AeroVironment, Inc. ($AVAV)

Here we go. Good afternoon, everyone. Welcome back to the aerospace defense track at the JPMorgan Industrials Conference. I'm Seth Seifman, aerospace and defense equity analyst here at JPMorgan. We are very grateful to have AeroVironment with us, AV. And we have both CEO, Wahid Nawabi; and we have CFO, Kevin McDonnell, here with us. Guys, thank you very much. We appreciate you being here, and there's a lot of stuff that's kind of very topical for us to talk about. So thanks for coming. Maybe we'll just do some Q&A here. And then I'll also open it up to the audience if anyone in the room has any questions. I guess we've had a lot to cover, but maybe starting off, it seemed recently that there was a little bit of slowness maybe in some of the funding that was was coming out, particularly from the reconciliation bill. And I'm wondering now that the government has been back open for a few months, now that we're a little further into the calendar year, have you started to see more of those resources flowing? And when you think about what was in the reconciliation bill, where are the main opportunities for AV?

Yes. So thank you for having us, Seth. Yes, there were some delays primarily due to the government shutdown and reconciliation bill and the CR that happened throughout the whole year. The budget just got approved a little while ago, not a month ago or so. The dollars are still coming through from the approval process from the Congress to the OMB. And from there, it's going to flow into the specific accounts of the services, Army, Navy, Air Force. We are starting to see some trickle of that. I think it's the beginning. In the next three to six months, I think we'll see a significant more uptick on the potential of orders coming in and contracts flowing down to us as well, A. B, in terms of the -- is there a lot -- or is there anything for AB in the reconciliation bill and in the budget? Absolutely. We're on some of the highest priority categories. We're on the strategic categories in terms of both demand and importance. Those are things such as drones, Group 1, 2 and 3, loitering munitions, one-way attack, RF detect and defeat jamming systems, such as our Titan series as well as is obviously requirements now because of the conflict that's going on in Iran for directed energy LOCUST systems that could be a very significant player in the long run. I also mentioned that persistent long-range, long endurance ISR, such as our Group III JUMP 20, JUMP 20-X is ideal for those types of needs that are out there in the market. So there's half a dozen of our products that are in production today. We're making them in quite probably largest volume in the industry. And we have the capacity to produce and we have the ability to actually deliver at a military-grade operationally relevant systems to the market as soon as the funding makes its way.

Okay. Okay. Excellent. Yes, you mentioned loitering munitions among the products that are in demand. Maybe if you could talk -- and loitering munitions product where AV was really a pioneer in the market. Can you talk a little bit about how you see that market evolving? I know people hear about loitering munitions being manufactured by several different companies. How do you think this market evolves in terms of how many companies can grow and kind of have a decent share in this market? And what distinguishes AV from the competitors?

So our history is exactly what you described. I mean these categories that we're the leader in and it's essentially categories in many cases that we've invented the category. The term loitering munition did not exist before, Switchblade. -- and Switchblade has become anonymous to the term loitering munition in the market, number one. Number two, we've got the most proven technology in the market. We're producing in high volumes today at program of record level rigor and certification and safety confirmation levels for the loitering munition, and we're way ahead of everyone else in this category. The market, however, is large. And as a result of the success of Switchblade and loitering munition, the lowest end of the market, probably the smallest part of the market is this FPV drones that have some sort of explosive strap to it. That is a 1 to 5-kilometer conflict problem and solution. It's most likely not relevant for majority of the conflicts that are around the world that the U.S. is going to face. The kind of conflict that we're fighting in Ukraine is very different than what's going on in the Gulf. It's going to be in the Pacific. It's going to be in other parts of the world, potentially, hopefully not. So that's one. Two, in that space that we're in, we're the leader, and we're on second or third-generation products. We're not only producing in volume. We've iterated and improved this technology multiple times. And we just, as you know, announced Switchblade 600 Block 2. It's a next generation more capable. We are on Switchblade 300 Block 20. And we've also introduced our Switchblade 400, which is a whole new category for launched effects for it going into other platforms, tanks, armored vehicles, helicopters, airplanes. And then as you get larger, there's also room for larger loitering munitions on platforms such as the Predator, Reaper, manned airplanes, et cetera, et cetera. And so you see a huge portfolio. We have a phenomenal category solution provider portfolio, and we're even expanding that with our one-way attack solution such as Red Dragon. And that's another piece of the market related to loitering munitions that is complementary. They're not actually competing with each other, very different missions for those two. So you're going to see more players. The market is growing. It's going to be a multibillion-dollar market. If it's not already today, it's on its way. And we've doubled our business last year. We've doubled our production. We're building another plant for $2 billion a year worth of production capacity for Switchblade or other products. That's going to come online later this calendar year, beginning of next fiscal year, next calendar year. And that gives us an additional capacity. And the reason why we're doing that is because we see tremendous growth opportunities here in the next 12 to 36 months.

Okay. Okay. Excellent. If we dig into the products a little bit and we think about from the Switchblade 300 going to 400 and 600. What are the improvements that have been made? How do they -- how does some of these improvements address the issue of jamming, for example, to give the product more capability?

Yes. So I think this is a very underestimated aspect of the competitive differentiators that we have in the market. Most of the entrants of new players in this market is like on their prototyping, early phase production level product. And if they've done that, they've never done it at the rigor of the U.S. DoD's safety, certification, operational requirements and logistical footprint and training and all that. We are way, way beyond that in that regard. So there's a lot to be done for anybody who wants to compete in this market to make tens of thousands of it that goes into stockpiles with the U.S. military for a decade or so. That's a whole different ball game than making a quadcopter FPV in a garage and using it next week and 90% of it doesn't hit a target. That's not what the U.S. military is going to have in a stockpile. It's going to go in a stockpile. It's going to stay there for years. And any time it's pulled out, it's got to work the same exact way it was working when you tested it before this thing, A. B, improvements. Switchblade 300 Block 20, for example, has a user field swappable warhead. You literally put your thumb inside the nose of the airplane, you pull it out, the warhead comes out, you put another warhead. The other warhead that we've actually certified in that airplane in that loitering munition is called EFP. It's an explosive that an airplane that three of them weighs about 25 pounds that one person can carry. It could penetrate 90% of armored assets on the Ukrainian battlefield. Essentially, everything that the Russians make, except a main battle tank can be defeated with a little weapon system that goes this long and it's three of them carrying the [indiscernible]. That's a paradigm shift on what type of missions you can do with the Switchblade 300. And that's just one of 20-plus other improvements and enhancements in that product line. Same thing with Switchblade 600 and same thing with Switchblade 400. And we don't have time to go into all the details, but I just gave you one little example on one iteration of the Switchblade 300 that is we're working on those levels of improvements and enhancements while others are trying to make the first one hit a tank effectively, let alone do all these other missions...

600 is a maritime capable. That's right. You put it on ships.

That's a big improvement. And you could go on a small boat, a boat that is actually moving with a lot of problems in the water. It could take out other assets that are moving on the water. And it's got a whole plethora of things. The gimbal improvements are significant. The anti-jamming software algorithm is significant. The type of radios you can put on it is modular, it could be done. There's a whole list of stuff. It's essentially a next-generation product. It's like a next-generation car. It's a significant improvement to the old model.

To what extent do you find among customers that cost can be a decisive factor in how they buy? And is there kind of a distinction you think in the U.S., maybe there's a little bit more of a capability focus. We wanted to do X, Y and Z, whereas when you take products of fraud to sell, the competitive environment is tougher because cost becomes more of a factor.

Yes. So this is very different than a consumer product like a laptop or an iPhone or iPad. There's a lot of talk about low cost, right? First of all, an FPV that I described that cost $3,000 to $5,000 that's used for the mission that I described is a very small portion of the target TAM or market. We intentionally decided not to play there because we knew that, a, it won't be a bigger mission set; and two, it's not as relevant and it's hard to make a lot of money in. The rest of it, we're the cost leader actually. We're the high-volume producer with the lowest cost, and we compete with all sorts of players in every market, whether it's Puma or Ravens or Switchblade or any of our products, we have not only domestic competitors, but in every international opportunity, we have half a dozen or a dozen of the domestic local competitors. So we can compete on cost very effectively, number one. Number two, I would say, is that there's a different bar when you talk about the U.S. military and our closest allies. Those drones that are made in Ukraine that have all sorts of Chinese parts will never make it into our stockpiles. There's way too many problems with that just on the supply chain alone. The level of the safety that you have to have to get these things certified to the U.S. rigor is significant, high bar. The ability for the performance of the product size, weight and power is enormous. Like one of the most difficult things about Switchblade 300, for example, was to make 3 of them fit in a rack stack with all the gear that can be launched and weighs less than 25 pounds and it carries all that mission, all the warhead, et cetera, et cetera. And so that's not an easy requirement when you include all the other things. The book of requirement becomes the stick. And so the bar people think it's like, all right, I'm going to make a lower cost book, and I'm going to be able to compete with this handbook. That's not this market. This market is years of expertise in the areas, building us a moat, a technology stack, and we've been successfully doing it for 20-plus years. We've had competitors from all corners of the world. And we don't usually lose because of cost. We haven't really. And if you look at our win rate, it's really high in that regard, too.

Okay. So the opposite side of loitering munitions, you've got counter UAS. And so can you talk a little bit about the path to growth? You've got several products here, Titan, Freedome Eagle, which is an effector, LOCUST, which is a directed energy weapon, which you're discussing on Sunday evening on 60 minutes. Where do you have scale already in your counter UAS business? Where could you scale quickly if the demand emerged? And kind of where do you see -- there's clearly high demand for this. How do you see the growth emerging?

Sure. So I'm glad you brought this up because we've lived through it, and it's a very crisp and clear takeaway in my view. The Ukraine war was an inflection point for drones, and warfare with drones and one-way attack and Kamikaze drones such as Switchblade and Red Dragon, actually mostly Switchblade. The Iran conflict is, in my view, and the demand has gone up and the brand and the awareness and the need and the programs and requirements and all that. The conflict in Iran is an inflection point for counter drones and counter one-way attack drones. We have always believed that this market is going to come in, and it's going to lag the market that I just described initially. And I just read a report last week that Iran has launched 1,400 one-way attack drones on UAE alone in one week. One week, I think two or three weeks ago, the head of the oil business within UAE said this is going to be a catastrophic event for the oil economy of the world. And you've seen that in the news every day, et cetera, et cetera. So my point is that we're at that inflection point. We've always had a multilayered approach to defending against drones and counter drones and Kamikaze missiles. First, the easiest, fastest way to protect is RF jammers, detect and defeat. We have the world's best deployed, successful program record won full rate production Titan series of counter UAS systems. You're going to see a lot more of that and all sorts of applications. And the second thing is that just recently, the U.S. government approved the use of those kind of systems for civilian applications of protecting stadiums, music festivals, hospitals, critical infrastructure. That is a massive market. It is not even -- nobody has even scratched the surface. And that is going to start opening up in the next 1 to 5 years. We've got the world's best solution. We're already producing them. We've doubled, tripled capacity. We're going to -- we're increasing the capacity of that product up to $0.5 billion next fiscal year. And it's going to be a significant growth driver.

And that's just Titan.

Just Titan series of products for RF jammas for all these applications. The second category -- the second layer of defense is directed energy. That is our LOCUST systems. That was in the 60-minute news this past Sunday. And why is that important? We -- I believe personally that the holy grail for counter drones and counter loitering munition and counter one-way attack is going to be a direct energy solution for military? Why? Because military adversaries have -- are more sophisticated and these drones and counter drones are not going to be jam a bull. They're not going to have dependency on RF communication. When you don't have that, then you have to be able to detect these things and defeat them without having an RF signature. And that's where direct energy LOCUST comes into play. We've got, by far, the largest moat and competitive differentiators in that category than anybody else that I know of in the whole world. And we've got the sweet spot solution. There's a program record with the U.S. Army. They're competing it, and we're competing on a program. And hopefully, they'll have a decision. And that -- it's the first ever program record in this category for the U.S. military ever to buy production level product and the conflict in the Iran is basically as poster child of. What are you going to do when thousands of these come to you? That thing takes the cost of kill per target from millions of dollars per missile to $3 to $5 per shot. That economic equation is going to absolutely eventually prevail. And that's the solution. The third layer is if those two first layers of defense fail, then you use a kinetic kill. And that's where the Freedome Eagle-1 comes into play, which is a little bit further behind in adoption. We've got -- we've been down selected with the U.S. Army for program on record. It could be as large of a franchise as a javelin missile. It's a very economical system that is focused directly for Group 1 through 3, mostly on Group 3 and eventually even to hypersonic missiles in terms of its market. And so our approach has always been a layered approach. We've got the best solutions on the first two, and we're developing the best solution on the third, which is another 1.5 years or 2 away.

Right. And is the -- do you think purchases from nonmilitary customers on Titan will be coming soon?

Really hard to predict the exact timing. I do believe it's going to come, whether it's going to be in the next 3 quarters or next 1.5 years, I believe it's going to continue to pick up because there is a significant amount of awareness in this area. And I believe that -- I hope it doesn't take a catastrophic event for this to happen. But events such as the World Cup, the Olympics, large stadiums, there's already expertise within these organizations trying to develop solutions and capabilities to defend against these kinds of threats. And NFL doesn't want to be known for a football game that doesn't have protection against this or the Major League Baseball or whatever, I'm just using that to develop examples.

And what he referred to the law change allows state police to use the Titan systems, and we've already seen some demand picking up there from the state governments. State police.

And we've seen, I guess, it's been reported in the press some use of the LOCUST by Customs and Border Patrol or the Army on the southern border. We know that there were some issues there involving the airport in El Paso. But we assume that, that has to do with -- that was -- that doesn't -- that involves the system working the way it's supposed to. It's just there wasn't maybe as much knowledge as there should have been about the fact that it was going to be on.

Well, the system worked exactly how it's advertised and how it's supposed to work. A drone was in airspace that it was not supposed to be there. The commander had the decision authority, had to make the decision. It's their decision, not ours. We're not involved in that. We provided a system that said we're going to do X if you ask it to do X, and it did exactly X when it was asked to do X. The bigger awareness is about the use of directed energy systems in the national airspace. That has been a big, big challenge because nobody has been able to crack this code. We're one of the first players that actually has a system that's now operationally deployable that could be useful for those use cases. And FAA actually just recently did a test against a manned airplane where they took our system and they used it against that to see if it is safe. And there's, first of all, hundreds of safety measures built into the system to begin with, literally over 100. But beyond that, actually proved in the FAA test that you are not going to be able to harm a commercial private manned airplane with the system that we have and the use cases that we have. So I think it's going to open up a significant more -- this is a new territory, right? FAA and U.S. Border Patrol and U.S. Army, they all have to work together on deconflicting. And that's something that is happening as we speak, and that's not the decision that we make as our customers.

I guess maybe two questions about just the stuff that's going on in the world now. I mean, are there opportunities to sell counter UAS systems quickly to countries in the Gulf?

Absolutely, there is. So really, right now for counter UAS RF detect and defeat Titan is really not necessarily demand, it's capacity. We are making them as fast as we can. And like I said, we're going to probably do -- we've published some numbers, as you know. We're significant -- we've more than doubled the capacity this fiscal year, and we're taking it up to $0.5 billion worth of capacity production this fiscal year, which is 1.5 months away. And so I believe that we're going to -- that's going to be a very -- probably one of the top growth drivers of our portfolio. We have a lot of growth drivers, but that's one of the biggest ones in terms of next fiscal year. And it's also a very highly profitable and EBITDA favorable product line.

That's -- is that like -- that's a fixed price...

Commercial item.

Commercial item with commercial margin?

That's right. And that came from the BlueHalo portfolio. It actually is in our Segment 1 business in terms of where it exists within the portfolio and reporting, but it actually came from the BlueHalo portfolio. It is the one that is most mature that's transitioned into a commercial product. We're selling it as a commercial item. We have a price list. We are already selling it to a bunch of international customers. It's been publicly disclosed that it's very effective in Ukraine conflict, and the market for that is fairly large globally.

Okay. Other conversations or conversations about other products you may have been having recently, have things picked up with the Department of Defense here about not just counter UAS, but also whether it's loitering munitions or drones. And to the extent that we see a war time supplemental, is that something where you might expect to see some funding for AV products?

Absolutely. I'm spending a lot of time in D.C., including this week and next few weeks, because, a, our categories are in high visibility, high profile, high importance and urgent, and we've got the best solutions in the market. And then also our system -- we're one of the very few companies that can actually produce these by the thousands today. We're doing them today. We're the volume leader in terms of production capacity now, not two years from now, not 24 months from now. So there's a lot. And of course, the complex that you see is like poster child of the side type of system that you need from AV and that we make, and we've been pioneering these for a while

Okay. Okay. I wanted to ask you about SCAR. I started covering the stock relatively recently. And it seemed like something happened in November reading about SCAR and the feedback from the customer and then the stop work order in January and then subsequently, the cancellation last week. Can you talk a little bit about what happened between now and then? And how is there a potential path to continuing to work on this?

Sure. So I'm only able to comment on it based on what I'm allowed due to our contracts and sensitivity to our customers in respect for them. Ultimately, we are a firm, firm believer in this capability and also in this capability gap. It is of high, high importance and urgency to the Department of Defense war. It is a very high priority for the space force, and it's a gap that must be addressed. We believe we have a very significant head start than anyone else. This program was completed. We were -- we won the program. There's been a lot of scope creep. And we want to make sure that the overall program is successful to meet our -- the mission of our military customers and our country. What we wanted to have is a structure where we can actually develop and deliver this product at a commercial item. That is now really, really attractive to the U.S. Department of War. And so we sat down to see if we can renegotiate this contract and come to an agreement and there was only two options. You can come to an agreement on the existing contract or you can cancel and basically restart the program out the way. We believe in this capability so much that we're going to continue to develop the capability as a commercial item on our own investments because we do know that the market for this is significant. Every satellite that we have in geosynchronous satellites in space, including even nondefense satellites is going to need this capability. You've got a parabolic dish right now talking to a satellite one at a time. And it's limited in bandwidth, limited in capacity, it's vulnerable, et cetera, et cetera. Our phased array BADGER system allows you to talk to multiple satellites, up to 20 at a time, and you could do it simultaneously with higher bandwidth and multiple bands, and you could do it such that you could point -- without pointing the dish, you just point it digitally with electronics. It's basically a satellite dish and a chip instead of a dish. And the improvements in performance is massive. Eventually, all the satellites in the world that are geosynchronous and even neosynchronous satellites are going to take some of the systems like this. So that's why we believe in the fundamental problem and fundamental solution architecture. While we do this, the government may recompete, recompete that they've said that publicly. And we are going to absolutely compete for that. But we hope that we actually develop this ahead of all that and deliver a solution off the shelf and the customer could buy and the whole thing is solved faster. It was about 5% of our revenue last year. We're still going to have a strong growth this year. We're still expecting to have double-digit growth next year. It's going to be less than 5% of our revenue going forward. We wanted to get this all cleared, so the story is behind us and we move forward with all the other exciting growth stories that we have in our business.

And -- when you were saying that the growth next year, you meant for the company as a whole? Or are you talking about SCAR?

No, company as a whole. Like I said, we have so many shots on goal that are very large potential growth opportunities. SCAR is just 1 of 10 or so. And we wouldn't expect SCAR to grow that fast immediately anyway. And it wasn't a massive revenue contributor either.

Okay. Okay. So when you think about the write-down that you took in the quarter last week, the -- does your future success on whether the program is called SCAR or something else, but on delivering that capability, might there be further write-downs depending on how that goes?

We don't think so. I mean it really relates to the whole space business, not just the SCAR program. So we've had a lot of positive developments on long-haul laser communications. We've got a $500 million contract there. That business also includes what we call gun sites business. So that's replacing the point and tracking capability on existing armored vehicles is included in that business model. So [ Panther ], the phased array hypersonic missile tracking system is in that portfolio. So there's a lot of things in that portfolio that we feel very good about. It's just -- when you just -- when an event happens, the auditors pull out their spreadsheets and start evaluating the cash flows, and it just so happens that it was a little bit of a shortfall. It wasn't really that significant. The total value of the asset was $3 billion and the write-down was $150 million or so.

Noncash.

Noncash, right?

Noncash entry into the balance sheet.

Yes. Okay. Okay. You mentioned optical communications technology. How should we think about the scale of that opportunity and kind of what happens next there? That seems to be a pretty critical technology as the Space Force thinks about building out the architecture that they want.

So again, we have so many exciting things. It's hard to talk about every one of these and give it enough merit of its own doing. Most companies have one or two maybe max, and we've got like a dozen of these things. Laser communication, so we talked about BADGER being this RF communication phased array that revolutionizes RF communication with satellites. But even that needs to be complemented or supplemented with a laser system because RF systems are all jammed. And so you do not want to rely on one way of communicating to these billion-dollar satellites. The next-generation evolution is to actually have optical laser communication from the ground to these satellites. A, it's much, much more non-jammable; and two, it has got a much, much higher throughput of bandwidth. And we won a program of record basically with the U.S. military to develop and deliver and progress the program, which we have what we call the laser communication terminal. We've got the technology that allows you to actually hit a satellite halfway to the moon from the ground. That technology is 250,000 kilometers out. And so it is the holy grail, again, long term for satellite communication to the ground. And we are -- and the secret sauce that is in our BADGER system and our LOCUST system is and our laser gun site is very similar to what Kevin had described here, which is the ability to track and hit the target at long, long distances. And that's something that's not easy to do. Everybody is focused on more power. It's like giving somebody more bullets, but they don't know how to hit the target. It doesn't help solve the problem if you can't aim. The most important thing is solve the aiming problem, then I can give you more bullets to kill more targets or hit more targets. And so our ability to hit a small -- give you an analogy how precise and how accurate this is a laser pointer that we have in here, for example, imagine pointing this to a strand of human hair about a football field away from you with your human hand. Yes. So you got to have the precision to be able to put that laser on a strand of human hair at a distance of about one football field. We've got to hit a satellite dish at 70,000, 80,000, 100 kilometers out in the space from the ground while the satellite is moving and the earth facilitating. That's the technology that makes it so unique. And I do believe that in the next five years, a significant more funding and acquisitions will happen in this area specifically.

Okay. Yes. Excellent. .

And we're to lead in the space, by the way.

Yes. And I know it's a place where people have been trying for a while to make progress. The piece -- when I think about the BlueHalo merger and the company that came in, I thought of it as like a kind of stable piece and a growth piece. And we just talked about kind of the growth pieces is space and directed energy. The more stable piece was kind of cyber and Mission Systems. That business seems like it's headed for maybe $350 million-ish of sales this year, ballpark. But we have seen some pressure. Can that cyber and mission business maintain that level of sales going forward? Is that kind of how people can think about it? Is there further pressure on it? Can it return to growth? What's sort of the profile there.

Yes. So by far, the biggest value driver as part of the acquisition of BlueHalo was all these pieces that I described that are long term. The strategy has always been to bring these very complementary set of solution sets to make a portfolio that really solves our customers' missions better. Cyber, we've always said it's not going to be the fastest growing. It is also the one that got hit with the [ dodge ] activities at the beginning of the fiscal year, the administration. We have a baseline. Yes, $350 million is very doable, number one. Number two, we expect that actually to grow going forward. It's just that the growth is not as explosive as the other categories. We've always said that. We maintain that. We're doing -- it's absolutely a high mission-critical set of cybersecurity operations that we do that's both offensive and defensive that is really unique and desperately needed in our military and our intelligence community. So we believe that this is important, but it's not high growth. It's going to grow, but very slow, single digits.

Okay. Okay. We're getting close to the end. So maybe if we can sneak in one more. Just when we think about the expectation and the cash flow expectation for the year, we've seen some working capital growth year-to-date. What gives you confidence of being able to liquidate that here in the fourth quarter?

Well, this year, we had a lot of growth in our Switchblade or loitering munitions business. So a significant growth. And at the same time -- and that's probably the main driver of the working capital growth during the year is that business. We also, during this year, had some product transitions and new products, specifically, as Wahid was mentioned earlier, the Switchblade 600 and 300 went to new generations. And that just caused a little bit of a log jam in our unbilled receivables. And that all seems to be behind us now. I think we'll see some good progress in the fourth quarter, but not all the way there, but then in the successive quarters start to see that unbilled coming down for that business.

Right. Okay. Okay. Excellent. And with that, we're out of time. So yes, this was very informative, and we appreciate both of you being here. Thanks very much.

Thank you so much. .

Thank you