Description

We and our affiliates are short AVAV. We may buy or sell shares without notification. This is not a recommendation to buy or sell shares.

Overview

We believe AeroVironment (AVAV) is a short. AVAV is a manufacturer of unmanned aerial vehicles (UAVs), also called unmanned aerial systems (UAS). Roughly 65% of sales are to the US military (sometimes to serve overseas clients) and another 25% are directly to international militaries. The remainder of revenue consists of an international telecom program, small amounts to other commercial areas, and unmanned ground-based vehicles from their 2021 Telerob acquisition. Our thesis is that AVAV is a niche, effectively zero growth producer of defense systems masquerading as a growth company that has a new bid due to the deployment of one of its programs to Ukraine. It trades at a significant premium to every defense peer at 24x forward EBITDA versus the group at 12x and the next highest multiple of 16x. At 15x EBITDA there would be >40% downside.

Business Mix

Small UAS (SUAS)

Close to half of the business is the company’s “Small UAS” segment (~$240m in revenue). Its main products are the Raven and Puma. These were workhorse platforms during the Iraq war, but in recent years there has been little growth, although the company is pursuing international opportunities. These systems are not deployed in Ukraine but the hope is that increased spending by our European allies will generate significantly higher sales. The company has also tried but failed to win content on miniature drone programs.

Tactical Missile Systems (TMS)

TMS accounts for just under 20% of sales (~$90m in revenue). All sales here are for AVAV’s Switchblade system. This is a loitering munition that has mainly been deployed by the US Army (through its Lethal Miniature Aerial Missile System, or LMAMS program). Generally, an infantryman or group of them deploy the system from a backpack on site. It can loiter for short durations (

Medium UAS (MUAS)

Another roughly 20% of sales are for medium distance UAVs (~$95m in revenue). Basically all of this segment is Arcturus, which the company acquired in early 2021 (late fiscal 2021) for $405m. Its mainstay product is the Jump 20, which is currently competing for the Army’s Future Tactical Unmanned Aircraft Systems (FTUAS) program to replace the Shadow expeditionary drone. The company touts this as a $1b program over 10 years. Current MUAS revenue is close to $100m. The R&D phase of this program is generating most of the segment’s revenue.

HAPS and Other

The remaining 15% of revenue (~$80m) is roughly split between the company’s High-Altitude Pseudo-Satellite (HAPS) product and “Other”. 100% of HAPS revenues are sold to Softbank. It is a very large UAV intended to deliver 5G services. The company used to own 5% of a UAV-delivered 5G JV with Softbank but has since sold its stake to Softbank (for a nominal amount). The remainder is minor commercial revenue and the Telerob ground business.

Why Does the Opportunity Exist?

With AeroVironment there is always a dream that often provides attractive opportunities to short the stock. We believe the current setup, with excitement over Ukraine and to a lesser extent FTUAS, is one of those times. To demonstrate the historical pattern of (misplaced) enthusiasm for the company, consider a few instances over the past five years when the setup was particularly enticing.

Four years ago there was hope that the Army would dramatically increase the size of its LMAMS program. Bullish analysts believed that Switchblade would become a massive $500m+ program of record from the $40-80m program it had been. The stock reacted and went from the mid-$40s to >$80. Since that time, the TMS segment has never generated more than $90m of revenue per year.

Three years ago the company was expected to become a significant player in commercial UAVs for applications like agriculture and telecom. At the company’s 2018 analyst day, management spent a quarter of its presentation on HAPS and agriculture. Since that time, AVAV has effectively exited the agriculture business and its telecom-related revenue has declined from a high of $60m to this year’s $25-35m. The HAPS JV itself was expected to be a massive boon, and management had the option to acquire up to 19% of it. Instead, they exited completely (for $6.5m) and it does not look like the Softbank effort will go anywhere.

Despite poor earnings performance, enthusiasm generated by the war in Ukraine has again presented an opportunity to short. Promises of explosive international sales along with the more powerful Switchblade 600 make this a redux of the past.

Recent History

There has been very little growth at AVAV for the past several years. In FY 2020 (ending April 2020) revenue was $367m. In FY 2021 revenue was $379m, including $16m in revenue from MUAS from Arcturus. Ex-MUAS in FY 2022 revenue was $353m and this year they might do $400m. This is hardly exciting given the valuation. These deals also took the balance sheet from a comfortable net-cash position (around 20% of the market cap) to ~1.0x net debt to EBITDA.

At the same time the financial performance of the company has degraded. Gross margins have moved from a consistent 40-43% to <36% and adjusted EPS is down >40%. The company has blamed supply chain issues for recent shortfalls, but the reality is the core business is struggling to grow. We also believe Arcturus has been a disappointment, which the company is hiding. When they did the deal they told the market it was at 11.6x trailing EBITDA, $35m of EBITDA on $84m in revenue for a 42% margin (AVAV earns a roughly 17% margin). They explained that this extraordinary margin was due to Arcturus having some attractive “contractor-owned, contractor-operated” (COCO) business. Guidance for this year is for $82-92m in EBITDA, which adds back $7m in SBC that until this year they had included. In FY 2021 the company did $70 in EBITDA, implying $10m in EBITDA growth when Arcturus was supposed to add $35m. Our research suggests the COCO revenue was actually very high margin service revenue associated with the Army’s testing in the FTUAS R&D program that is no longer a part of the program and will not return. In the end the company seems to have paid > 40x EBITDA for Arcturus.

The stock spiked to $140 per share on the Arcturus deal, which coincided with the meme mania of 2021. It then sold off to $60 on the aforementioned earnings disappointment, only to rally back to >$100 per share on Ukraine.

Thesis

The Switchblade will be a bust, just as it has been in the past

We see very little evidence that the Switchblade 300 is having an effect in Ukraine. It simply lacks power relative to the more potent artillery international partners are sending to the theater. At the same time Ukraine has demonstrated far cheaper and similarly effective dropped munitions from its growing fleet of drones. They have deployed thousands of inexpensive drones, like the DJI Mavic 3 which costs only ~$2,000 (compared to Switchblade 300s at $70-80k). More recently Ukraine has deployed some of the same low-cost drones as tactical drones, deployed much in the same way as the Switchblade 300. The following links just from recent weeks show some examples:

-New reloading method:

https://mobile.twitter.com/tomaburque/status/1576607241112735746

-Commercial drone deployed as a tactical missile system by operator using Fat Shark first-person-view goggles

https://dronexl.co/2022/08/11/kamikaze-fpv-drone-precision-attack-ukraine/

Together these are supplanting their original fleet of Turkish Bayraktar TB22 drones, which are now being used more in a surveillance capacity. Not surprisingly, we have not seen any additional announcements for new Switchblade drones since the first wave of Ukraine aid. There is evidence the US is restocking its inventory and some additional international partners are trying them out, but ultimately we see very little growth for the product.

To date, AeroVironment has not deployed Switchblade 600s. Management blames supply chain issues, particularly around chip supply. But we also suspect they are losing to conventional Javelin deployments. The US Air Force has also sent a previously unknown tactical drone to Ukraine called the Phoenix Ghost. See for example:

https://breakingdefense.com/2022/04/meet-phoenix-ghost-the-us-air-forces-new-drone-designed-for-ukraines-war-with-russia/

Size-wise, it looks closer a Switchblade 300 but apparently has more explosive power. In any case, it’s more evidence that the Ukraine war has pushed a rapid evolution of drone warfare in a way that is exposing AVAV’s limitations.

FTUAS at best will be marginally incremental

The FTUAS program has been funded through the Army’s R&D budget but is close to moving to procurement. The Army has set up the procurement phase in two parts.  Increment 1 deploys a single drone (with an option for seven more) into one brigade combat team. Similar to the R&D program, increment 1 is designed to collect data to further set requirements for the full increment 2. AVAV recently won increment 1 for $8m. While this is a small positive, we don’t believe it implies AVAV will win increment 2.  We expect it to continue to be competitive.

The increment 2 bid includes a set of formidable set of competitors. The incumbent producer Textron is competing for the program in conjunction with Northrop Grumman. L3Harris is another large contractor that is participating. The startup supplier Martin UAV has been involved from the start. Martin is owned by Shield AI, which is one of the premier AI pilot startups. Just recently the Army invited another startup, Volansi. Furthermore, it is possible this gets awarded to more than one supplier, though we assume that will not be the case.

If AVAV does become the full supplier of FTUAS in increment 2, we see the maximum revenue in any given year at $100m. When the company discussed a $1b opportunity that seems to be for an overarching program called “Future UAS Family” that includes the FTUAS. There are other elements to the program, and in turn we see $100m as the maximum opportunity. We believe the company has done close to $75m in annual revenue from the R&D phase of the program plus related revenue. We model upwards of $50m in incremental revenue from the program. A loss would be a significant blow.

The valuation does not make sense

We believe the latest hype around AVAV will fade and this will be a company run-rating around $85m in EBITDA. We don’t see why AVAV won’t trade closer to a peer multiple (many of which are growing faster than AVAV) at 15x, in which case there is >40% downside. As for upside, one must assume a very robust multiple given the likely earnings trajectory in the coming years.  At 25-30x EBITDA of $110m in FY 2024 (which we think is very generous), the stock is worth $110-130 per share.

Catalyst

-Ceasfire in Ukraine

-No additional Switchblade 300 shipments and/or Switchblade 600 is never fielded

-Loss of FTUAS increment 2