AeroVironment Inc., a highflying drone company that has seen its share price soar over 2017, may be headed for a hard landing, according to a short seller who expects the stock could lose as much as half of its value.
Spruce Point Capital Manage on Wednesday issued a “strong sell” opinion on AeroVironment AVAV, blasting the company’s management, technology, and recent share-price appreciation, which it argued gave it a valuation that was “nonsensical and distorted.” So-called short sellers profit when a stock declines by borrowing a chosen name and selling it with the hope of returning it at a lower price and pocketing the difference.
After the Spruce Point report was released, a spokesperson for AeroVironment provided a statement that read, in part, “As a result of the strategic investments we have been making, our growth portfolio includes multiple pioneering initiatives advancing toward very large markets with the potential to significantly expand our business.”
Ben Axler, Spruce Point’s chief investment officer, responded to the statement by saying, “We look forward to AeroVironment’s ability to hit targets this year and in the coming years. The company has a history of false starts and missed expectations. Everywhere I look I see a business whose quality has declined, though the stock is at all-time highs.”
AeroVironment’s stock has been a strong performer throughout 2017, up more than 70% thus far this year, hitting record levels in October. However, it fell 7% on Wednesday after the report was published, bringing its drop over the past month to nearly 16%.
The S&P 500 is up 15.6% over 2017, while the ETFMG Drone Economy Strategy ETF an exchange-traded fund that owns companies who derive some portion of their revenue from drone technology, is up nearly 33%.
Rather than optimism over the company’s growth prospects, Spruce Point credits the move in AeroVironment’s stock to the high degree of ownership that ETFs have in the company. The company is widely held by ETFs, with nearly 22% of its shares outstanding held by them, according to data from research firm XTF, a rate that is much higher than average.
According to an analysis of XTF data, the 15 smallest components of the S&P Small Cap 600 index have an average of 12.2% of their shares outstanding held by ETFs, and those companies boast much smaller market capitalizations than AeroVironment, which is currently worth $1.12 billion. Smaller companies tend to have a higher percentage of their shares outstanding held by ETFs.
A particular buyer of AeroVironment’s stock is the ROBO Global Robotics and Automation Index ETF which has been an investor favorite this year. The fund has seen $1.3 billion in year-to-date inflows, bringing its total assets to $1.7 billion. The stock is the 20th largest holding of the fund, accounting for 1.55% of the portfolio.
“We believe AVAV’s price surge has been fueled by billion-dollar inflows into the fastest-growing ETF ROBO, which at one point had AVAV as its #1 holding,” Spruce Point’s report read.
Typically, heavy trading of an ETF has limited effect on the underlying holdings. However, there is a more pronounced effect when the ETF in question is more heavily traded than its underlying securities, particularly when those stocks are smaller or less liquid.
According to a July report from Cirrus Research, “companies with higher ETF exposure have steadily underperformed their counterparts since last June.” It added, “There is clearly a clustering in long-only ETF strategies that has resulted in blind mispricing.”
The ETF buying, in Spruce Point’s view, has contributed to AeroVironment’s valuation. The stock has a price-to-earnings ratio of 53.8, according to FactSet data, more than twice the ratio of the overall S&P 500 and significantly higher than other drone companies. The average P/E of the components of the Drone ETF is 35.53. (There are few public companies that are exclusively involved in drones, which makes direct comparisons difficult. The Drone ETF also counts names like Boeing and Intel among its major holdings.)
The company “trades at the highest valuation multiples in its history and at 2-3x the multiples of defense-industry peers—the despite the fact that it has produced no sustained revenue of [free cash flow] growth over its history, has not undergone any fundamental transformation, and earnings visibility declines every year,” Spruce Point wrote.
The firm forecast downside of 30% to 50% in the stock, and beyond its concerns over the company’s valuation, it cited severe doubt about AeroVironment’s technology.
“The market has overlooked the evidence that its drones work poorly even for military uses,” it wrote, citing internal Department of Defense documents that it said it had obtained through a Freedom of Information Act request. The document “shows that one of AVAV’s key products “‘did not meet key performance parameters,’ calling into question its usefulness in actual combat. Problems included poor landing accuracy (with a 44% failure rate), an inability to cope with high winds (a feature that was supposed to be designed into the product), and an unexpectedly heavy and fragile carrying case.”
These issues “stem from its stale technology,” Spruce Point wrote, arguing that its research and development staff, as well as its capital expenditures as a percent of sales, had declined in recent years.
AeroVironment’s statement read that the company expects double-digit revenue growth in its 2018 fiscal year.
According to FactSet, individuals have been the biggest sellers of AeroVironment stock over the past three months, selling 54,650 shares. Timothy Conver, the company’s chairman, has been the biggest seller, reducing his position by 46,000 shares. (He continues to hold 2 million shares, or 8.39% of the total outstanding stock.)
Cathleen Cline, a senior vice president at the company, has sold her entire stake of about 18,000 shares over the past three months, according to FactSet.