ESLT - Elbit Systems Is Much Too Risky

2024-01-18 05:49:43 ET

Summary

• From an ESG perspective, Elbit Systems carries too much risk, even by the standards of the weapons industry.
• The company’s name has been linked to controversial weapons, human rights violations, and overall poor business conduct.
• The management's efforts at better profitability and long-term growth are being undermined by the mounting pressure for divestment.

Responsible investing being one of my twin areas of interest, I write mostly about companies that are champions of sustainability in their respective industries. Occasionally I cover ESG laggards and firms with intrinsically high ESG risks. Elbit Systems (ESLT) is a plain example of the latter.

The company has been dropped by many an investor (as evidenced below) who have cited controversial weapons, human rights violations and poor business conduct as their motivations. This, coupled with flagging financial performance and waning price momentum, makes Elbit Systems a hard pass, and not only for impact investors.

Financials: 3Q'23

In Q3 ended September 30, revenue increased by 11% to $1.5b; gross profit rose by 13% to $367m. About a fifth of revenue is contributed by Israel; North America, Europe and Asia Pacific each bring about a quarter of sales. By segment, aerospace is the single largest (28% of revenue), and it also performed the best, up 24% in the quarter.

Net income grew by 8% to $60.7m; at $1.65, EPS missed estimates slightly, by $0.05. (Nonetheless, this was regarded as a negative event by the only investing group covering Elbit Systems on Seeking Alpha.) Despite expanding top and bottom lines, margins show no immediate progress, gross profit margin stable at 24% and net income margin around 4%.

Although profitability remains wanting, Elbit maintains a decent balance sheet. As of September 30th, cash and equivalents stood at almost $147m and total debt at $1.2b, resulting in net debt to equity of 37.6%. Overall, however, debt levels have been increasing and are not covered by operating cash flow, which is negative.

Risks: ESG

Now onto the reason why Elbit's fair financial performance and, more importantly, growth prospects may be compromised by its poor ESG track record.

Israel and Elbit Systems, the principal contractor for the Israeli Defense Force , are mutually dependent and reinforcing - I see this exposure being the biggest source of risk for the company. Though Israel is no longer the largest geographical contributor to revenue, the relationship is strong and enduring. Since October last year, the company has boosted production of arms for Israel; in December , it reported having signed new contracts with the Israeli Ministry of Defense.

Elbit Systems' drones , artillery shells and cluster munitions are used heavily by the IDF in military operations around the region. The government also uses its security equipment to maintain the separation wall between Israel and the Gaza Strip (deemed illegal by the International Court of Justice) and for surveillance in the West Bank.

Given the allegations of human rights violations and involvement in contravention of international law , the company has been a target of multiple sustained activist campaigns . More importantly, Elbit Systems features prominently on EGS-themed investment screening platforms such as one by the American Friends Service Committee .

Aside from the apparent Israeli connection, Elbit Systems has also been entangled in other controversies - for supplying surveillance technology for use along the US-Mexico border and doing business with the Burmese military junta (which was charged with "genocidal acts" against the Rohingya). A report by Inclusive Development International berates socially responsible funds for investing in companies, Elbit Systems among them, that sell to Myanmar.

But at least Elbit Systems has seen its fair share of divestments. Some of the earliest exits were by Scandinavian funds, most notably Norway's sovereign wealth fund, the world's largest, in 2009 . Numerous financial institutions have followed suit: Germany's Deutsche Bank , France's AXA (after years of campaigning by NGOs), UK banking giant HSBC and Australia's SWF Future Fund . Others are under immense pressure to exclude Elbit Systems, like Canada's Scotiabank .

Since the beginning of 2019, Elbit Systems has been dropped by 77 financial institutions across mostly developed countries based on data compiled by the Financial Exclusions Tracker .

Conclusion

So far, Elbit Systems has been spared the worst of the divestment drama. Over the past five years, the stock, ESLT , returned 68% (almost 78% with dividends), much of it in tandem with the defense industry. So repeated investor exits have not necessarily translated into a loss of shareholder value.

The rich valuation corroborates the point: at 31x, P/E ((TTM)) is 27% higher than the five-year average of 25x. This could be explained by a strong base of support in the US market as well as political efforts at normalization of relations between Israel and the Arab nations before the recent escalation in Palestine.

This time, however, the events in Gaza may have much greater repercussions for Israel and, by association, Elbit Systems too. Institutional investors with ESG tilts that hold defense stocks (which many do) will face ever greater pressure to let go of controversial names like Elbit Systems, or risk reputational damage with material ramifications. The shareholders are bound to suffer, and retail shareholders disproportionately so.

For further details see: