AeroVironment (AVAV) Surges as Activist Investor Seeks to Cure Valuation Disconnect
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AeroVironment, Inc. (NASDAQ: AVAV) is ripping 13% higher Wednesday after 5.1% shareholder Engaged Capital filed a 13D and issued an open letter, outlining a path for the stock to achieve fair valuation.
Engaged Capital highlighted its belief that AeroVironment’s stock is undervalued and numerous opportunities exist to correct the Company’s valuation discount through improved corporate governance, enhanced financial disclosure, an optimal capital structure, and a stronger focus on value creating capital allocation. Engaged Capital expressed its commitment to work constructively with the Company’s board of directors and management to help achieve fair valuation for AeroVironment.
"We believe that AeroVironment's impressive product and technology portfolio, leading market position, varied and significant growth prospects, and excellent balance sheet should command a higher valuation. In our view, concerns over an excess of cash in the capital structure, a lack of granularity and specificity with respect to its growth plans, and uncertainty surrounding its heavy exposure to the defense budget are all addressable issues,” said Glenn W. Welling, Engaged Capital’s Principal and Chief Investment Officer. “We are fully committed to working with the board of directors and management of AeroVironment to implement strategic initiatives to enhance the Company’s equity valuation and maximize value for all shareholders."
Engaged Capital doesn't believe the share price adequately reflects:
1. The potential for significant earnings and cash flow growth from the Issuer’s core Unmanned Aircraft Systems (“UAS”) business as U.S. Department of Defense (“DoD”) spending normalizes,
2. The value of the Issuer’s cash, short- and long-term investments, which was $217.5 million as of April 30, 2013,1 representing approximately 47% of the Issuer’s market capitalization as of July 16, 2013, and
3. The Issuer’s advantaged position in pursuing multiple growth opportunities in the fast growing UAS market.
The Reporting Persons believe the Issuer has numerous opportunities to enhance the Issuer’s equity valuation. Since their initial investment in November 2012, the Reporting Persons have maintained a dialogue with the Issuer’s management team regarding the Issuer’s (i) capital structure, (ii) capital allocation strategy, (iii) communications with investors, and (iv) corporate governance, including board composition. The Reporting Persons have recently intensified their communications regarding these topics and, based on the discussions to date, the Reporting Persons believe the Issuer is interested in taking action to improve its performance.
Unrecognized Value
Unmanned Aircraft Systems – The Reporting Persons believe the Issuer maintains the world’s premier small UAS franchise as evidenced by the Issuer’s dominant market share. As reported by the Issuer in its 2012 Annual Report,2 the Issuer’s small UAS represent 85% of the more than 7,500 unmanned aircraft in the Pentagon’s inventory. The Reporting Persons believe the Issuer’s dominant position within the DoD for small UAS will lead to continued growth as defense appropriations for UAS stabilize and grow over time combined with an anticipated increase in both international UAS defense sales and non-defense, small UAS demand (including usage for border patrol, law enforcement, and agricultural monitoring). The Reporting Persons believe that any negative impact the U.S. government’s budget sequestration is having on the Issuer’s revenues will be a short-term phenomenon driven by the short cycle nature of the Issuer’s UAS business.
Flexible cost structure – The Reporting Persons believe the Issuer operates under a flexible cost structure, as evidenced by the announcement on the Issuer’s June 25, 2013 conference call (the “June Call”) that the company had lowered its breakeven quarterly revenue run-rate to a range of $50-$55 million, down from a range of $60-$65 million cited on the previous quarterly earnings call.3 For the Fiscal Year 2014, the Issuer has advised that it expects to generate revenue of $230-$250 million and earnings per share on a fully diluted basis of $0.35-$0.50.4 However, during each of the fiscal years ending 2007, 2008, and 2009, the Issuer was able to generate over $1.00 in earnings per diluted share5 on annual revenues that were below the high-end of the Issuer’s Fiscal Year 2014 revenue guidance range of $250 million. As a result, the Reporting Persons believe that if currently depressed revenue levels were to persist beyond Fiscal Year 2014, the Issuer has ample ability to right-size its cost structure and more than double diluted earnings per share.
Intellectual property – Since its founding in 1971, the Issuer has developed expertise in areas including lightweight aerostructures, power electronics, electric propulsion systems, and efficient electric power generation. The Reporting Persons believe the Issuer owns an enviable IP portfolio, the value of which the Reporting Persons believe is material and is not reflected in the Issuer’s current equity valuation.
Growth initiatives – The Reporting Persons believe the Issuer has numerous near-term (Switchblade, UAS mission services, international small UAS) and long-term (commercial UAS, Global Observer, Efficient Energy Systems) growth opportunities that are not currently reflected in the Issuer’s equity valuation.
Switchblade – The Reporting Persons believe the Issuer’s Switchblade loitering munition has the potential to generate significant revenue growth given its unique characteristics as a back-packable, non-line-of-sight, precision strike solution. In Fiscal Year 2013, Switchblade revenues increased 25% as DoD adoption began to ramp.6
UAS mission services – The Reporting Persons believe UAS mission services represent a significant near-term growth opportunity for the Issuer to expand the use of its small UAS. Mission services clients sign long-term leases that include both equipment and labor services. Such agreements generate predictable recurring revenue in contrast to the volatile revenue associated with direct equipment sales. The Issuer expects the U.S. Department of State (“DoS”) to release a mission services request for proposal (“RFP”) in the first half of Fiscal Year 2014 with an award anticipated in the second half of Fiscal Year 2014.7 Based on the size of a recently cancelled DoS RFP for mission services ($1 billion over five years) the Reporting Persons believe this RFP will be sizable and that the Issuer is in a strong position to compete for some, if not all, of the award.
International small UAS – International small UAS revenue reached an all-time high in Fiscal Year 2013. Total international revenue in Fiscal Year 2013 grew over 100% and represented 15% of total revenue as compared to 5% of total revenue in Fiscal Year 2012.8 On the June Call, the Issuer stated that multiple U.S. allies have small UAS acquisition plans for this year and next.
ommercial UAS – The Federal Aviation Administration (“FAA”) has been tasked by Congress through the FAA Modernization and Reform Act of 2012 (the “Act”) with integrating UAS into the National Airspace System by September 2015. The Act anticipates 30,000 drones operating domestically by 2020. Once the FAA’s requirements for commercial drone usage are finalized, the Reporting Persons believe small UAS will be in high demand from domestic security agencies, such as police departments and border patrol, as well as from commercial customers in the agriculture, energy, and industrial markets. The Reporting Persons believe the Issuer is uniquely positioned to take advantage of this demand given its first mover advantage and reputation serving the DoD.
Global Observer – Global Observer (“GO”), the Issuer’s largest UAS, is a hydrogen-powered, long endurance plane that can fly for up to seven days, effectively operating as a satellite. While these systems are expensive relative to small UAS, the Reporting Persons believe GO is significantly cheaper than most satellite-like alternatives. GO could potentially be adopted by a wide variety of customers, appealing to markets such as communications relay, disaster relief, and maritime operations in addition to the DoD.
Efficient Energy Systems (“EES”) – The Reporting Persons believe the Issuer’s EES segment is in a position to capitalize on the increasing demand for electric vehicle charging stations as more automobile manufacturers offer electric and plug-in hybrid models.
Correcting the Valuation Discount
Capital structure – The Reporting Persons believe the Issuer’s balance sheet provides significant risk mitigation as well as a source for equity value creation and/or capital distribution. As of April 30, 2013, the Issuer maintained a cash, short-, and long-term investments balance of $217.5 million,9 representing approximately 47% of the Issuer’s market capitalization as of July 16, 2013, or $9.62 per common share outstanding. Further, tangible equity value per share was $13.94.10 The Reporting Persons believe the Issuer’s current capital structure is inefficient. While the Issuer reports it has a series of near-term growth opportunities that may require increased capital investment, the Reporting Persons believe financing for these capital investments can be secured through the use of a revolving credit facility or term loan structure once contracts have been negotiated and revenues are more certain.
Capital allocation – The Reporting Persons believe that capital allocation will be an important component of equity value creation given the Issuer’s significant cash balance, annual free cash flow, and numerous growth initiatives. However, the timing, size, required investment, and risk-adjusted returns for these growth projects do not appear to be well understood by investors. As a result, the Reporting Persons believe the Issuer’s equity valuation does not reflect the value of a disciplined use of the Issuer’s large cash balance and future cash flows. The Reporting Persons plan to work with the Issuer to assist the Company in implementing a proper capital allocation process with disciplines in place and which is duly communicated to investors such that the current cash balance and future cash flows are allocated to the highest and best return alternatives, whether organic/inorganic investments, share repurchases, or special/ordinary dividends.
Investor communications – The short-cycle nature of the Issuer’s core business, combined with customer concentration around the DoD, has historically created significant short-term revenue volatility. The Reporting Persons believe the negative impact of this volatility on the Issuer’s valuation has been compounded by the Issuer’s failure to provide an adequate level of financial disclosure to investors. The Reporting Persons plan to work with the Issuer to improve both financial disclosure and transparency.
Corporate governance – The Reporting Persons believe the addition of independent directors with expertise in capital allocation, public company valuation, and communications with investors would enhance the quality of the Issuer’s board of directors (the “Board”) and its governance profile. Consistent with best practices, the Reporting Persons also believe the Issuer should declassify its board structure in a manner consistent with its organizational documents beginning with the 2013 annual meeting of stockholders (the “2013 Annual Meeting”).
Engaged Capital highlighted its belief that AeroVironment’s stock is undervalued and numerous opportunities exist to correct the Company’s valuation discount through improved corporate governance, enhanced financial disclosure, an optimal capital structure, and a stronger focus on value creating capital allocation. Engaged Capital expressed its commitment to work constructively with the Company’s board of directors and management to help achieve fair valuation for AeroVironment.
"We believe that AeroVironment's impressive product and technology portfolio, leading market position, varied and significant growth prospects, and excellent balance sheet should command a higher valuation. In our view, concerns over an excess of cash in the capital structure, a lack of granularity and specificity with respect to its growth plans, and uncertainty surrounding its heavy exposure to the defense budget are all addressable issues,” said Glenn W. Welling, Engaged Capital’s Principal and Chief Investment Officer. “We are fully committed to working with the board of directors and management of AeroVironment to implement strategic initiatives to enhance the Company’s equity valuation and maximize value for all shareholders."
Engaged Capital doesn't believe the share price adequately reflects:
1. The potential for significant earnings and cash flow growth from the Issuer’s core Unmanned Aircraft Systems (“UAS”) business as U.S. Department of Defense (“DoD”) spending normalizes,
2. The value of the Issuer’s cash, short- and long-term investments, which was $217.5 million as of April 30, 2013,1 representing approximately 47% of the Issuer’s market capitalization as of July 16, 2013, and
3. The Issuer’s advantaged position in pursuing multiple growth opportunities in the fast growing UAS market.
The Reporting Persons believe the Issuer has numerous opportunities to enhance the Issuer’s equity valuation. Since their initial investment in November 2012, the Reporting Persons have maintained a dialogue with the Issuer’s management team regarding the Issuer’s (i) capital structure, (ii) capital allocation strategy, (iii) communications with investors, and (iv) corporate governance, including board composition. The Reporting Persons have recently intensified their communications regarding these topics and, based on the discussions to date, the Reporting Persons believe the Issuer is interested in taking action to improve its performance.
Unrecognized Value
Unmanned Aircraft Systems – The Reporting Persons believe the Issuer maintains the world’s premier small UAS franchise as evidenced by the Issuer’s dominant market share. As reported by the Issuer in its 2012 Annual Report,2 the Issuer’s small UAS represent 85% of the more than 7,500 unmanned aircraft in the Pentagon’s inventory. The Reporting Persons believe the Issuer’s dominant position within the DoD for small UAS will lead to continued growth as defense appropriations for UAS stabilize and grow over time combined with an anticipated increase in both international UAS defense sales and non-defense, small UAS demand (including usage for border patrol, law enforcement, and agricultural monitoring). The Reporting Persons believe that any negative impact the U.S. government’s budget sequestration is having on the Issuer’s revenues will be a short-term phenomenon driven by the short cycle nature of the Issuer’s UAS business.
Flexible cost structure – The Reporting Persons believe the Issuer operates under a flexible cost structure, as evidenced by the announcement on the Issuer’s June 25, 2013 conference call (the “June Call”) that the company had lowered its breakeven quarterly revenue run-rate to a range of $50-$55 million, down from a range of $60-$65 million cited on the previous quarterly earnings call.3 For the Fiscal Year 2014, the Issuer has advised that it expects to generate revenue of $230-$250 million and earnings per share on a fully diluted basis of $0.35-$0.50.4 However, during each of the fiscal years ending 2007, 2008, and 2009, the Issuer was able to generate over $1.00 in earnings per diluted share5 on annual revenues that were below the high-end of the Issuer’s Fiscal Year 2014 revenue guidance range of $250 million. As a result, the Reporting Persons believe that if currently depressed revenue levels were to persist beyond Fiscal Year 2014, the Issuer has ample ability to right-size its cost structure and more than double diluted earnings per share.
Intellectual property – Since its founding in 1971, the Issuer has developed expertise in areas including lightweight aerostructures, power electronics, electric propulsion systems, and efficient electric power generation. The Reporting Persons believe the Issuer owns an enviable IP portfolio, the value of which the Reporting Persons believe is material and is not reflected in the Issuer’s current equity valuation.
Growth initiatives – The Reporting Persons believe the Issuer has numerous near-term (Switchblade, UAS mission services, international small UAS) and long-term (commercial UAS, Global Observer, Efficient Energy Systems) growth opportunities that are not currently reflected in the Issuer’s equity valuation.
Switchblade – The Reporting Persons believe the Issuer’s Switchblade loitering munition has the potential to generate significant revenue growth given its unique characteristics as a back-packable, non-line-of-sight, precision strike solution. In Fiscal Year 2013, Switchblade revenues increased 25% as DoD adoption began to ramp.6
UAS mission services – The Reporting Persons believe UAS mission services represent a significant near-term growth opportunity for the Issuer to expand the use of its small UAS. Mission services clients sign long-term leases that include both equipment and labor services. Such agreements generate predictable recurring revenue in contrast to the volatile revenue associated with direct equipment sales. The Issuer expects the U.S. Department of State (“DoS”) to release a mission services request for proposal (“RFP”) in the first half of Fiscal Year 2014 with an award anticipated in the second half of Fiscal Year 2014.7 Based on the size of a recently cancelled DoS RFP for mission services ($1 billion over five years) the Reporting Persons believe this RFP will be sizable and that the Issuer is in a strong position to compete for some, if not all, of the award.
International small UAS – International small UAS revenue reached an all-time high in Fiscal Year 2013. Total international revenue in Fiscal Year 2013 grew over 100% and represented 15% of total revenue as compared to 5% of total revenue in Fiscal Year 2012.8 On the June Call, the Issuer stated that multiple U.S. allies have small UAS acquisition plans for this year and next.
ommercial UAS – The Federal Aviation Administration (“FAA”) has been tasked by Congress through the FAA Modernization and Reform Act of 2012 (the “Act”) with integrating UAS into the National Airspace System by September 2015. The Act anticipates 30,000 drones operating domestically by 2020. Once the FAA’s requirements for commercial drone usage are finalized, the Reporting Persons believe small UAS will be in high demand from domestic security agencies, such as police departments and border patrol, as well as from commercial customers in the agriculture, energy, and industrial markets. The Reporting Persons believe the Issuer is uniquely positioned to take advantage of this demand given its first mover advantage and reputation serving the DoD.
Global Observer – Global Observer (“GO”), the Issuer’s largest UAS, is a hydrogen-powered, long endurance plane that can fly for up to seven days, effectively operating as a satellite. While these systems are expensive relative to small UAS, the Reporting Persons believe GO is significantly cheaper than most satellite-like alternatives. GO could potentially be adopted by a wide variety of customers, appealing to markets such as communications relay, disaster relief, and maritime operations in addition to the DoD.
Efficient Energy Systems (“EES”) – The Reporting Persons believe the Issuer’s EES segment is in a position to capitalize on the increasing demand for electric vehicle charging stations as more automobile manufacturers offer electric and plug-in hybrid models.
Correcting the Valuation Discount
Capital structure – The Reporting Persons believe the Issuer’s balance sheet provides significant risk mitigation as well as a source for equity value creation and/or capital distribution. As of April 30, 2013, the Issuer maintained a cash, short-, and long-term investments balance of $217.5 million,9 representing approximately 47% of the Issuer’s market capitalization as of July 16, 2013, or $9.62 per common share outstanding. Further, tangible equity value per share was $13.94.10 The Reporting Persons believe the Issuer’s current capital structure is inefficient. While the Issuer reports it has a series of near-term growth opportunities that may require increased capital investment, the Reporting Persons believe financing for these capital investments can be secured through the use of a revolving credit facility or term loan structure once contracts have been negotiated and revenues are more certain.
Capital allocation – The Reporting Persons believe that capital allocation will be an important component of equity value creation given the Issuer’s significant cash balance, annual free cash flow, and numerous growth initiatives. However, the timing, size, required investment, and risk-adjusted returns for these growth projects do not appear to be well understood by investors. As a result, the Reporting Persons believe the Issuer’s equity valuation does not reflect the value of a disciplined use of the Issuer’s large cash balance and future cash flows. The Reporting Persons plan to work with the Issuer to assist the Company in implementing a proper capital allocation process with disciplines in place and which is duly communicated to investors such that the current cash balance and future cash flows are allocated to the highest and best return alternatives, whether organic/inorganic investments, share repurchases, or special/ordinary dividends.
Investor communications – The short-cycle nature of the Issuer’s core business, combined with customer concentration around the DoD, has historically created significant short-term revenue volatility. The Reporting Persons believe the negative impact of this volatility on the Issuer’s valuation has been compounded by the Issuer’s failure to provide an adequate level of financial disclosure to investors. The Reporting Persons plan to work with the Issuer to improve both financial disclosure and transparency.
Corporate governance – The Reporting Persons believe the addition of independent directors with expertise in capital allocation, public company valuation, and communications with investors would enhance the quality of the Issuer’s board of directors (the “Board”) and its governance profile. Consistent with best practices, the Reporting Persons also believe the Issuer should declassify its board structure in a manner consistent with its organizational documents beginning with the 2013 annual meeting of stockholders (the “2013 Annual Meeting”).
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