Why Investing in Drone Companies Make Sense and What Company to Start With…

BUY AeroVironment (AVAV-$22.03) AS A POTENTIAL TAKEOVER TARGET

By Charles Laloggia

If you are willing to invest the old-fashioned way by buying a stock and having the patience to hold for 12 to 24 months I think there is a very good possibility that AeroVironment (AVAV-$22.03) could become a takeover target at a price substantially higher than where it currently trades.

AeroVironment makes small unmanned aircraft — also known as drones, unmanned air systems (UAS) or unmanned air vehicles (UAV) that wirelessly transmit live video and other information to a hand-held ground control unit. AVAV also makes electric vehicle charging systems for passenger and fleet vehicles. AVAV is the Pentagon’s largest supplier of small drones, which can give troops an aerial view of a situation that may be around the bend or over a ridge.

The use of drones to kill suspected terrorists has received a lot of publicity lately, but that controversial utilization of unmanned air vehicles is just the tip of the iceberg when it comes to the expanding use of drones which is almost certainly on the horizon.

The market for unmanned air systems ranges from the larger systems made by companies like Northrop-Grumman (NOC) and privately-held General Atomics to the much smaller systems that are AeroVironment’s specialty.

With model names such as Raven, WaspAE and Puma, AVAV’s drones are “man-portable”, have wingspans ranging from 3 to 9 feet and weigh anywhere from 2.8 to 13 pounds.

The military market for drones is still in the early stages of development and can only get bigger as the nature of warfare evolves and the armed forces take advantage of technologies that can deliver actionable intelligence information without risking lives — which is exactly what AeroVironment’s UAS are designed to do. On January 23, 2013, AVAV announced a $12 million order for its Wasp AE Unmanned Aircraft System on behalf of the Navy and Marine Corps, the largest order for that system to date. Defense industry consulting firm Teal Group has estimated that worldwide annual spending on UAS will nearly double to $11.4 billion within the next ten years.

But as I see it, the really exciting growth potential for AVAVs small UAS is in the commercial sector, a market that is in its embryonic stages but could literally explode over the next two to three years, because in February 2012 Congress directed the Federal Aviation Administraion to open U.S. skies to drones by September 30, 2015..

On a civil basis, these small drones can and will be used for law enforcement, traffic monitoring, monitoring of infrastructure for both security and safety purposes, search and rescue, border patrol and even mapping and analyzing terrain and geologic formations, which would be of value to companies such as oil and gas drillers.. They can contain instruments that measure airbone dangers such as chemicals, pathogens and radioactive materials.

Drones can be used to monitor hurricanes and volcanic activity and to evaluate natural disaster areas in real time, or to help farmers monitor crops and even to monitor golf courses to determine what fairways might need watering. The Royal Canadian Mounted Police (RCMP) recently placed an order for an AVAV drone to deal with emergency response situations. In Ontario Province in Canada, drones are already used to take aerial photographs of crime scenes for use in court.

Ohio, one of the most enthusiastic states in terms of its eagerness to utilize drones, plans to use a UAS it has already purchased to map road and bridge projects, saying it is far more cost effective than utilizing a commercial aircraft. Drones for such commercial and civil applications can be as small as a model airplane.

As of now, AeroVironment sells its UAS primarily to units of the U.S. Department of Defense. But the commercial and law enforcement market for UAS is only going to get bigger, which should mean that the growth opportunities are going to dramatically expand.

The growing millitary and commercial applications of drones is almost certain to attract the heightened interest of the big defense contractors, who are actively looking for new avenues of growth in an era of tighter military spending and new methods of warfare that rely less on putting personnel in harm’s way and more on technology that can provide reconnaissance and intelligence. This trend may have already begun: in November 2012, Lockheed Martin (LMT) acquired Chandler/May, a privately-held  manufacturer of unmanned air systems that has been a supplier of these systems to Lockheed.

To me, a company like AeroVironment, which appears to be sitting on the cusp of a dramatic upswing in demand for its products, would be a natural takeover target for any number of defense contractors seeking a foothold or a broader presence in this near-certain growth area.

An added plus is that AVAV has a 40-year history of being an extremely innovative company with leading-edge product development. Of its 817 employees, 271 are engaged in research & development and engineering. The company has an extensive patent portfolio which could be a “hidden value” not readily apparent by traditional analysis that could appear to its appeal as a takeover target.

AVAV’s annual revenues have risen over 50% since 2008, from $215.7 million to $325 million in fiscal 2012, which ended in April 2012.  Earnings per share are up from $1.08 to $1.41 during that period. That’s a pretty solid growth trajectory in view of the fragile economy during that frame combined with the fact that, in my opinion, AVAV’s main product line is one whose time has not yet arrived in full force. Unmanned air systems accounted for around 84% of fiscal 2012 revenues, with its electric power stations accounting for the balance. For the fiscal year ended April 2013, the average earnings estimate is $1.45, up slightly from 2012, and the average revenue estimate is $353 million, a rise of around 8%.

At only around 15 times earnings with over $6 per share in cash and no debt and with growth propsects like this, AVAV would be an ideal takeover candidate and could be purchased at a substantial premium to its current price.

CHART ANALYSIS OF AVAV
As uninspiring as this 3-year chart of AVAV may appear, this is exactly the sort of entry point a long-term value investor would want to see if you agree that the market for UAVs is about to take off — and especially if you believe, as I do, that AVAV is a genuine takeover candidate.

Chart 1

AVAV peaked in mid-2011 just over $36 and has been in a steady downtrend since — not atypical of a company whose major product line may be just a bit ahead of its time. The fact that this relentless downtrend has taken place in a generally strong stock market should not deter you in the least — in fact, this is a plus when it comes to getting in early on a potential takeover target, since potential acquirers will not be deterred by what may appear to be an over-valued stock making new all-time highs.

AVAV bottomed at $19.25 in November 2012 and now looks as though it’s trying to sketch a base pattern, possibly due in part to the recent publicity over military drone usage which is raising public awareness of UAS in general. I would view any move above $23.40 as a signal that a bottom has been reached and that AVAV is embarking on a sustained uptrend. Another key level to watch is AVAV’s 50-week moving average, which is currently at $23.25.

Chart 2
AVAV’s 1-year chart above shows the potential bottoming formation more clearly. The upward gap in December took place after AVAV reported better-than-expected results. Since then the stock has sketched out what could be a “flag” consolidation pattern suggesting that this roughly 3-month trading range is just a rest stop on the way to another advance.

Keep in mind that investing in potential takeover targets is often times a far cry from investing in momentum stocks.  Very often — in fact, more often than not — the most ideal takeover candidates can be stocks that have gotten lost in the shuffle, where there is not enough earnings momentum to appeal to the fast-money, instant gratification crowd and hedge funds that are all chasing the same stocks just because they’re moving and they need to keep up with the peer performance.

Another factor to keep in mind is that in the current disfunctional political environment in which the federal budget is being used as a political football any company that is highly dependent on military spending is vulnerable to contracting delays. For this reason, it’s possible that in any given quarter AVAV or any other company with military customers may find that expected revenues have been delayed and an earnings miss may occur. This just comes with the territory, and while short-term setbacks like this would send a momentum investor into apoplexy it wouldn’t phase me, nor should it phase you, one bit because we are interested in AVAV for it’s long-term value to a strategic buyer as a takeover candidate, which is not affected by short-term earnings fluctuations so long as the positive long-term theme remains intact.

It doesn’t take a genius to identify and chase stocks that are already moving. That’s not the game we’re playing here. Rather, we are going off the beaten path to look for stocks that could attract the attention of strategic buyers who would be willing to pay a substantial premium to acquire a company, so that the profits we are hoping for may come suddenly and in one fell swoop, and not necessarily steadily over time.

About Charles Laloggia …Charles LaLoggia
In 1974, at the age of 23, Charles M. LaLoggia left his position as a securities analyst at Merrill Lynch and began publishing The CML INVESTMENT LETTER. For the next 30 years, as the newsletter evolved as LALOGGIA’S SPECIAL SITUATION REPORT and then as THE SUPERSTOCK INVESTOR, Charles LaLoggia compiled an amazing record of spotting emerging growth stocks and potential takeover candidates that attracted the attention of respected journalists, financial publications and serious investors around the world.

Over the years Charles LaLoggia’s opinions and stock recommendations have been quoted in virtually every major worldwide financial publication, including The Wall Street Journal, The New York Times, The Los Angeles Times, Barron’s, Business Week, Forbes, Fortune, Money Magazine, Newsweek, The Financial Times, The Financial Post of Canada and numerous others. He appeared on Wall Street Week With Louis Rukeyser during an era when you actually had to compile a track record of documented success to be invited to appear on a financial television program. He also appeared on PBS’ The Nightly Business Report, CNBC and numerous other television and radio programs.

During one particularly productive 55-month period through September 2000 a total of 48 of Charles LaLoggia’s recommended stocks received takeover bids — an achievement that has never been duplicated. This track record, and the methods LaLoggia utilized to achieve it, were documented in 2001 in LaLoggia’s book, THE SUPERSTOCK INVESTOR, published by McGraw-Hill.

On October 1, 2000, in a front-page article in The New York Times Sunday Business section, Gretchen Morgenson noted Charles LaLoggia’s track record of picking takeover targets and asked him to recommend five stocks. Over the next 7 months, a period in which the S&P 500 lost 12% and the NASDAQ plunged 40%, these stocks rose an average of 32%. One of them — Houghton-Mifflin, Inc. — received a takeover bid at a 52% premium above its recommended price. The performance was so impressive that Ms. Morgenson wrote a follow-up article on June 3, 2001 highlighting the performance of LaLoggia’s recommendations.

In 2004 Charles LaLoggia sold his newsletter, THE SUPERSTOCK INVESTOR, to devote his time to his other passion, thoroughbred horse racing. Under the guidance of Sovereign Award-winning trainer Mark Casse, his horses won some of the most pretigious races in Canada, including The Grey Breeders Cup Stakes, The Natalma Stakes and The Ontario Debutante. Two of his horses ran in Breeders Cup races. His horses have won over $1.7 million in purse money.

In January 2012 financial columnist Gene Marcial, a respected veteran journalist who had previously written the Heard on the Street column in The Wall Street Journal and the widely-followed Inside Wall Street column at Business Week, invited Charles LaLoggia to put his stock-picking talent to the test once again and to use his methodology to give Mr. Marcial an topic for a column he was writing for MSNMoney.com.

LaLoggia recommended Texas Industries (TXI), a cement-maker, which was then trading at $31 and was completely out of favor. In fact, TXI was so utterly out of favor that Gene Marcial could not find one single mainstream Wall Street analyst who followed the company — and there were several — who would recommend buying the stock.

Over the next 12 months, TXI gained 90%.

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