Send In The Drones
Summary
- Growth of military drone fleets continues.
- Volatile AeroVironment is a key player.
- Competition will only get tougher.
- Better to spread your bets when investing in drones.
Introduction
Turn on the news and chances are you’ll hear about a drone strike on bad guys in Pakistan or Yemen. What you probably won’t hear about are the more mundane missions drone operators are performing to gather intelligence about those and other bad guys.
Military drones range in size from the .6 oz BLACK HORNET manufactured by FLIR Systems (FLIR) to the 14,000 lb. Global Hawk from Northrop Grumman (NOC). In addition to size, drones can be categorized as strategic or tactical and armed or unarmed with the latter outfitted with sensors for conducting intelligence, surveillance and reconnaissance (ISR).
AeroVironment (NASDAQ:AVAV) is the leading manufacturer and provider of support services for a niche market of ISR drones used by tactical military units (consisting of roughly between 40 to 100 personnel). In addition to FLIR, other companies with products in this space include the unmanned segment of publicly held Textron (TXT) and a growing number of privately-held firms that include Aeryon Labs, Physical Sciences and InstantEye Robotics.
The drones are equipped with electro-optical and infrared cameras that transmit images and full motion video back to unit commanders. Some are also equipped with additional communication packages or light sources that identify targets for strike by other platforms carrying laser-guided munitions.
Industry And Dominant players
The CIA began using drones during the 1990s' conflict in the former Yugoslavia. The military ramped up their acquisition and use of drones following the September 11th terrorist attacks. By 2015, the military drone market reached about $6B. Estimates for future compound annual growth rates vary widely from 20% (2015-2021) to 8% (2016-2021) and 4.89%(2016-2026) so as to make the estimates seem like wild guesses.
AeroVironment manufactures the RAVEN, WASP IV PUMA AE ISR drones used by the US military services, Australia, NATO and Middle East militaries. These systems have varying ranges/endurance and weigh between 3 and 14 lbs. Last year the company released their SNIPE ISR system weighing less than one lb. The company also makes an armed drone/tactical missile called SWITCHBLADE.
A separate AVAV reporting segment provides charging systems and services for electric vehicles for commercial, consumer and government customers. Their unmanned aerial systems segment, however, brings in over 85% of their sales. Of note, the company also has a nascent commercial business providing drones and services geared toward monitoring infrastructure such as pipelines, roads and bridges.
Financials
Ticker | Net Income/Sales | Sales/Assets | Assets/Equity | ROE |
AVAV | 10.5% | 0.72 | 1.1 | 8.3% |
FLIR | 5.9% | 0.66 | 1.53 | 5.9% |
TXT | 2.1% | 0.93 | 2.72 | 5.3% |
Table 1- DuPont Ratios (TTM)
AeroVironment’s 8.3 % ROE over the trailing twelve months is a far cry better than the roughly 4% return during the preceding years but falls short of the average of 11.5% achieved during the five years before the 2012 budget sequestration took effect. While sequestration undoubtedly had an impact on the company’s fortunes, their main problems over the past few years have been rising R&D and SG&A costs.
From 2013-16, R&D costs averaged almost 15% of sales before leveling off at 12.5% in 2017. Typically, the average aerospace and defense company spends about 13% on R&D. SG&A costs rose over time due in part to higher bid and proposal costs as well as increases in sales commission expense as a result of our increased international revenues.
The company is debt-free and enjoys a current ratio of 9.45. It does not pay a dividend.
As of January 2018, the company had a funded backlog of unfilled orders for products and services from the Department of Defense (DOD) and other government agencies totaling $123.5M, up from $78M in April 2017. Management has indicated its intention to keep R&D costs to about 10% of sales going forward.
Recent Developments
Recent Congressional and a US Army procurement action suggest a better ROE for AVAV going forward. The Fiscal Year 2018 DOD budget authorizes procurement and R&D spending on drones. AVAV executives believe their firm could compete for about $60M in projects.
Among the bidding possibilities is the Army’s Soldier Borne Sensors procurement program for the acquisition of unmanned nano aerial systems deployed at the soldier level which could total about $34M over the next few years. Requirements for selection include a weight of roughly 5 ounces and a flight time of about 15 minutes. AVAV’s SNIPE system is a strong contender. In addition to R&D funds, Congress has authorized up to $100M in security assistance aid to the Ukraine in a number of categories that specifically can include unmanned systems.
Additionally, the House Armed Services Committee held a hearing in January 2018, a few months after the release of the FY 18 budget on equipment needed to prepare the US Military for future conflicts. Among those providing testimony was Paul Scharre, Senior Fellow at the Center for a New American Security who recommended that DOD give priority to buying “swarming” unmanned air vehicles.
Swarming in military parlance means a convergent attack from all directions with a multitude of interconnected, low-cost devices so as to overwhelm or saturate enemy defenses. Should Congress follow-up on this recommendation, funding may become available in the FY 19 DOD budget that AeroVironment would be well positioned for.
Valuation
The stock had been on a tear, up 93% over the past twelve months before dropping 14% in early morning hours of trading on March 7 after announcing a net loss of $800K for the quarter. (FLIR up 38%, TXT up 22% for the year by comparison). The stock is richly priced (based on the close of the March 6th trading day). Its Forward P/E puts in the same stratosphere as Salesforce.com Inc. (CRM) whose 3-year revenue growth is 28% compared to less than 2% for AVAV. Its P/S is a little higher than Apple (AAPL), which sports a nearly 14% ROE
Ticker | P/B | Forward P/E | EV/EBITDA | P/CF | P/S |
AVAV | 3.07 | 62.5 | 23.7 | 57.92 | 3.89 |
FLIR | 3.82 | 24.27 | 18.85 | 22.88 | 3.92 |
TXT | 2.7 | 19.6 | 12.9 | 16.4 | 1.1 |
An Alternative
Investors who believe in the drone growth story and want to spread their bets out may want to consider buying the ETF Manager’s Group Drone Economy Strategy (IFLY). The ETF has about 10% of its 47-stock portfolio invested in AVAV and another 10% in Paris-based Parrot SA (OTC:PAOTF), a maker of civil drones. Boeing rounds out the top 3 holdings at about 5%.
Other lesser holdings include TXT (2%), FLIR (1%) and NOC (2%). The ETF which debuted in 2016 is up 35% over the past twelve months with 2.3% volatility compared to AVAV’s 7.3% before it came crashing down to earth. In the early morning hours of trading on March 7. (IFLY was down about 1.2% that morning.) With only $47M in assets, the ETF is thinly traded at a 1% premium with an expense fee of 0.79%.
Summary And Recommendation
Like many growth stocks, AVAV and their investors get pounded when the Street’s expectations are not met each quarter. (Investors may remember a similar, two-day slide in November 2017 that took AVAV down 15%.) Even with the stock’s fall on March 7, should the stock close at $42 and average Yahoo Finance EPS projections of 85 cents for 2019 remain unchanged, the Forward P/E would be a still sky-high 48.8.
I believe the drone growth story is real and, as such, I believe that more and more competitors will enter the space as barriers for entry into the arena are low. Further, the growth story will lead to acquisitions of small specialized drone companies like FLIR’s purchase in 2016 of Prox Dynamics, maker of the BLACK HORNET.
The influx of competitors coupled with my expectation that the DOD and other government agencies will become at least marginally better negotiators (e.g. insisting on more company internal R&D vs. government funding and firm fixed prices vs. cost plus contracts) will, in my view, lead to an erosion of AVAV’s dominance in its niche drone space.
Bottom Line: Play the field and make a modest investment in IFLY instead.
This article was written by
Analyst’s 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.
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Comments (1)
-First the military.
-Then law enforcement/emergency response.
-Finally, commercial companies.* Commerce will require comprehensive regulation and 5G telecommuications to be implemented before adoption en masse. Look for the explosion here between 2020-2025. Note that drones will basically become commoditized Internet of Things devices, where the big data they gather will be prize.