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There seems to be a strong case for getting net short at the moment. Earlier this month, we highlighted a Twitter user’s intriguing theory for the “All Clear Echo” which would necessitate the market reaching “Max Stupid”. The laundry list of insanity that we highlighted in that post suggested that we were nearing that point.

On Friday, of course, market indices turned sharply south:

The culprit was the annual policy speech from Federal Reserve Chairman Jerome Powell. Powell made clear that the Fed was not going to back off its previously-announced plans for rate hikes, dashing hopes for a “pivot” to a more accommodative posture.

It seems like the “risk-off” trade is back in force. Even Bitcoin (BTC) — promised as a hedge against inflation, but acting more like a measure of risk tolerance — is below $20,000.

There’s one catch, however: the case for being bearish here seems a bit too easy. Not necessarily in the “everyone is bearish so that’s bullish” sense, but more in the sense of asking: what really changed between Thursday and Sunday? Some of the positioning that likely drove the rally from May lows — particularly in the most speculative names — was unwound on Friday, but no doubt much still remains. Even with higher bond yields presumably on the horizon, there’s still a “TINA” (There Is No Alternative") case for U.S. equities, particularly with so much trouble looming overseas.

The argument that the bounce off May lows has been purely a “bear market rally,” ended by a single speech, seems simplistic. Even if we broadly agree with that sentiment, and even with futures in the red on Monday morning, the market rarely works that way.

That said, now does seem like a time to be cautious. Investors might easily move away from “risk-on”, even if they don’t necessarily flee to 100% “risk-off” mode. Even an incremental step in that direction could set up an attractive short position in drone manufacturer AeroVironment AVAV .

The Short Case For AVAV

AVAV has been one of the better stocks in the market this year, rallying 57% year-to-date:

source: finviz.com

The reason for the optimism is simple, if tragic: the Russian invasion of Ukraine. AeroVironment’s Puma surveillance UAS (unmanned aircraft system, the technical term for what is colloquially known as a “drone”) already has received a $20 million contract from the U.S. Department of Defense (DoD) as part of its efforts to support Ukraine. Ukraine has also used AeroVironment’s Switchblade, a so-called “suicide drone”, and AeroVironment chief executive officer Wahid Nawabi said on the fiscal Q4 call in June that Ukraine’s military had specifically asked for more.

With approval to sell to additional European countries on heightened alert following the invasion, AeroVironment seems to have strong growth prospects ahead. Indeed, RBC Capital upgraded AVAV stock last week in part due to potential benefits from the conflict.

But it’s worth taking a step back to view the broader picture — which shows some reason for concern. The first is valuation. AVAV closed at $97 on Friday, yet is guiding for adjusted earnings per share in FY23 (ending April) of just $1.35 to $1.65. Even at the high end of the outlook, shares are trading for almost 60x earnings and roughly 30x EBITDA.

On its face, that’s perhaps not a huge problem — but those multiples come amid relatively weak growth. Organic revenue declined in FY22, which colors the outlook for double-digit growth on that basis this year. Adjusted EPS was $1.48 in FY19, roughly equivalent to the midpoint of the FY23 guidance range. In the interim, AeroVironment has spent just over $500 million on acquisitions, most of it in the early 2021 purchase of Arcturus, a manufacturer of medium- and large-sized UAS.

There’s another factor to consider with fiscal Q1 earnings arriving on Sept. 7. This is a stock that has made some big moves:

source: YCharts

In fact, as I wrote a few years ago, the Q1 report itself catalyzed those big moves. In both cases, the quarter came in outside expectations (once above, once below). In each case, management reiterated full-year guidance, pointing to order timing as driving the respective divergences of results and expectations.

We haven’t really seen that Q1 issue recur since 2017, but it’s possible the fiscal Q1 release provides an issue this time around. That’s particularly because AeroVironment continues to struggle with its supply chain. That continuing backlog could in turn lead to a Q1 “miss” driven largely by timing — in a market that may well sell first and ask questions later.

At the very least, it’s difficult to see what positive surprise is coming from AeroVironment in Q1. What’s driven the gains since the start of the year has been a prediction of orders that will come, not those that are coming.

The outline here, then, is a stock not terribly far from this year’s highs, in a market that suddenly looks nervous, and a valuation that on a headline basis looks incredibly stretched.

Being short ahead of earnings seems like a reasonably attractive if higher-risk trade. More conservatively, valuation concerns support at least keeping a close eye on the post-earnings reaction to see if a better opportunity arises.

The Case Against Shorting AVAV

Again, that’s the broad case for a short. Looking closer, however, there are reasons to at least stay on the sideline.

First, valuation is stretched from a headline basis — but perhaps not quite to the same extent looking closer. Supply chain issues are real, and are hurting both revenue (as deliveries get pushed out) as well as margins. The MacCready Works business, which is looking to develop autonomous solutions, per the 10-K posted an adjusted operating loss of $2.4 million in FY22, a material if modest headwind to consolidated profits and margins.

Second, the medium- to long-term outlook isn’t based simply on reactions to the crisis in Ukraine. On the Q4 call, CEO Nawabi said that a 10-year contract with the DoD for FTUAS (Future Tactical UAS) could be worth over $1 billion in aggregate. That average revenue would equal ~20% of the company’s guided revenue for FY23. This month, AeroVironment announced that it had won Increment 1 of that award.

Orders in Ukraine and Europe suggest further growth. The $20 million Puma award is ~4% of this year’s revenue — but it’s the Switchblade that Ukraine really wants. Defense budgets across the Continent are increasing.

From this perspective, the problem with a pre-earnings trade is that the market is taking the long view — for good reason. Similarly, a short based at least in part on valuation is focusing too intently on FY22 results and FY23 guidance.

After all, this isn’t an electric vehicle stock in 2021, where investors are bidding up the name based on a broad thesis (EV adoption will increase!) while ignoring company-specific risks (this EV manufacturer has no capital!) or insane valuations (a pre-production electric truck maker valued at nearly $100 billion on its first day of trading).

Valuation is stretched, yes, but if revenue can double between Europe and FTUAS, a bit of operating and financial leverage can allow AVAV to grow into its valuation. The company has been seen as a potential acquisition target for years, and a sale at some point to one of the larger defense contractors probably makes sense. And the thesis here isn’t necessarily broad, in that investors have bid AVAV up simply because Russia invaded Ukraine. Rather, AeroVironment has already won awards in Ukraine and, again, the company’s leadership is asking directly for more product.

Something worth noting here is that short sellers are familiar with AVAV. But they’ve been out of the trade for a while:

Those short sellers might see Friday’s decline as an invitation to increase bearish bets. Indeed, a dearly-valued name like AVAV ahead of earnings might seem an attractive option. But even in that context, AVAV perhaps isn’t necessarily the best trade. Why not try and scalp Snowflake (SNOW) at 38x revenue, rather than AVAV at 30x EBITDA?

The Legacy Business

But in terms of a short (both medium-term and ahead of earnings) the case is stronger than it appears.

The long-term boost from European spending and FTUAS is material. But it’s only a materially recurring boost if the drones are actually destroyed. In other words, there needs to be significant, ongoing conflict, not simply the addition of UAS to the arsenals of European companies.

Indeed, AeroVironment’s business with the U.S. government bears that out. Going back to AeroVironment’s IPO in early 2007, the core business was small UAS, which served U.S. soldiers and marines in Iraq and Afghanistan. But as the US presence in the Middle East declined, demand stagnated. In FY09, AeroVironment’s domestic revenue was $211 million. Last year, with a far broader product portfolio, it was $262 million, for a compound annualized growth rate under 2%.

Both acquisitions and improved international sales (thanks in large part to increased authorization from the U.S. government to sell to allies) have driven more impressive consolidated top-line growth rates. But there are headwinds on that front as well. Most notably, AeroVironment generated almost 10% of FY22 revenue from sales of its HAPS (high altitude pseudo-satellite) to Softbank (SFTBY). (The two companies originally had a joint venture, but Softbank bought out AeroVironment’s 7% stake last year.)

Nawabi has insisted that the program is in fine shape, despite AeroVironment’s exit from its ownership stake. He said after Q4 that the two companies were negotiating terms for the next stage of development.

But Softbank just posted a record loss, and the HAPS industry has been a graveyard for investor capital, with Alphabet (GOOG) (GOOGL) a recent victim after shuttering its Loon project last year. That program seems at real risk. Add continuing pressure on small UAS (revenue declined by nearly one-quarter in FY22) and the multi-year growth outlook may not be quite what investors believe.

That’s also true because AeroVironment has disappointed in the past. As a stock, AVAV has done well, certainly. Shares have gained 149% over the past five years. However, AVAV had been ‘dead money’ for its first decade on the public markets. And the big, thesis-changing opportunities haven’t necessarily played out. Most notable among them was a move into commercial drones through its Quantix program, which AeroVironment wrote off in FY20. (The company has donated Quantix inventory to Ukraine.)

AeroVironment too has struggled to drive significant operating leverage. The recent acquisitions generally lean more toward service revenue, which pressures gross margin and thus puts a ceiling on operating leverage. Even tossing FY22 as an outlier, Adjusted EBITDA margins have averaged in the 18% range; FY23 guidance (at the midpoint) is for a 17% print. Nawabi clearly changed the culture around cost after taking the CEO role in 2016, but it’s equally clear that the low-hanging fruit has been harvested. Without that operating leverage, even doubling revenue doesn’t make AVAV a huge steal at this price.

As for a takeout, bear in mind, too, that the seemingly logical buyout case faces real antitrust and national security concerns. Raytheon (RTX) CEO Greg Hayes said earlier this year that consolidation in the space is probably “not on the table in the near term.”

Three Reasons To Short Here

AeroVironment is a good business. It’s a business I’ve owned in the past. (It’s also one I’ve shorted in the past.) But it’s perhaps not quite as good a business as bulls believe. Profit growth has not been terribly impressive. Demand to some extent requires ongoing hostilities, not just the threat of war. UAS have changed the way battles are fought (at least by the U.S. military), but likely haven’t been transformative in the way that might have been predicted 20 or even 10 years ago.

Yet even in the context of growth opportunities, AeroVironment is priced as a very good business indeed. And I see three core reasons to bet otherwise right now.

The first is that we know that investors will sell this kind of stock off at the moment:

source: finviz.com

Kratos Defense & Security Solutions (KTOS) is a competitor, though KTOS stock isn’t necessarily a peer. KTOS isn’t a drone pure-play, nor does it have the same direct exposure to the Ukraine conflict (though the stock did rise in the days after the invasion).

Still, we have a strong data point here to suggest that investors won’t simply hold any defense stock until some sort of clarity is reached in the Ukraine-Russia war.

Second, we’ve seen this story before with AVAV itself. This is the third time AVAV has gone up in a hurry to above $100. Each time, the bull thesis to at least some extent has been relatively narrow. In 2018, it was the commercial opportunity (AVAV soared at the same time cannabis stocks were doing the same, following the investment in Canopy Growth (CGC) by Constellation Brands (STZ) (STZ.B)). In 2020, it was the massive market-wide bull run that began in Q3, in which investors bid up these kinds of ‘futuristic’, industry-changing plays. (Readers will not be surprised to know that Cathie Wood was buying AVAV last year.)

In both cases, AVAV reversed in a hurry. In each case, the stock fell more than 50%. There’s the possibility that history repeats, particularly ahead of a report where upside catalysts seem potentially thin.

That in turn gets to the third point. In the options market, the odds for taking that bet look rather attractive. Dependent on liquidity, modestly out-of-the-money puts at the September expiration probably have two ways to win: a post-earnings sell-off and/or a broad market downdraft. Investors who believe in one of those potential catalysts should have AVAV on their watchlist; investors who believe in both may not see many better near-term short opportunities out there.

As of this writing, Vince Martin has no positions in any securities mentioned. He may initiate a short position in AVAV this week.

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