AeroVironment: The Strategic Value Of Drones Is Rising

| About: AeroVironment, Inc. (AVAV)


AeroVironment has been managing well a tough period for defense companies, as illustrated by a strong Q3.

Now that comps become easier, we see very limited downside risk, while the upside risk is significant in view of emerging commercial applications for drones (delivery of goods, Internet access ...).

Following the potential acquisition of Titan by Facebook, M&A is likely to be part of the game and to boost AeroVironment's valuation.

We have long been highlighting AeroVironment (NASDAQ:AVAV), a defense name operating in the promising segment of UAVs (unmanned aerial vehicles/drones). Unsurprisingly, AeroVironment has not been immune to the poor defense environment in the US (85% exposure) and to defense budget pressures all around the world as the company derives most of its revenues from defense drones.

But it looks like the company is bottoming out. AeroVironment can now grow revenues and earnings from the lows reached one year ago as illustrated by its recent Q3 figures. Revenues were up 47% and 6% above consensus and EPS reached $0.49 vs. the Street at $0.19.

The low comps suggest very limited downside risk going forward, while the upside risk is huge and mainly dependent on the commercial takeoff of drones.

Commercial applications are expanding day after day

Military applications are just the tip of the iceberg. Indeed, civil and commercial applications (assisting emergency services during crisis situations, monitoring hard to reach locations …) are expected to boom in coming years thanks to UAVs' declining costs. The single biggest commercial application for drones (i.e. c.50% of the whole market) is expected to be agriculture.

The development of the commercial market is expected to take off very soon, with AeroVironment mentioning 2015 as a possible timeframe for revenue acceleration. But interestingly, the commercial market could prove much bigger than initially expected. Recently, drones made the buzz thanks to Amazon (NASDAQ:AMZN) CEO Jeff Bezos who revealed that Amazon was testing drones for delivery purposes, with a potential large scale deployment within five years expected to reduce shipping times and costs. In recent weeks, Facebook (NASDAQ:FB) was reportedly in talks to buy drone maker Titan for $60m. A drone fleet would allow Facebook to provide Internet access to consumers in undeveloped parts of the world.

Even if the regulation does not yet allow a broad use of small drones, the long-term outlook is thus promising. The Association for Unmanned Vehicles (AUVSI) forecasts that the economic impact of the unmanned aviation industry could reach $82bn for the 2015-2025 period, but there could be significant upside on this figure if Amazon, Facebook and peers confirm their large-scale initiatives.

A perfect M&A target for defense contractors and tech giants

Given the rising interest for commercial drones, we believe that AeroVironment is likely to attract M&A attention. Natural buyers would be Boeing (NYSE:BA) and large defense contractors Northrop Grumman (NYSE:NOC) and Textron (NYSE:TXT) that are active in this segment but have not been successful in small drones until now.

But as illustrated by the potential Facebook-Titan deal, tech giants [Google (NASDAQ:GOOG), Facebook, Amazon …] seeking to offer new services to their customers could also be part of the game. In view of their financial power and AeroVironment's relatively small market cap, they could easily bid up the price for drone assets.

In conclusion, we believe that the downside risk is limited and well under control now that expectations for defense contracts have been reset, while the upside risk is significant in view of emerging commercial applications and potential M&A appeal.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.