AeroVironment FY2024 Earnings: Switching Gears On Switchblade Demand (NASDAQ:AVAV)

Investment Thesis

Military drone maker AeroVironment (NASDAQ:NASDAQ:AVAV) reported their full-year FY24 earnings results today, which beat expectations on the top and bottom lines. The company reported a huge surge in sales in their LMS segment (Loitering Munition Systems) due to the sustained demand for their Switchblade drones, which continued to propel the company’s sales forward.

Since the start of the year, I have been bullish on AeroVironment. In my last coverage, I valued AeroVironment at ~$210. The company’s stock extended 6% beyond my previous price target, before giving up some of its gains to eventually settle at ~$192, right before earnings.

I now believe there may be a few headwinds that could be forming on the horizon that could put pressure on the stock for some time. The first was the heightened levels of competition, and the second was delays in contracts and approvals, which may put some pressure on the company.

Despite the surging demand for its military drones, I believe the company is currently fully priced, and I move my recommendation to a Hold for now.

Demand for Switchblade drones propelling AeroVironment

In the final quarter of their FY24, AeroVironment reported revenues worth $197 million, up 6% y/y and easily beating expectations where markets had projected AeroVironment’s Q4 revenues to stay relatively flat at ~$187 million. This can be seen in Exhibit B below.

The Arlington, VA-headquartered drone maker enjoyed a surge in sales of their Switchblade drones, namely the Switchblade 600 and the Switchblade 300, which resulted in the company’s Loitering Munition Systems revenue segment growing 74% y/y. On the earnings call to discuss results, management mentioned that demand for switchblade 300 and 600 continues at an unprecedented rate, and they expect the pace to continue into FY25.

During the quarter, AeroVironment secured a major contract to deliver Switchblade 300s to the U.S. Marine Corps under the Organic Precision Fires-Light (OPF-L) program. The first phase of the contract is worth $8.9 million, with the potential to go all the way to $249 million if AeroVironment can win the entire contract. In addition, in May, the company announced that its extended-range loitering drones, the Switchblade 600s, were also selected under Tranche 1 of the U.S. DoD’s Replicator initiative. According to the Pentagon, the total funding under the Replicator program is expected to be ~$1 billion, building enough runway for AeroVironment to benefit from. However, I will note that the billion-dollar funding is dependent on the FY25 budget, which has yet to be approved.

On the other hand, the company saw large declines in its UnCrewed Systems, or UxS (formerly called Unmanned Systems), and its McCready Works segment, which offset the impressive sales performance seen in its LMS segment. While management did highlight demand for its Puma & Jump20 small and mid-sized UAS systems, they also revealed that they saw lower revenues from the Ukraine program. The UxS segment Q4 revenues declined 15% y/y. UxS is AeroVironment’s largest revenue segment, accounting for 53% of the company’s revenue.

At the same time, the company’s McCready Works segment again saw several delays in receiving government authorizations for funding and contract approvals, which pushed out the timelines for the company to recognize more revenue as well as secure more contracts. The McCready Works segment saw revenues decline ~9% y/y. For the quarter, AeroVironment reported its funded backlog was down 5.6% y/y to $400 million.

In addressing the recent news of one of its peers, Anduril, securing approval for the sale of drones to Taiwan worth $300 million, management said:

First and foremost, the recent announcement that you saw for the FMS, it’s just an authorization. It’s actually not a contract yet. It is just an authorization by the State Department that they will allow these companies. And there is a lot more work to be done for those to actually convert into contract and orders, number one.

Number two, we know that Taiwan prefers and would like to acquire more of AV’s solutions including Switchblade.

Three, as I said before, this market is growing quite rapidly. So, it’s very natural for a lot more competitors to show up, because it’s going to attract more competition and the US military and our allies, by definition, are going to make sure that there’s more than one player in the market.

Given all that, the track record that we have in terms of our win rate and the ability for us to deliver in volume now, a battle-proven test and battle-tested solution, is unmatched.

In fact, on the call, management also said they plan to scale the production capacity of their Switchblade drones to ~$500 million in order to use their capacity as an advantage to be factory-ready and deliver their battle-tested Switchblade drones quickly, especially since the demand for their Switchblade drones skyrocketed this past year.

Margin profile and profitability significantly improving

While the company’s fourth quarter earnings per share came in at 43 cents, higher than the 21 cents in EPS that was expected but lower than the 99 cents last year, for the full year FY24, AeroVironment reported non-GAAP EPS of $2.99, rising 137% over the EPS reported last year. On a GAAP basis, the company reported net income of $59.7 million, or $2.18 per share, versus a net loss of $176.2 million, or $7.04 per share.

Gross margins saw significant improvement, rising from 32% last year to ~40% this year. Management attributed this bump in gross margins to an improved product mix as they sold more Switchblades. This also resulted in adjusted EBITDA improving on a y/y basis, with the company recording a 42% increase in adjusted EBITDA to $127.8 million, or 17.8% of the company’s revenue.

I expect the company’s margins to keep improving as demand for the company’s higher margin Switchblades continue to skew the product mix toward a favorable margin profile. Management also pointed to an environment where the company stands to benefit in negotiations with its sovereign customers as it sells its product in a high-demand environment.

I note that AeroVironment also reduced their debt levels, with debt falling to ~$60 million, including lease liabilities, down from ~$163 million in the same period last year. Cash and equivalents stand at $73 million, which to me indicates a very well-capitalized balance sheet. The only item that I was surprised by was the ~9% increase in the share dilution rate, when I was expecting ~2%. This will impact my valuation of the company, as it dilutes shareholder value.

Valuation points to capped upside

I now believe AeroVironment will be growing its top line at a 16–17% CAGR, down from the 20% CAGR I had expected per my previous coverage. While I am encouraged by management’s plan to scale the capacity of its top-performing drone segments in the LMS segment, I believe that delays in securing approvals and authorizations for contracts to move through various contract stages to delivery authorization will weigh on the company’s outlook in the short term. I explain this in further detail in the risks.

On the other hand, I believe the company is poised to deliver superior EBITDA margins to investors on an adjusted basis. The company has demonstrated the benefits of a superior product mix skewed towards the sale of higher-margin Switchblades.

While my model utilizes a discount rate of ~8.8%, which includes the higher beta, it also includes a higher weighted average share volume, which surprised me.

Based on these assumptions, I believe a forward multiple of ~33x can be applied to earnings expected to grow at ~18% CAGR after comparing growth rates to the S&P 500.

Risks & Other factors to consider

Securing timely contracts and approvals is critical for AeroVironment to keep the momentum going, especially when it is already up ~53% for the year. As I mentioned earlier, these approvals are going to get harder for the company to get in the interim period as we cycle through a few months of political uncertainty. I had already noted this as a risk in my previous coverage, where I said that “the company may face some delay in funding from its sovereign customers periodically, which may delay revenue prospects for AeroVironment.”

On the Q4 call, management mentioned that their visibility of their FY25 target was lower than usual per comments below:

While this level of visibility is lower than recent years, it is important to note that our visibility reflects some uncertainty in the government contracting process.

I believe this could put pressure on the company in the interim period.

Although I am quite optimistic about AeroVironment in a rapidly growing drone munition market, I am curious about the rising competitive threats from players such as Anduril, who may be setting up to win more orders. Anduril also participated in the U.S. Marines’ OPF-L program I mentioned earlier, and this uncertainty could weigh as well on the outlook in the near term.

Note: AeroVironment will be holding their FY25 Analyst & Investor Day presentation tomorrow morning, June 27th, before markets open.

Takeaway

I am optimistic about the long-term prospects of AeroVironment since the company has a robust operating profile with strong demand for its products, especially the company’s extended range of Switchblade drones.

However, a few near-term headwinds, such as funding delays and a gradually rising competitive landscape, could impact the outlook in the short term.

Based on this analysis, I believe I will downgrade the company to a Hold and watch how these headwinds play out in the near term.