AeroVironment (Nasdaq: AVAV) is an aerospace and defense contracting firm which specializes in the design, development, and production of both unmanned aircraft systems ("UAS") and efficient energy systems ("EES") for government agencies and commercial clients. The company was founded in 1971, and has historically focused on developing progressive products such as solar powered airplanes and electric cars. Today, AVAV specifically focuses on its UAS and EES divisions, operating those segments separately to better align strategic goals. On the UAS side, AeroVironment typically competes with firms such as L-3 Communications (NYSE: LLL) and Lockheed Martin (NYSE: LMT). On the EES side, AVAV faces competition from large industrial firms such as General Electric (NYSE: GE), as well as private companies such as ChargePoint and ClipperCreek. With a focus on two different product offerings that both appear attractive with respect to secular trends, we considered AVAV as a candidate to warrant further research as to whether or not it makes sense as an investment at these levels.
AVAV closed on 3/29/16 at $28.22, which represents a 4.24% YTD decline and $2.43 off its 52-week high which was achieved in December. However, the multiples represent the truly concerning part of AVAV's valuation, with the stock currently trading at an EV/EBITDA ratio of 24.98x, while also trading at 94.8x trailing earnings. While these ratios are frightening on their own, it is even more concerning when you factor in the near-term growth expectations. In a presentation made at AVAV's analyst day this past summer, the company guided for just 4% top line growth in 2016, with EPS being guided to decline based on an uptick in investments to drive long-term growth. The sell-side community does not appear to have a more bullish outlook, with the 5-year PEG currently being negative. While the company is likely well-positioned to capitalize on the long-term secular trends unmanned aircraft systems and electric vehicles, we think a significant correction in the stock price will occur to reflect near term expectations.
After determining that AVAV's multiples are in fact troubling, we decided to look at the multiples of several of the company's competitors to try to gain a sense of where AVAV could correct to prior to becoming an attractive investment. Given the differing capital structures across the defense space (AVAV has no debt, while many others are highly levered), we feel it is more appropriate to use EV/EBITDA multiples for benchmarking purposes rather than earnings multiples. Currently, L-3 Communications and Lockheed Martin trade at EV/EBITDA multiples of 11.3x and 12.8x, respectively. We admit that GE (identified competitor for the EES unit) trades at a 31.2x EV/EBITDA multiple, but think that GE's current focus on restructuring a lot of its business as it continues to divest GE Capital assets and focus on core industrial businesses likely makes it difficult to benchmark a comparable multiple.
So What Is the Right Valuation?
While AVAV's UAS competitors trade at 11x-13x EBITDA, we do think that the company should warrant a premium based on its specialized focus on UAS and EES. These not only should help AVAV grow long-term, but it likely increases AVAV's attractiveness as an acquisition target. Despite these positives, we feel that some multiple compression will occur in the near future before the company appears attractive again from the long side.
While benchmarking AeroVironment to defense contractors such as LLL and LMT is a bit difficult as their revenue sources and contract vehicles are much more diversified, attaching a premium to their trading multiples appears reasonable as something for the "shorts to play for." As it stands right now, I see the main bull case for AVAV in the near term is that it gets taken out via acquisition which would likely give investors a premium. Potential buyers could be companies such as LLL and LMT which would be looking to take out a smaller competitor, reduce AVAV's costs, and gain an attractive product portfolio for the long-term. In our opinion, either of those companies buying AVAV right now would result in a terrible deal from the buyer's perspective, as they would likely have to pay a significant premium for a company that is already trading at higher multiples. In addition, this would likely involve taking on additional leverage, which is significant given that many large defense contractors are highly levered right now given the recent surge in large M&A deals. Between buying a company with much higher multiples and tacking on additional debt which would increase interest expense, this transaction would likely be dilutive to shareholders, and be a tough pill to swallow for the buyer's stock price in the short term. Therefore, I believe a company such as LLL or LMT would wait for a pullback in the stock price to make a bid for AVAV, or wait for some signs that growth was going to pick up within the company to support higher multiples. To ballpark a number, I think buyer interest would be significant at 13.5x-16.7x, which represents a 20%-30% premium over the larger defense contractor multiples, which I feel they could justify to shareholders if they made a bid for AVAV.
As of the market close on 3/29/16, AVAV's Enterprise Value was $442.66M, trading at the aforementioned 24.98x EV/EBITDA multiple. Bringing this multiple down to our target range would yield an Enterprise Value range of $239.2M-$295.9M, or $10.24-$12.67 per share. As AVAV does not have any debt, we can add back the cash, short, and long-term investments (adds to $11.07 per share based on the last 10-Q as of the end of January). This brings us to a target share price range of $21.31-$23.74. To use cleaner numbers, let's say $21-$24 represents a fair valuation. With the stock trading at around $28, this represents potential downside (upside for shorts) of 14%-25%, which could be a compelling opportunity for investors looking to profit off a pullback before entering into a long-term holding. While we like AVAV and its products over the long-term, we see this as a very real short opportunity based on valuation concerns. For investors that prefer to take a long-only approach, we recommend waiting for a correction into (or below) the $21-$24 range prior to entering into a position.
All investments carry significant risks, especially those that involve short selling. A few key risk factors for investors that are considering entering this trade are highlighted below:
- AVAV has a share repurchase obligation with about $21.2M remaining on it according to the company's last 10-Q (as of 1/31/16). If the share price were to decline, AVAV could repurchase shares to try to support the stock price which would limit upside for shorts.
- As mentioned earlier, AVAV has a very healthy balance sheet with no debt, and sizeable cash and marketable securities balances. If management noticed that short interest in the stock was high, there are levers that could pull to try to "scare" some shorts out of the stock. For example, AVAV could elect to make a one-time special dividend to make the stock more expensive to short. While this is possible, we note that AVAV has never paid dividends, so while this risk is possible, we view it as fairly unlikely.
- Due to the long-term attractiveness as an acquisition target, there is the risk that a company such as LLL or LMT could purchase AeroVironment despite its currently bloated valuation, which could result in a premium over current levels. This would be the "worst case" for shorts. While a transaction like this would likely be very dilutive to earnings for the buyer, there is no way to truly rule out this risk for a short seller of AVAV.
We like AeroVironment's focus on UAS and EES, and think it is well positioned for the long-term. However, we think that the valuation is way too high at these levels, and presents a compelling opportunity for a short seller. For investors with a long-only focus, we recommend waiting for the stock to enter our target range of $21-$24 prior to entering into a position at a fair valuation.
Disclosure: I/we 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.