AeroVironment Shareholders Ride Out Expensive Expansion

AeroVironment Inc. (AVAV) walks the line between aerospace and tech, which might explain why the drone manufacturer is the rare defense contractor that is putting off profits to invest in new technologies. The market has allowed it so far, though investors might be starting to lose patience.

The Monrovia, Calif.-based company late last month reported a net loss of $2.9 million in a quarter where gross profit fell 25% and sales were down 19% year over year. Shares of the company lost nearly 10% of their value as a result, and have gained little of it back in the days since.

AeroVironment has a lot going for it. The company has a commanding market share selling small drones to the Pentagon, and its well-regarded products including its Raven vehicle should figure prominently in future Army purchases. Unmanned aerial vehicles have been a rare bright spot in an otherwise dismal military spending story, and analysts expect small drones like the ones AeroVironment makes to continue to hold up well in the event of further Pentagon cuts.

Small drones are preferred to larger UAVs like the Predator or Global Hawk because they are less expensive to operate. They are also more mobile and can be brought directly into a combat area, unlike larger crafts which often have to navigate great distances before engagement.

But the government has proven to be a fickle customer for even the best of suppliers, and troop drawdowns in the Middle East have created uncertainty about future demand for tools of combat.

AeroVironment is attempting to diversify, with investments in commercial drones and a growing business making electric vehicle charging stations. The company is trying to avoid following the path of military contractors including ManTech International Corp. (MANT) , a high-flyer during the peak war years that has been languishing during the drawdown.

"AeroVironment is well run and has great products," a defense banker said. "They're taking risks but they are smart risks that can pay off down the road."

But expansion can be expensive: AeroVironment blamed its negative operating margins that were worse than Wall Street expected on its investment in new products.

Raymond James & Associates analyst Brian Gesuale said that while the company's commitment to investing in new products is "a long-term positive," it is uncertain when that commercial potential will translate to revenue and "operating cost expansion trumps revenue growth in fiscal 2015 and potentially beyond."

AeroVironment has some cushion to try new things. Despite the post-earnings drop, shares remain relatively fully valued, with the company enjoying a trailing twelve month price-to-earnings ratio more than double the industry average. The company also has more than $200 million in the bank and no debt.

Investors might have a better gauge on AeroVironment's commercial future in the months to come. Company bears have argued that AeroVironment's highly-engineered drones are vulnerable to a wave of cheap toy-like products on the market now that, should they increase in quality, can give corporate users much of the same benefit as what AeroVironment is designing for just a fraction of the cost.

But the Federal Aviation Administration could put a halt to those low-cost efforts, and put AeroVironment in the catbird seat. The regulator is expected to place highly-restrictive rules on commercial drone use. AeroVironment CEO Tim Conver told analysts last week that his company is the only manufacturer so far to have met the FAA's likely requirements.

"I think in summary we have a good understanding of what those rigorous requirements are," Conver said. "We have been uniquely successful in operating with them and we are looking forward to moving ahead with being able to extend those operations more broadly."

If so, the higher spending on R&D will be well worth it. But if the investor reaction to the latest quarter is any indication, AeroVironment needs to show results from that spending sooner rather than later.

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