Elbit Leads in the Smart Defense Niche

 |  Includes: ESLT, LLL
by: Shlomo Greenberg

The other day, I sat and tried to decide which Israeli company, or company with Israeli connections, I wanted to go with for the next five or ten years, besides Marvell Technology Group (Nasdaq: MRVL), Teva Pharmaceutical Industries Ltd. (Nasdaq: TEVA), or NDS Group (Nasdaq: NNDS). My conclusion was that the most interesting investment for the next five years is actually Elbit Systems (Nasdaq: ESLT).

On Tuesday, UBS Investment Research analysts Joseph Wolf and David Kaplan upgraded their rating for Elbit (ESLT) to “Buy 1”, the highest rating that the Swiss bank gives, and set a target price of $34 a share, 30% over its current market price. This is the second time that UBS analysts have raised their ratings for this stock, after raising it in to May from “Neutral” to “Buy” (one level lower than "Buy 1"). They based their recommendation on the increase in orders backlog in all the company’s businesses, and on the belief that the improvement in margins will raise profit margins. On the other hand, they also lowered their earnings per share forecast slightly to $1.60 from $1.63.

As for 2007, Wolf and Kaplan predict sales totaling $1.505 billion for Elbit with earnings per share of $2. In other words, earnings per share will increase 25% while sales will increase 7.6%, indicating that, in their view, the cost efficiency measures will continue. Incidentally, their previous forecast predicted sales of $1.5 billion and earnings per share of $2. In other words, they raised their 2007 sales forecast by $5 million.

To be perfectly frank, I have never understood why analysts are such sticklers for accuracy, but why not? According to UBS, Elbit is currently trading at p/e ratios of 16.5 for 2006 and 13.3 for 2007, which are pretty similar to those of L-3 Communications Holdings (NYSE: LLL). It’s interesting to note that the analysts did not put L-3 in their comparison tables with other companies in similar fields, although they did include Lockheed Martin, Raytheon, and Rockwell of the US and French company Thales. I would have definitely included L-3, since it is more like Elbit than any of the others. This year’s jump in Elbit stands out in these tables. Despite agreeing with the analysts, I believe that they are too apprehensive, because they are unable to accurately assess the affect of the merging of the four companies which Elbit has acquired over recent years: El-Op, Tadiran Communications, Elisra Group, and the small US company, Sandel Avionics, which deals in electronic display for civilian aircraft.

It should also be remembered that analysts tend not to get too enthusiastic about companies which can be associated with what is called “military.” Companies like these, along with tobacco and asbestos manufacturers, have also been considered untouchable, especially during recent decades. They were never popular with anyone, despite their profitability.

Elbit Systems is not entirely a defense company, but it is also Israeli, making it beyond the pale in some circles. Another problem that has always been associated with military technology companies is its business cycle. However, Elbit’s sales have risen sharply in recent years, from $897 million in 2003, to $1.4 billion in 2006 (according to average analysts’ forecasts), a 55% jump in three years, with profit rising from $45 million to $70 million this year. Since 2003, Elbit’s stock has climbed 80%. Investors could, however, be slightly misled by the fact that the controlling interest in Elbit transferred in 2004 from Elron Electronic Industries (Nasdaq: ELRN) to David Federman at a price of $26 a share.

I do not think that the two weak spots that defense technology companies are prone to - antipathy and a problematic business cycle - are a problem for Elbit. It could well be that the concern about cyclicity stems from the ups and downs in net profit in recent years, but that was in fact a function of the acquisition of the four companies I mentioned. Now that that is over, profitability can be expected to continue to growing.

I see the "smart defense" niche expanding, at least for the next decade. Terror, wars in Iraq and Lebanon, tighter security in general around the world, especially in aviation, and, more than anything, the effort to improve command and control and remote detection, will only lead to more business for Elbit. Add to that the changes taking place in armed forces, with the emphasis on small, sophisticated units, and you have a niche that is developing more rapidly than any other, with very few bumps along the way.

ESLT 1-yr Chart

Published originally by Globes [online], Israel business news - www.globes.co.il
© Copyright of Globes Publisher Itonut (1983) Ltd. 2006. Republished on Seeking Alpha with full permission.