President and Chief Executive Officer

Thank you, Ella.

Operator

(Operator Instructions) There is a follow-up from Ella Fried of Bank Leumi. Please go ahead.

Ella Fried -- Bank Leumi -- Analyst

May I, another question. When do you expect the announcement of completing the acquisition of Israel Military Industries? Is it -- we expected actually in the end of September the last time we heard you update, I think.

Bezhalel Machlis -- President and Chief Executive Officer

Ella, as you know, we completed our part and right now we are waiting for some approvals from the government. I believe that it's soon, and it's difficult for me to say a date, but I believe it's quite soon. I believe it will happen -- I believe there is a good chance that it will happen soon and for sure this year.

Ella Fried -- Bank Leumi -- Analyst

Okay. Thank you.

Operator

(Operator Instructions) There are no further questions at this time. Before I ask Mr. Machlis to go ahead with his closing statement, I would like to remind participants that a replay of this call will be available two hours after the conference ends. In the US, please call 1-888-782-4291. In Israel, please call 03-92-55-929, and internationally, please call 9723-925-5929. A replay of the call will also be available on the company's website, www.elbitsystems.com.

Mr. Machlis, would you like to make your concluding statement?

Bezhalel Machlis -- President and Chief Executive Officer

I'd like to thank all our employees for their continued hard work. 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

Thank you. This concludes the Elbit Systems Limited second quarter 2018 results conference call. Thank you for your participation. You may go ahead and disconnect.

Duration: 29 minutes

Call participants:

Kenny Green -- Managing Partner

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Bezhalel Machlis -- President and Chief Executive Officer

Yoav Burgan -- Poalim Sahar -- Analyst

Michael Klahr -- Citigroup -- Analyst

Ella Fried -- Bank Leumi -- Analyst

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