Investment Thesis

Drone-maker AeroVironment, Inc. (NASDAQ:AVAV) recently won a big military contract from the U.S. Army worth over a billion dollars, which changes the outlook for the Simi Valley, CA-based company.

This is a record deal for AeroVironment since most contract values for the military drone maker usually land in the millions range. The scope of the contract also implies that it could boost not just the overall growth rate of the company due to the size of the contract but also its double-digit EBITDA margins, getting it close to the 20% range.

AeroVironment has been on a tear for the year, already up 67% after accounting for today’s surge in the stock’s price. This was after the company’s stock outperformed the S&P 500’s (SP500) ~24% gains by 2x in 2023.

The mega contract win for the company provides management with grounded visibility for a revenue source at least for this decade due to the size and multi-year tenure of the contract. This improves the outlook for the company as it heads into its Q1 FY25 earnings report next week.

I have now upgraded AeroVironment back to a Buy again after the shot in the arm it received today.

What AeroVironment’s $1B Contract Win Means For Its Outlook

My overall outlook on AeroVironment has always remained bullish due to the consistent nature of management’s habit of sourcing contracts, winning deals, and delivering growth and shareholder value for its investors. My last coverage on AeroVironment was a Hold purely due to a valuation standpoint that played out for the most part until the record contract won by AeroVironment yesterday.

According to the U.S. DoD’s press release yesterday, AeroVironment was awarded the contract

“to provide an organic, stand-off capability to dismounted infantry formations capable of destroying tanks, light armored vehicles, hardened targets, defilade and personnel targets,”

mainly implying the production of AeroVironment’s most popular drone, the Switchblade, which is used by military forces to dismount and neutralize targets without causing the army collateral damage.

The company’s latest contract win from the U.S. Army appears to be a mix of cost-plus and firm-fixed-price contracts designed into the pricing stipulations. While the pricing aspect is always important in today’s times due to the escalating nature of supply costs, as I had explained in separate coverage on its peer, Northrop Grumman Corporation (NOC), it does not make a significant difference in AeroVironment’s case.

First, management has made a concerted effort to focus on winning more funded contracts that help it reliably chart a future course of growth, versus relying on unfunded contracts. Second, AeroVironment is one of the few nimble manufacturers of military machinery that can work through its backlog and quickly deliver products to its customers, recognizing revenue from its backlog faster than its peers. Per its latest 10-K, AeroVironment recognizes ~90% of its funded backlog over the next twelve months.

What this deal does for AeroVironment is it will increase the backlog growth significantly for the company. As I had mentioned earlier, most of the contract values for the company are usually won in the range of millions of dollars. But this billion-dollar contract substantially changes the game for AeroVironment.

Plus, the contract appears to be open in terms of the quantity of the “capabilities” that AeroVironment is now required to provide to the U.S. Army since the contract states that “funding will be determined with each order.” The contract also plays into a significantly strategic move AeroVironment’s management had made in the past few months, specifically for the Switchblade product. Here is an excerpt from management’s recent commentary:

As demand for Switchblade continues to rise, AV stands ready to meet our customers’ increasing expectations. Our current manufacturing levels have expanded to support more than $500 million in annual product revenue, and we’re actively planning for additional capacity growth. We are factory-ready today to supply the US DoD and our allied countries with the products and technology they need to succeed in their missions. The LMS business has grown tremendously this past year, and we expect it to similarly lead our growth in fiscal year 2025.

Management had been ramping up the manufacturing capacity of its drone products, positioning it to gain from operational efficiencies, especially as demand would scale higher. They had even signaled to increase manufacturing capacity even higher in FY25 due to Switchblade demand. Switchblades are part of the company’s LMS segment, which should again start to see growth after getting a huge boost post-Russia/Ukraine conflict.

This is one of the reasons why I believe the company will not only benefit from growth in its top line but should also see its EBITDA margins expand on an adjusted basis. This is due to the benefits of production scale from its new production capacity. Currently, management expects about 60 points of EBITDA margin expansion on an adjusted basis.

AeroVironment Valuation Gets A Boost As Well

Based on the information at hand, I believe AeroVironment should be able to now post at least 17% growth rates in its top line over the coming years. This is due to a much stronger-looking backlog and increased upgrade activity at many allied forces locations and conflict locations. The company’s Q1 earnings report next week should add more details as to how management quantifies the scale of orders it can receive from this $1 billion contract.

I also see EBITDA margins expanding by at least a percent, pointing to a minimum of 20% growth in EBITDA on an adjusted basis, as shown in Exhibit E. My model assumes a discount rate of 8.2%.

Given the projected growth rates that I now see, I believe AeroVironment should be priced at 38-39x forward earnings given its 20% growth rates through my investment horizon. This implies an upside of 15-17%.

Upcoming Quarterly Report Key Points To Watch

In the Q1 FY25 report AeroVironment is slated to announce next week, I will be keenly looking for an upgraded outlook from management, most importantly.

Q1 FY25 Expectations: Consensus estimates expect AeroVironment to report earnings per share of 65 cents on revenues worth $188 million, growing ~23% y/y.

FY25 Projections: Management usually refrains from providing specific quarterly guidance but does update their annual guidance periodically. For FY25, consensus estimates expect management to report earnings of $3.42 per share on revenues worth $815 million, growing 13.7% y/y. In contrast, management had projected EPS of $2.61-2.92 on revenues between $790-820, implying elevated expectations for the company. Expect the company’s stock to drop if management is unable to upgrade its outlook that can beat these FY25 expectations, especially with the $1 billion U.S. Army deal.

Other Items & Risks: One of the things I will specifically want to see is if there is a larger portion of the fixed-price component of the $1 billion contract. Investors should note that AeroVironment was the only bidder that applied for this contract and won, so I would want to hear from management about any potential risks that could arise from taking on the contract.

Takeaway

The $1 billion win for AeroVironment, Inc. was good news for the company as it sets itself up for reporting its Q1 FY25 earnings next week. This is perhaps one of the largest, if not the largest, contracts won by the company and will be a huge game changer for the company’s growth prospects, significantly adding to the company’s backlog.

I have upgraded my outlook on AeroVironment and am now recommending it as a Buy again.