ESLT – Build That Wall and Elbit Might Get Paid For It

The following is our initial stock call the overall business and share price of Elbit Systems (ESLT-NASDAQ). The purpose of this report, and the underlying research provided, is to better understand the future direction of ESLT relative to its peers and the NASDAQ composite.

The main criteria that will determine the future share price, earnings per share and dividend per share is anticipating the next few quarters’ dollar revenue recognized, based off the order backlog numbers. Any unexpected changes in revenue recognized in a given quarter will impact the overall buy/sell valuation.

This information is provided with the understanding that we are not allowed to trade the stock of the companies we cover or recommend. We do not receive any form of compensation from any other parties besides subscribers.

Elbit develops and supplies a broad portfolio of airborne, land and naval systems and products for defense, homeland security and commercial applications. We suggest you read page 13 to 18 of the 20-F.

https://www.sec.gov/Archives/edgar/data/1027664/000162828017002762/eslt1231201620-fdoc.htm

Note that Unmanned Aircraft Systems (UAS) are drones, and are an important product for the company. What has moved the share price higher than the market has been the potential to win material work on U.S. border security. However it is still in the P/E range that normal defense contractors trade at. The biggest question mark at this point appears to be how much of this upside is already priced in.

An example of what Elbit’s border system does was given by U.S. Senator John McCain of Arizona. On describing Elbit’s solution in his State, he noted that it would “be able to detect a single, walking, average-sized adult’ at a range of 5 miles to 7.5 miles during day or night, while sending close to real-time video footage back to agents manning a command post” (Source: Jpost).1) Best Position To Win Material U.S.-Mexico Border Wall – With details of the U.S.-Mexico border still ongoing, ESLT would appear to have an upper hand versus the competition. In particular, they have perhaps the most experience in high tech border security, starting with being responsible for security and surveillance of the Israeli – West Bank barrier.

Their expertise in Israel and manufacturing in Texas, New Hampshire, and Florida likely played a part in the U.S. Department of Homeland Security in selecting and deploying Elbit Systems North America (wholly-owned subsidiary) to deploy an Integrated Fixed Towers (IFT) in 2014. UPDATE: On September 12th U.S. Customs and Border Protection selected Elbit to provide an in-fill radar system and towers located in Texas. At the State level, Elbit was contracted to supply IFTs, sensors, radar, communications and control towers for the Arizona border with Mexico (Source: TheStreet) in 2014.

2) More Focused than their Peers – Elbit beat out peers, such as General Dynamics Corporation (NYSE: GD), Lockheed Martin (NYSE: LMT), and Raytheon Corporation (NYSE: RTN) for the Arizona project worth $145.3 Million, supplying 52 towers with various radar and camera technology (Source: TheStreet).

The recent announcement of the approval from the U.S. House of Representatives for $1.6 Billion in funding as a down payment for the border wall in the pipeline (Source: Business Insider), we feel ESLT can be a notable player in the discussion for which companies are to be selected to support the project.

2) U.S. Military Spending Rebound is Accelerating – In the United States, the current budget proposal from the U.S Department of Defense will come in at $ 639.1 Billion for fiscal year 2018, effective Q4 2017 (Figure 1). This is an increase of approximately 9% versus the fiscal year 2017.

Source: U.S. Department of Defense

At the global level, military expenditure has been averaging 2% growth since 2004 until 2016. However, military expenditure has been relatively flat in the past couple years, hovering at $1,688 Billion as of 2016 (Figure 2).

Source: Stockholm International Peace Research Institute

With a defense company-friendly budget proposal from the U.S. Department of Defense, we feel ESLT can capitalize on this with its exposure to the U.S. market.

3) New U.S.-Israel Military Aid Memorandum Appears Set to Help Elbit –

While the Israel Ministry of Defense’s gross budget proposal for 2017-2018 will be 70.7 Billion NIS (New Israeli Shekel) and 70.5 Billion NIS respectively, compared to the 69.7 Billion NIS for 2016 (Source: INSS). This is a 1% increase in the budget from 2016 to 2017, with 2018 looking flat versus 2017. The net budget amounts are dependent on “income-dependent expenditure”, which is primarily aid provided by the United States (Source: INSS).

The current memorandum providing Israel with $3.0 Billion in military aid annually from the United States is set to expire in fiscal 2018 (Source: Reuters). The succeeding MOU signed in 2016 will increase military aid to Israel to $3.8 Billion annually beginning in 2019 to 2028 (Source: Reuters).

However, the new memorandum has certain restrictions on the funds that the Israeli government will need to abide by. Under the existing agreement, Israel was permitted to convert 26% of the military aid into Israeli New Shekels (ILS) and use it on Israeli-made defense systems and 13% of it or $400 million annually on Jet Fuel (Source: USA Today, The New York Times). In the subsequent arrangement, this provision will be phased and will not permit Israel to convert any of the aid into Shekels (Source: INSS).

This restriction will impact local Israeli companies that have received funds from the Israeli government. Nonetheless, ESLT will not be impacted by this restriction as they currently have operations in the United States (Source: Elbit). Elbit appears primed to benefit on this restriction, as being one of the first Israeli companies with a foothold in the United States, in comparison to other Israeli companies (Source: CNBC). We also believe the Israeli government will likely procure items from Elbit’s U.S. subsidiary versus other U.S. based companies, due to ESLT’s ties to Israel.

4) Lack of Analyst Coverage – With brokers facing political pressure for covering a company that built and maintains what some call an ” Apartheid Wall”, Elbit has not been promoted to a significant extent. As of September 11, 2017 there was only one sell-side analyst covering the stock.

5) Focus on International Growth – North America, Europe and Israel accounted for 26%, 23% and 21% of total revenue respectively (Source: ESLT Q2/17 Report). However Elbit is increasingly focused on growth in APAC and LATAM with a shifting sales presence in these regions. Over the next few years despite increasing U.S. defense spending, Elbit expects these regions to increase as a percentage of revenue. Elbit has stated to us this is the reason they believe they see relatively steady revenue growth in comparison to peers.

6) Elbit’s R&D Spend is Similar to Many Technology Companies – Elbit’s R&D spend is roughly 8% of revenues. Most defense contractors R&D spend is well under 5% of revenue. Among the areas Elbit invests a significant amount in innovation are UAV systems which are seeing growing demand, command center software, transmission of data, pilot training simulation, infrared energy used to detect missiles and lasers to jam missiles.

7) Ongoing Effort to Improve Gross Margins is Slowly Paying Off – Elbit’s gross margin has grown from 28% in 2014 to an expected 30% in 2017. First of all Elbit makes no bones about not competing on price. Secondly the company is making improvements in a number of areas. This includes combining contract lines which remains an ongoing effort. Also about a year and a half ago they decided to make the move to one ERP system (Infor). With over 10 ERP systems at the moment, the hope is that over the next four years they are able to move to one system.

8) Dividend Should Move Higher – While having no board mandate on the dividend, the company generally targets a 28% to 30% payout ratio. With our 2018 EPS expected to increase by 5% y/y, we would expect the dividend to do the same.

Summary:

The points mentioned above summarize some of the catalysts we feel strongly position Elbit for the quarters and years ahead.

Our model projects quarterly and annual figures for 2017 and 2018 EPS. We currently forecast 2017 EPS at $6.34 versus consensus of $5.74 and 2018 EPS at $6.68 versus the consensus of $6.27.

As ESLT’s peers currently trade at a P/E ratio of 24x 2017 EPS, we feel this is a good reference to use for what ESLT and its peers will trade at for 2018 EPS.

Stock Call: BUY – We believe Elbit should trade at 24x its 2018 EPS of $6.68 in one year’s time. Our price target is $160 being reached by the time Q2/18 is reported.

Source: Bloomberg

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