Description

AeroVironment traded up recently to a nonsensical valuation prior to and immediately following its latest earnings report on September 5, likely due to a combination of superficial market commentary (for example, Motley Fool, provided below and Zack's, which has had similar comments) and perhaps some algo trading (that focuses on parsing press releases without any context).

I believe that the stock will decline for these very reasons after the next earnings call in December, when the current “good” news inverts to “bad” news.

Business:

AVAV designs, develops, produces, supports and operates a technologically‑advanced portfolio of products and services for government agencies and businesses. AVAV supplies unmanned aircraft systems (UAS – i.e. drones) and related services primarily to organizations within the U.S. Department of Defense and to international allied governments, and tactical missile systems and related services to organizations within the U.S. Government. AVAV derives the majority of its revenue from these business areas and believes that the markets for these solutions have significant growth potential. 

From what I can tell, AVAV is not a particularly strong competitor in the UAS field – per the 10-K:  We believe that a number of established domestic and international defense contractors have developed or are developing small UAS that continue to compete, or will compete, directly with our products. Some of these contractors have significantly greater financial and other resources than we possess. Our current principal small UAS competitors include Elbit Systems Ltd., L3 Technologies, Inc., and Lockheed Martin Corporation. We do not view large UAS such as Northrop Grumman Corporation’s Global Hawk, General Atomics, Inc.’s Predator and its derivatives, The Boeing Company’s ScanEagle and Textron Inc.’s Shadow as direct competitors to our small UAS because they perform different missions, do not typically deliver their information directly to front‑line ground forces and are not hand‑launched and controlled. However, we cannot be certain that these platforms will not become direct competitors in the future. Potential competition from consumer-focused drone manufacturers could emerge as their capabilities increase and their prices remain low relative to existing defense solutions, which could result in some level of military consideration even if such drones do not meet traditional military performance or security specifications.

Financials:

Valuation:

AVAV currently has a P/E of over 100x.  Capex exceeded depreciation in each of the last three years, so free cash flow multiples are also high.  As of 7/28/18, the company had net cash and investments of $326 million, implying a current enterprise value of $2.25 billion for a defense drone company with $300 million in revenue and $25 million in net income, and the growth profile outlined above.

Why?

Some of the excitement was generated by the “good” performance in the fiscal first quarter ended 7/28/18.

The market was excited by the first quarter earnings press release, which says:

Revenue for the first quarter of fiscal 2019 was $78.0 million, an increase of 127% from first quarter fiscal 2018 revenue of $34.4 million. The increase in revenue was due to an increase in product sales of $36.5 million and an increase in service revenue of $7.1 million. 

Gross margin for the first quarter of fiscal 2019 was $32.6 million, an increase of 275% from first quarter fiscal 2018 gross margin of $8.7 million. The increase in gross margin was primarily due to an increase in product margin of $22.7 million and an increase in service margin of $1.2 million. As a percentage of revenue, gross margin increased to 42% from 25%. The increase in gross margin percentage was primarily due to an increase in sales volume and an increase in the proportion of product sales to total revenue. 

Income from continuing operations for the first quarter of fiscal 2019 was $14.2 million, an increase from first quarter fiscal 2018 loss from continuing operations of $8.1 million. The increase in income from continuing operations was primarily a result of an increase in gross margin of $23.9 million, partially offset by an increase in research and development (“R&D”) expense of $0.9 million and an increase in selling, general and administrative (“SG&A”) expense of $0.7million. 

AND ….

Earnings per diluted share from continuing operations attributable to AeroVironment for the first quarter of fiscal 2019 was $0.85 compared to a loss per share from continuing operations attributable to AeroVironment for the first quarter fiscal 2018 of $0.19. 

What’s not to like?

In an example of market commentary on AVAV stock, Motley Fool said on 9/6/18:

https://www.fool.com/investing/2018/09/06/why-aerovironment-stock-just-popped-17.aspx

 From the above article:

Expected to report $0.29 per share in profits for the first quarter of its new fiscal year, AeroVironment instead said it earned $0.85 per share. Sales for the quarter reached $78 million, which was also more than Wall Street had been expecting.

So what

AeroVironment had a tough time of things last year as its stock was dogged by short reports questioning its ability to grow its business and calling its valuation "nonsensical and distorted." The best way to respond to such short reports, however, is by proving the critics wrong -- and AV did that in spades last quarter.

Q1 sales surged 127% year over year, and gross profit margins earned on those sales came close to doubling, up from 25% a year ago to 42% in fiscal Q1 2019, pulling AeroVironment up from an operating loss a year ago to an operating profit this year. On top of all that, proceeds from a beneficial litigation settlement added $0.26 per share to AeroVironment's bottom line, resulting in the aforementioned $0.85-per-share profit.

Now what

Expect more good things from AeroVironment as the year progresses. Backlog at the company (which will transform into revenues as the year progresses) more than doubled to $157 million by the end of the quarter, lending AeroVironment management confidence to make the following prediction:

By the end of fiscal 2019, AV expects to have earned between $1.10 and $1.40 per share on sales of from $290 million to $310 million.

Assuming this is how things work out, at the midpoint of those estimates, the company is on track to grow earnings 49% on sales growth of only 11%. No wonder AV's shareholders are thrilled. 

However, the reality is that management did not change FY19 annual revenue or EPS guidance. The company had announced earlier in the year that revenue would flatten across quarters in FY19 compared to previous years, and it lived up to that outlook in the first quarter.

The implications for the rest of the fiscal year are:

Over the next three quarters combined, AVAV expects to report total EPS of $0.25-0.55, compared to $1.14 in the last three quarters of FY18 combined.  Revenues will be down slightly.

AVAV management explicitly confirmed this in response to a question in the 1Q19 earnings call:

Brian Ruttenbur

Okay. So you’ve made $0.85 in the first quarter but you only anticipate making another $0.35 to $0.60 whatever, you’ve made half – over half – I haven’t done the math or have it on top of my head, I apologize. You’ve made half here in the first quarter and you anticipate the second quarter being also very strong. Is that correct at least on the revenue side but not as much on the margin side? Is that correct?

Wahid Nawabi(CEO)

That is correct, Brian. So this is Wahid. You bring up a really good point which is absolutely as you heard from my remarks, we expect the second, third, and fourth quarters in terms of revenue to be roughly equal up to that of our first quarter. However, the profit margin on the second quarter and the remaining of the year has a significantly different picture than the first quarter, and it’s driven primarily by the following factors.

First, the mix of our revenue for the remainder of the year is quite different. We have lower margin product sales as well as a higher percentage of services contracts than product contracts that we anticipate to shift throughout the remainder of the year. Second, we also expect to increase our OpEx investments. Q1 was lower as we mentioned that to you guys last quarter.

And then third, our effective tax rate would also be higher for the remainder of the year. We benefitted from that on the first quarter, and that would not be the case in the remaining three quarters. So the combination of those three factors equates to a lower EPS for the remainder of the year, and we therefore reconfirmed our guidance of $1.10 and $1.40 for the full year.

Meanwhile analysts have started to figured out what the future holds, and have begun to cut future quarterly earnings estimates.  Price targets are well below the current stock price.

https://www.dailypolitical.com/2018/09/09/analysts-set-expectations-for-aerovironment-inc-s-q2-2019-earnings-avav.html

Previous VIC Write-up

AeroVironment was written up as a long report on VIC in May 2013 at a price of $19.98.  A contrast of valuation metrics between then and now is illuminating:

Catalyst

The stock should trade lower after the next earnings call (December 2018) when earnings begin to decline on a comparable quarter basis, or in anticipation of that call.