Over the past decade, the United States has increased military spending by more than 80%. The White House recently announced plans to shave $400 billion off of the Defense Budget over a 10-year period. In response to this news, the stocks of some large defense companies, such as Raytheon (RTN) and General Dynamics (GD), experienced modest price declines. Given the likelihood of cuts in a number of defense programs in the years ahead, we believe that investors interested in companies in the defense sector should consider overseas options.
In particular, Israeli firm Elbit Systems (ESLT) stands out in our view. Elbit designs, develops, manufactures, and integrates defense systems. It operates in the areas of aerospace, land and naval systems, command, control, communications, computers, intelligence, surveillance & reconnaissance (C4ISR), unmanned air vehicles, advanced electro-optic and space technologies, electronic intelligence systems, data links, military communications systems & equipment, and radios. The company also upgrades existing military platforms and develops technologies for defense, homeland security, and commercial aviation applications.
Although Elbit’s primary operations are located in Israel, it has subsidiaries in the United States, Europe, Asia, Australia, and South America. Business to the United States represents a sizable portion of revenues, but even so, Elbit derives over two-thirds of its sales from other nations. We think that as time progresses the company will make a stronger push into emerging economies, particularly in Asia and South America. A key driver of geographic expansion and diversification for Elbit has been a healthy acquisition strategy. Over the past year, it purchased the balance of the shares of Elisa Electronics Systems and Azimuth that it did not previously own. In addition, it took over Brazilian companies Ares and Periscopio Equipamentos Optronicos S.A, American aviation services company M7, and bought a stake in the Israeli intelligence gathering firm Pearls of Wisdom. These deals, combined with higher research and development spending, will likely help cushion the business against a possible slowdown in demand from the United States and broaden its arsenal of products.
In 2009, Elbit Systems reported record revenues of over $2.8 billion. Last year, though, the top line retreated 7%, to around $2.6 billion due mainly to a decline in European sales of land systems and C4ISR systems. The softness spilled over into the first quarter of 2011, with relatively flat year-over-year sales and a decrease in share earnings of 43%, to $0.65. A significant jump in financial expenses, stemming from currency hedging activities and higher costs related to the issuance of debt, was one of the main culprits behind the shortfall. Nevertheless, backlogs climbed from $5.2 billion a year earlier, to $5.6 billion at the end of the March, 2011 quarter, which indicates that orders are still rolling in. What’s more, 68% of these orders are scheduled to be performed during the next three quarters of this year and in 2012. Indeed, this healthy order backlog and recent contract wins from Asia, Europe, Africa, South America, and the United States reinforce our expectation for a top-line recovery this year.
We are more optimistic in regard to Elbit’s prospects over the next three to five years. First, the company will probably continue to generate strong cash flow in the years ahead, creating a solid platform to fund further acquisitions and product introductions. Second, the stock’s relatively low Beta and P/E multiple suggest that it is a good fit for those seeking low volatility and a good entry point for investment. Third, we think that Elbit will achieve record earnings by mid-decade, which gives the stock the potential to almost double in price from its current quotation. Finally, when factoring in the dividend yield, which at the moment stands at almost 3%, this equity fits the profile for risk-averse, income-oriented, long-term investors.
For those looking to diversify their portfolios with some exposure in the defense sector but are concerned by the prospect of reductions in the United States Defense Budget, Elbit Systems appears to be an option worth considering. Expansion of the company’s global operations and customer base, a wide spectrum of product offerings for various military needs, and Elbit’s ability to acquire entities that are strategically sound ought to insulate it from a downturn in demand from our government. Still, as with any investment there are risks. These include more intense pressures from rivals, such as Honeywell (HON), BAE Systems, and Rockwell Collins (COL), among others, delays caused by suppliers or prime contractors, and foreign currency fluctuations.
At the time of this article’s writing, the author did not have positions in any of the companies mention.