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Elbit Systems Ltd (NASDAQ:ESLT)
Q3 2019 Earnings Call
Nov 26, 2019, 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 the Elbit Systems Third Quarter 2019 Results Conference Call. [Operator Instructions]

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. Ehud Helft of GK Investor Relations. Mr Helft. Please go ahead.

Ehud Helft -- Investor Relations

Thank you and good day to everybody. On behalf of all the investors, I'd like to thank Elbit Systems management for hosting this call. Joining us on the call today are Mr. Butzi Machlis, Elbit's President and CEO; and Mr. Yosi Gaspar, Elbit Systems' Chief Financial Officer. Yosi will begin by providing a discussion of the financial results of the third quarter of 2019 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'd 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.

With that, I would now like to turn the call over to Yosi. Yosi, please.

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Thank you, Ehud. Hello, everyone, and thank you for joining us today. As we do every quarter, we will provide you with 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. The results of the third quarter of 2019 showed a good revenue growth with particularly strong growth in the United States, a strategically important market for us.

Elbit has now seen four consecutive quarters with revenues at over $1 billion per quarter and our backlog nearing $10 billion provides good visibility over the coming years. I should note that the balance sheet and the backlog of Harris Night Vision business has been consolidated as of September 30, 2019.

I will now highlight and discuss some of the key figures and trends in our financial results. Our third quarter 2019 revenues were $1.1 billion compared with $895 million in the third quarter of 2018, up 23% year-over-year. In terms of revenue breakdown across our areas of operation in the quarter. Land systems accounted for 27% of total sales and have increased significantly year-over-year, mainly due to our acquisition of IMI completed in the fourth quarter of 2018.

Airborne systems sales at 36% of sales increased year-over-year due to avionic sales and the sale of IMI product into the US and Israel. In terms of geographic breakdown, we continue to be fairly well diversified between the various regions in which we operate. North America was the largest at 30% of our revenues. Asia-Pacific at 23%, Israel at 22%, Europe at 18%. The strong growth in North America was primarily due to increased airborne sales, as I mentioned a few moments ago, and the growth in Israel was due to the acquisition of IMI.

For the third quarter. Non-GAAP gross margin was 26.3% compared to the third quarter of last year of 29.1%. The lower gross margin in the quarter reflects an unfavorable sales mix during the quarter and the lower gross margin of the IMI sales. Third quarter non-GAAP operating income was $80.7 million or 7.3% of revenues compared with $85.7 million or 9.6% of revenues last year.

Third quarter GAAP operating income was $101.7 million versus $79.1 million last year. In the quarter, we exercised a purchase option that we had on one of our buildings and sold it generating a capital gain and income of $28 million, which reduced our operating expenses. The operating expenses breakdown in the quarter was as follows; net R&D expenses at 7.2% of revenues versus 7.8% last year; net R&D spend was 7.9 [Phonetic] -- $79.5 million in the quarter compared with $69.6 million last year.

Marketing and selling expenses at 6.9% of revenues versus 7.8% last year. G&A expenses at 5.2% of revenue versus 4.2% last year with the relative increase primarily due to our recent acquisitions.

Financial expenses for the third quarter of 2019 were $18.5 million compared with financial expenses of $8.1 million in the third quarter of last year. The higher level of financial expenses this quarter was due to the implementation of Accounting Standard ASC 842 relating to operating leases. In the quarter, this generated a non-cash accounting expense of $6.6 million, mainly due to the strengthening of the shekel versus the US dollar.

We had other expense of $2.8 million. This was due to non-service cost component of pension plans following the adoption of Accounting Standard ASU 2017-07.

For the third quarter, non-GAAP net income was $58.7 million or a net margin of 5.3% versus $67.3 million or a net margin of 7.5% in the third quarter of last year. On a GAAP basis, third quarter net income was $72.1 million versus $64.1 million in the corresponding quarter last year.

I know that during the second quarter, Elbit Systems raised $185 million through the sale of treasury shares to institutional investors in Israel. This increased our share count by about 3% to 44 million shares, having a slight corresponding impact on our earnings per share relative to last year.

Our non-GAAP diluted earnings per share were $1.32 compared with $1.57 in the third quarter of last year. GAAP diluted earnings per share were $1.63 compared with $1.50 in the third quarter of last year. Our backlog of orders as of September 30, 2019 was $9.8 billion, $1.7 billion higher than the backlog at the end of the third quarter of 2018 and $396 million higher than at the end of 2018. This represents over 21% increase in backlog, year-over-year. Approximately 46% of the current backlog is scheduled to be performed during the remainder of 2019 and 2020, and the remainder is scheduled for 2021 and beyond. The ratio is broadly similar to that of the third quarter of last year where it was 45%.

Operating cash flow for the quarter was $48.8 million outflow, compared with $19 million outflow in the same quarter last year. We have increased our focus on the cash generation and expect to see gradual improvement over the coming quarters. The Board of Directors declared a dividend of $0.44 per share for the third quarter of 2019.

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

Bezhalel Machlis -- President and Chief Executive Officer

Thank you, Yosi. Elbit Systems has evolved significantly in the past year and it's of much greater scale than only a year ago. This is especially true in our key strategic region, the United States. Over the past year, we completed two large acquisitions. In September, we completed the acquisition of the Night Vision business from L3Harris Technologies for $350 million. The Night Vision business has strong market positions in the US and adds advance technologies to Elbit Systems portfolio with significant potential for -- for revenue synergies.

This acquisition further enhanced our position in the US, a strategic market for Elbit. I would like to take this opportunity to welcome the Night Vision employees into the Elbit Systems family. At the end of last year, we completed the acquisition of IMI Systems. The combination of Elbit and IMI's capabilities together with Elbit Systems' broad market presence enables us to offer an enhanced product portfolio and realize the potential of IMI's technologies in Israel, and more importantly in the international arena. The integration of IMI is progressing in line with our expectations and we continue to explore further opportunities to extract revenue and cost synergies.

Our gross margin in the third quarter was impacted by the sales mix and IMI. Land systems management is working hard to raise IMI's margins up to Elbit's. Progress is encouraging, but the improvement will be gradual. Elbit has decades of experience in successfully integrating acquisitions and extracting synergies often significantly ahead of plan. Taking a closer look at the performance of Elbit Systems during the quarter, as Yosi mentioned, our revenue grew by 23% year-over-year. A mixture of organic growth and IMI. Our businesses continues to perform well and we have won new businesses across all our main target regions. I would like to highlight some of our recent wins. In Europe, we were pleased to have been selected to provide the Swiss Armed Forces with an armywide tactical Software Defined Radio solution, a key probability for the Swiss Armed Forces. This selection follow a rigorous evaluation procedure which ultimately found our system providing a better price performance ratio over the competition. The contract award is subject to approval by the Swiss Parliament. A few weeks ago, we announced a five year $50 million contract to supply the Portuguese Air Force with a complete Electronic Warfare suite and Customer Logistics Support for the new KC-390 multi-mission aircraft.

In the UK, we were awarded a $38 million contract to supply comprehensive Joint Fires Synthetic Training System to the British Army. The system will be supplied over two years and the contract includes four years of maintenance, technical support and on-site training.

In Southeast Asia, we announced $150 million contract for a multi-layered array of Unmanned Aircraft Systems or UAS. Under the contract, we will supply a network multi-layer UAS solution, including more than 1,000 THOR multirole vertical takeoff and landing mini-UAS, scores [Phonetic] of Skylark I-LEX, Skylark 3 and Hermes 450 tactical UAS, as well as Universal Ground Control Stations.

In the US, we recently announced a $23 million win by our new newly acquired Night Vision businesses for the supply of systems and various spare components to the United States Marine Corps. The order is part of the $249 million five-year Squad Binocular Night Vision Goggle system IDIQ contract awarded several days before the finalization of the acquisition of the Night Vision businesses by our US subsidiary.

In September, we announced our selection by Boeing to supply cockpit displays, datalinks and embedded training capabilities for the US Air Force T-X advanced pilot training aircrafts. We continue to see demand across the globe for our solutions from our legacy and recently acquired businesses, highlighting the value provided by our broad band product suite. In summary, as Elbit moves into 2020, we are not only a leading high tech defense electronic company. We are also a Company of significant scale, a bigger player in the large US market with multiple growth opportunities ahead of us. And with that, I will be happy to take your questions.

Questions and Answers:

Operator

[Operator Instructions]

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

Pete Skibitski -- Alembic Global -- Analyst

Yes, hello, Butzi and Yosi and Rami [Phonetic], good afternoon. My main question is on gross margin, I know you guys talked about mix. And then I want to make sure I understand exactly what you mean by that. Was the mix related to within IMI and in another words, IMI gross margin was down versus the first half of the year or was it related to some other item?

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

It's a combination of both. IMI's gross margin historically used to be in the teens, as -- as you know. And we are working hard to improve that and actually, they were able to improve slightly in the last three quarters and we see the gradual improvement for the future. However, they start for a relatively low number while we are in the high 20s, they are in the high teens. So that is one aspect. The other, the mix element is that even the rest of the business from time to time, we have a mix of products, a mix of programs sold in the quarter.

Sometimes with higher profitability. Sometimes with lower profitability and that's what we mean by a mix in the quarter. In general, speaking, I would look at the longer term gross profit performance of the Company and the value of the specific quarter gross profit, I would say is a little bit limited.

Pete Skibitski -- Alembic Global -- Analyst

Okay. Okay, so you're expecting an improvement sequentially in the fourth quarter? Yosi?

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Well, we are working hard to improve it, we don't provide guidance, as you know, usually the fourth quarter is a strong quarter, definitely in the revenue line. We'll see how it goes.

Pete Skibitski -- Alembic Global -- Analyst

Okay. Okay. And then let me ask on working capital, you made some comments in your prepared remarks. How do you think about the fourth quarter, do you think working capital will be a tailwind for you and is there maybe a free cash flow to net income conversion ratio for the full year that you think you can hit?

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

I expect to improve the situation in the fourth quarter. However, I do not expect total turnaround. We are working hard to collect from our customers the money here in Israel. We have a little bit difficult situation with the Ministry of Defense and in general, actually with the whole budgetary situation of the whole country due to the political situation.

However, we expect to collect that in the coming quarters in one way or another. Other customers, we're working hard to get the money in. The other element of the working capital, we have a slightly higher than usual level of inventory. Part of that will be reduced we expect during the fourth quarter. But part of that will continue with us in view of the fact that we have to provide for the growth of the revenue line in the future quarters.

Pete Skibitski -- Alembic Global -- Analyst

Okay. I understood. I guess I'll ask one last one. I appreciate all the color on active protection systems. It seems like you've had some breakthroughs recently. I think, you guys announced in August, you won the Israeli Eaton APS competition over Rafael. And I understand, that the Eaton will go into production in 2021. And so I'm trying to maybe think about a revenue profile there like maybe a similar US program could be. I'm guessing, maybe you have a limited number of development revenue you'll book before the Eaton gets introduced around 2021, but then thereafter, I mentioned maybe it ramps as the vehicle goes into production, is that the right way to think about it?

Bezhalel Machlis -- President and Chief Executive Officer

Yes, you're right, we almost completed the development of the system and we are waiting for -- we're waiting for an order from the Israeli Ministry of Defense. As you all know, that Eaton is a very important platform here in Israel and I'm sure, it will go into production with big numbers and we are very proud by the fact that we have been selected by the Israeli MoD. We don't yet have an order. Therefore, we didn't talk about that, but we expect to have this order soon, and it will go into production, as you said probably in a year -- in about a year time from now.

We see a lot of interest for the system in many other places as you all know. We are discussing the system also with the US Forces for the Bradley training in the US and there is also a lot of interest in Europe as well as in Asia Pacific and we expect this product or system to be a growth engine for our land division as well as for the entire corporation.

And we expect it to go into production, as I said in about a year from now for Israel as well as hopefully for other customers as well.

Pete Skibitski -- Alembic Global -- Analyst

That's Great. I appreciate all the color, guys. Thank you.

Bezhalel Machlis -- President and Chief Executive Officer

Okay.

Operator

[Operator Instructions] The next question is from Ella Fried of Bank Leumi. Please go ahead.

Ella Fried -- Bank Leumi -- Analyst

Good afternoon. Thank you for taking my questions. And first, regarding the appreciation of shekel and the current hedge situation. As we know, the third quarter was partially hedged. And if I remember correct, the fourth quarter, it was almost -- was no hedge at all. And how are you coping with the present rates and the shekel appreciation in general?

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Well, we are experiencing a strong shekel. And actually, the third quarter did suffer to some extent from the strong shekel as well. We -- the fourth quarter would be affected as well. I'm not sure what will be the average rate on that fourth quarter shekel. However, we are now in the 348 [Phonetic] per dollar, 346 [Phonetic] per dollar range. We're working hard to reduce, as you know, our cost basis and to be minimally affected by that. We did not hedge anything for the fourth [Phonetic] quarter, we will have some impact. I don't think that will be something extremely drastic.

Ella Fried -- Bank Leumi -- Analyst

And another impact or not. The labor costs, the letting go of -- parts of IMI and all this procedure, will we see the impact of it on the results of the fourth quarter and how much of it did we see in the third quarter?

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Well, actually, the impact of that you'll see it, first of all, in the cash flow. We did pay, whatever needed to be paid, according to the agreements that we had with the unions and the employees and the government when we bought IMI. So that is one impact. The other impact, we started seeing gradual initial reduction in the headcount and according to that reduction in the cost basis of the operation of IMI and therefore, we actually were able to bring them at a breakeven plus I would say, the operating profit level.

Some of the reasons of that are in that element that we just discussed right now. Looking into the future, we expect to get the benefit, the full benefit in the following year and by a reduction of cost -- cost basis. In parallel, we, of course, have gone through restructuring of the business and focusing in the business elements better according -- at IMI in line with what we do in the rest of the Company.

Ella Fried -- Bank Leumi -- Analyst

And for how long do you think is your estimate that this process. I mean, the bulk of this process will last two quarters, almost three quarters from now?

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Yeah, I think, we'll be done with most of it somewhere during 2020.

Ella Fried -- Bank Leumi -- Analyst

Thank you very much for taking my questions.

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Thank you.

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 US, please call 1-888-326-9310. In Israel, please call 03-925-5921. And internationally, please call 972-3-925-5921. 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?

Bezhalel Machlis -- President and Chief Executive Officer

I would like to thank all of 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 good day and good bye.

Operator

[Operator Closing Remarks]

Duration: 26 minutes

Call participants:

Ehud Helft -- Investor Relations

Joseph Gaspar -- Executive Vice President and Chief Financial Officer

Bezhalel Machlis -- President and Chief Executive Officer

Pete Skibitski -- Alembic Global -- Analyst

Ella Fried -- Bank Leumi -- Analyst

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