Strong EPS beat for the second quarter in a row shows that earnings are bottoming out in the core defense drones business.
Now the newsflow is likely to be dominated by the development of commercial drones: several positives suggest that this market could take off in 2015 and feed the EPS momentum.
Following the recent acquisition of Titan by Google, M&A is likely to be part of the game and to sustain AeroVironment's valuation.
Strong Q4 at AeroVironment confirms that US defense spending cuts are a thing of the past
While the stock had been rather weak in recent months, AeroVironment's (NASDAQ:AVAV) Q4 earnings acted as a reminder that something is going on in the drone sector. The drone maker delivered impressive Q4 figures with revenues and EPS respectively 6% and 17% ahead of consensus expectations. As for fiscal 2015, AeroVironment guided for $250-270m revenues (slightly above consensus of $257m) and for a 34.5-37.5% gross margin.
In all, this release confirmed our view that the company's earnings are bottoming out and that AeroVironment can now grow revenues and earnings from the lows reached last year when it was hit by the defense spending cuts in the U.S. (85% exposure) and around the world.
We reiterate 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.
First legally-approved commercial use of drones in the U.S.
We have long been saying that military applications were just the tip of the iceberg for drone makers as the expected development of the commercial market was a major growth avenue: assisting emergency services during crisis situations, monitoring and spraying crops, shooting videos for the movie and tourism industries…
Clearly, commercial applications are now becoming a reality, as illustrated by the five-year contract oil major BP (NYSE:BP) signed with AeroVironment to use drones to capture and analyze data about BP's operations in Alaska. This marks the first legally approved drone flight over land in the U.S., leading Transportation Secretary Anthony Foxx to state that "These surveys on Alaska's North Slope are another important step toward broader commercial use of unmanned aircraft".
Many initiatives are currently under way, such as Amazon (NASDAQ:AMZN) testing drones for delivery purposes (with a potential large scale deployment within five years) or Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook (NASDAQ:FB) mulling providing Internet access to consumers in undeveloped parts of the world through drones.
For the time being, the Federal Aviation Administration bans the commercial use of drones but it said recently that it would soon revisit the commercial use of drones and potentially put new rules in place by 2015.
In our view, commercial contracts are likely to become big as soon as FY15/16 (in its recent press release, AeroVironment's CEO states that "we have greater visibility into the timing of meaningful adoption for Commercial UAS…") and to feed the earnings beat momentum.
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.
As illustrated by the recent Google-Titan deal, tech giants (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.
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