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There will be five leading niches for investment in Israeli companies in the coming years, in my view. They are: defense electronics, alternative energy, water (it’s still not too late to float Mekorot), healthcare (mainly generic drugs and medical equipment), and wireless communications. I will try, in a series of articles, to analyze each field and assess the Israeli potential in it.

I’ll start off with defense electronics. It is clear to me that, over the next decade, this will become the field in which more money is invested than any other, aside perhaps from telecommunications. Elbit Systems (NASDAQ:ESLT), under the leadership of president and CEO Joseph Ackerman, is becoming the most interesting defense electronics company in the world (with the possible exception of L-3 Communications Holdings Inc. (NYSE:LLL), which could compete with Elbit Systems for that title).

A few years ago, Elbit Systems’ management made an extremely smart strategic move: It turned the company into a niche leader. Ackerman has done what Eli Hurvitz did at Teva Pharmaceutical Industries Ltd. (NYSE:TEVA): He entered a rapidly growing niche while sitting in the driver's seat. The company’s management builds on its contacts within the Israeli defense establishment and abroad, and on the know-how acquired in Israel. A clear example of this can be seen in its recent selection as a member of a Boeing-led consortium that won a major tender from the U.S. Department of Homeland Security. Elbit Systems is making firm progress towards achieving recognition in the field of defense electronics.

If it achieves this goal, the future for Elbit Systems’ investors looks fantastic. A good many investors around the world are following the company’s progress for a number of reasons. The first is the certainty that the defense electronics niche will continue to expand. Very few people envisage a fall in the level of investment in defense electronics and demand for products in the foreseeable future. The only scenario in which investment could come to a halt would be the realization of the biblical verse, “the wolf shall dwell with the lamb, and the leopard shall lie down with the young kid,” and this looks pretty far-fetched at present.

The second reason for following Elbit is its impressive progress and world-class experience and knowledge. Another reason is that, save perhaps for L-3 Communications, almost no other company is so ideally suited to this niche. At all the other leading defense and security companies, defense electronics is but one of many divisions. I expect that over time, Elbit’s valuation will have a premium.

With a market cap of $1.3 billion and sales of $1.23 billion in the year to June, Elbit Systems focuses exclusively on defense electronics. All its acquisitions over the past decade have supported this goal. Thirty-seven percent of its sales are to the U.S. and only 10% to Europe, a region that has tremendous growth potential for the company. A further 29% of its sales are in Israel, with the remaining 24% to other parts of the world. The company has been extremely busy over the past two years merging the companies it has acquired, a process that appears to be coming to an end. Elbit's management will now turn its attention to its sales efforts and will also launch an extensive streamlining process. These measures are likely to significantly boost sales and net profit in the coming years. Incidentally, Elbit Systems’ order backlog stands at $3.6 billion.

I think we will see a marked increase in Elbit Systems’ sales and profit margins in 2007, and these will be much higher than analysts’ estimates. Several changes will be needed in order to generate the premium on the stock. First, global investors need to be made aware of Elbit Systems’ tremendous potential. Those who know the company still view it as an Israeli defense company, and while most of these investors recognize its extensive know-how, technological experience, strong management, etc., this is not enough in itself to create a premium on the stock. This will begin to accumulate once Wall Street understands that this is a different kind of animal, and not just a company whose line of business is defense. Elbit Systems should be given the profile it deserves as the leader in a rapidly growing niche. To make this happen, we will have to wait for the breakthrough in sales and profit due in 2007.

Such a breakthrough (which has already begun) will eventually bring on board leading analysts and will lead to the appointment of people with international reputations to its board. At present, only four analysts cover Elbit Systems (compared with 20 for L-3 Communications, 24 for General Dynamics (NYSE:GD), and the many who cover leading companies such as Boeing (NYSE:BA) or Lockheed Martin (NYSE:LMT)). The analysts covering Elbit Systems are usually not of the seniority of those covering L-3 Communications.

In addition to the shortage of analysts covering it, Elbit lacks global figures on its board. The composition of the board of a global company amounts to the credentials it presents when approaching the investment world. A number of prestigious Israeli figures sit on the board alongside Ackerman, among them chairman and controlling shareholder Michael (Mickey) Federmann, a world-renowned figure (not just through his presence on the boards of Elbit and El-Op Electro-Optics Industries, but also through his association with academic institutions such as the Hebrew University of Jerusalem and the Weizmann Institute of Science, where he holds senior positions); Moshe Arad; Avraham Asheri; Yigal Ne’eman; Yaacov Lifshitz (external director); Jonathan B. Kolber and Rina Baum.

All these are respected figures, but the appointment two weeks ago of former U.S. Army undersecretary Joe R. Reeder to the Elbit Systems board was an important step towards creating a premium for the company’s stock. A key figure in the U.S. defense business community, Reeder is chairman of the Panama Canal Board, and graduated from the U.S. Army's Airborne and Ranger Schools. He was a field artilleryman and served as a member of the 82nd Airborne Division.

This is an important move in the right direction. It won’t do any harm to have a few more people like Reeder at Elbit Systems’ helm. Alongside such window-dressing, the company should keep doing what it has been doing for the last decade and continue to grow and streamline. In my view, Elbit Systems is the number one Israeli stock for the conservative investor for the next five years.

ESLT 1-year 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.

Source: Elbit Systems Poised to Profit in Defense Electronics Niche