Let This Drone Fly Without You

 | Apr 15, 2013 | 11:00 AM EDT  | Comments
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According to a Form 4 filed with the Securities and Exchange Commission, a trust associated with AeroVironment (AVAV) board member Arnold Fishman purchased 7,000 shares of stock in early April at prices of about $17.80 to $17.95 per share. We track insider purchases such as this one, because studies show that stocks bought by insiders tend to narrowly outperform the market.

We believe this happens because insiders already have an economic connection to the company, and so buying more shares -- which reduces the diversification of their wealth -- should signify confidence in the company. As a result, insider purchases make for a useful stock screen, and investors can evaluate whether or not the stock is worthy of further research.

AeroVironment is a $410-million-market-cap company that primarily provides unmanned aircraft systems to the U.S. Department of Defense. It also has a small business of operating charging stations for electric vehicles, but the defense business is responsible for 80% of revenue and 87% of gross income. The third quarter of the company's fiscal year ended in January, and AeroVironment reported a sharp percentage decline in revenue compared with the same period in the previous fiscal year (the quarterly revenue figure was also down considerably from what the company had recorded in the previous six months).

Both business segments reported lower sales. The company did shrink its costs as well, but it reported an operating loss for the quarter. In the first nine months of the fiscal year, operating income came in at $9.8 million, down from $17 million a year ago. While a portion of this decline can be explained by an increase in research and development, which some analysts argue can be thought of as an investment, the sum of operating income and R&D did decline as well.

In terms of earnings, AeroVironment does not look like a good value: The trailing price-to-earnings ratio is 14, and as we've seen, the company did poorly in its most recent quarterly report. The drone business, which is responsible for most of its revenue and gross income, should be doing as well now as it ever would, since the technology is quite hot in defense circles, but the U.S. military is confronting spending cuts. We're also skeptical of the ability of the charging-station business to catalyze growth.

If there is a bullish case for AeroVironment, it has to depend on cash flow (or speculative growth assumptions). AeroVironment does have considerable cash on hand: On its most recent balance sheet, cash, cash equivalents and investments sum to $195 million, and this obviously represents a significant share of the market capitalization.

If we adjust the enterprise value for this cash hoard and take a multiple of trailing EBITDA as calculated by Capital IQ, we get 4.7x, which looks considerably better from a value perspective. However, the company's own financials report only $5.1 million in cash flow from operations during the first nine months of the fiscal year, which was actually less cash than it used on capital expenditures. Part of the discrepancy seems to be due to an increase in working capital, but we're still skeptical of this line of thinking.

Since the business was suffering in the most recent quarter, which only included one month of the 2013 calendar year, and since the federal government is looking to cut military spending, we don't like the outlook for the unmanned aircraft business (which is not profitable enough to justify the current valuation as is). Barring a large shift in the military's focus towards drones -- which we'd say has likely already occurred, with not much of a positive effect on AeroVironment -- then the only source of growth is the very small electric-vehicle-related business.

We would avoid the stock, and only the considerable cash hoard prevents us from suggesting it as the short side of a pair trade along with a larger and more cheaply valued aerospace and defense company.

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