The rules of modern warfare are changing quickly. Traditional battle lines have been replaced by global terror networks with no boundaries or state affiliations.
That’s one of the biggest reasons for the huge growth of the unmanned aerial vehicle (UAV) industry, with U.S. spending jumping to $5 billion from $550 million in just the past 10 years.
But looking forward, it’s not just the military that is unlocking the incredible potential of drones. Law enforcement agencies, homeland security and the private sector are all driving an incredible boom in the drone industry that is still in the very early stages. That has the Federal Aviation Administration predicting the global drone market could grow to a staggering $90 billion in less than a decade.
But while the drone industry is set to benefit from surging demand, some of the best technology is coming from the major defense contractors, where drone-segment revenue can be buried among other larger divisions. That makes it challenging for investors to find a pure play investment in this high-growth market.
That’s why I’m bullish on a little-known defense company that has a big portfolio of industry leading drone technology and systems. That has given shares a big boost, up a market-beating 26% on the year after surging 15% in the last month.
Unlike large defense contractors -- some with market caps above $50 billion -- Elbit Systems (Nasdaq: ESLT) is small, with a market cap of just $2.2 billion. Through a series of mergers and acquisitions, Elbit has grown to own 90% of Israel’s non-state-owned defense sector. Elbit is also a major supplier to the U.S. government, with 28% of its $703 million in second-quarter revenue coming from North America.
Elbit is a major player in the global drone market, with its Hermes 450 the serving as the foundation of the unmanned inventories of Israel, Great Britain and other countries.
But Elbit isn’t content to focus on just the U.S. and Israel. The company has been moving aggressively to expand its global footprint and cash in on high-growth opportunities in emerging markets.
Elbit recently said it has teamed up with Sharp Aviation, a South Korean company, on a jointly owned venture called Sharp Elbit Systems Aerospace (SESA). The new company will supply avionic systems to the South Korean military; as a Korean company, SESA will also be allowed to offer its products and services to foreign suppliers and OEMs (original equipment manufacturers).
Elbit has a 19% stake in the new venture with an option to increase its share to 50% as well as a great platform to tap into high-growth Asian-Pacific markets, which currently accounts for 19% of total revenue.
Elbit is also tapping into South America with an emphasis on Brazil. In April, Elbit said it had won a contract to supply electro-optic observation systems to a Brazilian defense contractor focused on border technology. Although the amount won't have a huge effect on Elbit’s bottom line, it paves the way for additional investments in Brazilian assets and infrastructure.
But it’s not just the growing demand for drones and drone systems that Elbit is cashing in on. The company is also seeing strong demand from domestic and international law enforcement agencies. That was on display in August when Elbit announced a $32 million contract with the Australian Federal Police to supply an investigation, intelligence and incident management system set to be deployed over four years.
Elbit is also leading the way in unmanned ground vehicles (UGVs) in its partnership with Israeli Aerospace Industries. The strategic collaboration has Elbit applying its market-leading aerial technology to a new class of machines in a virtually non-existent market.
Elbit is also unique because in addition to producing some of the industry’s most popular drones, it also sells electronic control and management systems to third-party manufacturers. That provides the company with additional revenue diversification and reduces product-specific risk.
The string of new markets, technology and deals has increased Elbit’s order backlog by $340 million in the past 12 months, to $5.8 billion. Nearly 60% of that is expected to be processed in the rest of 2013 and 2014, with the balance set to be completed by 2016.
Elbit has also been strengthening its financial profile, with cash and equivalents holding steady above $200 million while long-term debt has been cut by more than $300 million to $536 million.
Risks to Consider: The biggest threat to Elbit and other defense contractors is reduced defense spending in the U.S. and Israel. Although defense spending continues to fall, Elbit’s strategic emphasis on unmanned technologies and emerging markets should help insulate it from the biggest cuts.
Action to Take --> Elbit Systems is cashing in on the bullish trend in drone technology. But in spite of a 29% gain in 2013 and surging estimates, shares still look undervalued, with a forward price-to-earnings (P/E) ratio of 10 times below its 10-year and peer average of 14 times. If Elbit simply traded with the same multiple as its peers, share would jump to $76, a 40% gain from current levels.