Will streamlining help Israel Aerospace recover?

Yuval Azulai

It is hoped that downsizing, mainly from loss-making commercial units, will return the government-owned company to profitability.

At least one half of the 730 Israel Aerospace Industries Ltd. (IAI) (TASE: ARSP.B1) employees expected to retire as part of the new streamlining agreement are part of the civilian groups, that were the source of most IAI losses in the past few years. The Commercial Aircraft Group and the Bedek Aviation Group have had difficulties recovering from the slump in orders that followed the 2008 economic crisis, which has led to underemployment. In 2015, the Commercial Aircraft Group sustained a $30 million operating loss, while Bedek Aviation Group's operating loss totaled $43 million.

The agreement was signed last week between IAI CEO Joseph Weiss and worker committee chairman Ehud Nof, after six months of intensive talks, and will be implemented over the next three years. According to IAI's stock exchange announcement, the agreement's cost is estimated at $150-250 million, and its financing has not been completely finalized yet. IAI executives hope that the Ministry of Finance will cover at least some of the costs, although ministry officials have clarified time and time again that they are out of the picture, and that the company is capable of funding the agreement using its own resources. The IAI still hopes to reach an understanding with the Ministry of Finance that will enable IAI to fund the streamlining agreement by decreasing the dividends paid to the state, in a scheduling for several years. At the same time, the company is preparing for the possibility that the Ministry of Finance will not participate, thereby forcing the company to pay for the agreement and take off under its own steam.

Increased investment in R&D

In parallel to its large-scale streamlining plan, the IAI plans to significantly increase its investment in research and development in the next few years, in order to develop a new, high-end product line, that will lead to increased revenue from sales in Israel and abroad.

At present, the company invests a bit less than $200 million in R&D annually. In the next few years, it seeks to increase this investment by dozens of percent, in order to reap the benefits in the long run: more products, which are more relevant to world markets, will constitute a growth engine, improve competitiveness and significantly bolster sales and revenue. Sources close to IAI believe that the state will profit from this process twice: both from tax revenues and from substantial dividends.

Sources close to IAI believe that this situation should motivate the Ministry of Finance to help finance the agreement: the greater its contribution, the more resources IAI could invest in R&D. 730 tenured workers who will retire are only the tip of the iceberg: in the next few years, hundreds of employees who reach the retirement age will leave, to be replaced with a smaller number of new employees. Moreover, the company is expected to cut the number of temporary workers, layoffs that were not limited in the streamlining agreement signed yesterday.

At present, IAI employs about 15,000 workers; its executives seek to decrease this number by 1,500 - while making the company much more efficient, dynamic, competitive and profitable.

Will this agreement be enough to fix the shortcomings of Israel's largest defense industry? Sources close to IAI's management hope so. In any case, they believe that this is a step in the right direction, one which will fundamentally change the company's situation.

In addition to extensive workforce cuts, the management's agreement with the workers, included the former consenting to limit the employment of external advisers, which, according to a report published by the State Comptroller in the past, had cost the company dozens of millions of shekels, and cut manpower in its HQs. In the past few months, the company terminated the employment of several executives; and, in the next few months, the employment of workers in other IAI groups will be thoroughly examined.

0.7% net profit

Sources in the defense industries have said that such an agreement should have been signed at IAI years ago. A realistic analysis of the global defense market indicates that while the market has been growing in some parts of the world, it has been characterized by severe competition. This requires enhanced marketing efforts alongside bolstered R&D, aimed at expanding the supply of products that could result in 'mega-deals' with a large financial volume. At present, IAI's orders backlog totals $8.5 billion, which are about 2.5 IAI work years. Company heads hope that the backlog will reach $9 billion by the end of 2016, and even $10 billion following the implementation of the agreement, due to the increase in its marketing operations.

Moreover, there are ambitions to boost IAI sales in the next few years by more than $4 billion, an increase which will be largely due to extensive global activity undertaken by its subsidiaries, and due to its top of the line products.

Compared with the IAI's results in the past few years, almost any forecast indicating a increase in profitability is optimistic: according to its second quarter financial results, company revenue dropped over 5%, to only $877 million, and net profits totaled only $6 million, 0.7% of its sales. As part of the new agreement, IAI hopes to save NIS 2 billion, alongside an across-the-board 5% cut in salary costs, reducing employee holiday gifts and further benefits. Moreover, the public sector wage agreement that has been signed by between Minister of Finance Moshe Kahlon and Histadrut chairman Avi Nissenkorn, will not be implemented in IAI in the next three years. Yesterday, the IAI's management complemented the concessions made by the worker's committee, headed by Ehud Nof, who has replaced Haim Katz as union chairman. Nof himself commented on this agreement, "In order to enable us to continue contributing to Israel's security and economy, and support about 50,000 families, we agreed to difficult rehabilitation measures which will consolidate the company's capabilities and its financial stability. Regretfully, we have not been supported by the state like other defense industries, and the price we will pay will be high."

Life without US aid funds

At the same time as IAI has been finalizing its historic streamlining agreement, its management has been facing further challenges which, if successfully tackled, could improve the company's status. One of these challenges regards the struggle, which has been undergoing under the radar for a long time, regarding IAI's inclusion in the Law for the Encouragement of Capital Investments. A revision of the law which took place five years ago excluded government-owned defense industries. Thereby, a private company like Elbit Systems Ltd. (Nasdaq: ESLT; TASE: ESLT), IAI's chief competitor, enjoys tax benefits as part of the law, leading IAI heads to feel, quite justly, that they are been punished for being owned by the state. In the past few months, sources close to IAI said that if the state is not willing to partake in the funding of the rehabilitation agreement, it should at least contribute by renewing IAI's inclusion in the Law for the Encouragement of Capital Investments. Talks between IAI executives and Ministry of Finance seniors regarding this issue are still underway.

The future holds another looming challenge for IAI, currently emerging from the talks between the Prime Minister's Office and the White House regarding US defense aid for the next few years. The White House has demanded that all aid funds provided to Israel will be used for procurement only from US companies, without the possibility of converting some of the aid into shekels for purchase from Israeli defense companies. Until now, the situation has been more beneficial for the defense establishment and defense industries: 26% of aid funds, about $3.1 billion, could be used for orders and procurement from Israeli companies. However, while Jerusalem and Washington have agreed that the annual defense aid for the next few years will increase to nearly $4 billion, Israel's defense industries will not receive a share of the aid. Seniors in Israel's defense industries have recently expressed significant concerns about such an outcome, which will significantly limit the options available to officials dealing with procurement in defense establishment and put the Israeli industries in an inferior position compared with their competitors in the US. The only consolation for them, as well as for IAI, is that they will have about seven years to adapt, until it will no longer be possible to convert aid funds into shekels.

Published by Globes [online], Israel business news - www.globes-online.com - on August 28, 2016

© Copyright of Globes Publisher Itonut (1983) Ltd. 2016

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