Will Drone Stocks Fly Higher?

Last month, Congress passed the FAA Reauthorization Act, which makes it easier for the government to fly unmanned spy planes over American airspace.  The bill also requires the Federal Aviation Administration to create regulations for the testing and licensing of commercial drones by 2015.  With the new legislation, some analysts believe the commercial drone market in the United States could grow to be worth hundreds of millions of dollars, leaving investors wondering how to capitalize on the expanding market.

The FAA estimates that there could be 30,000 drones flying over America by 2020, potentially creating a boom for drone makers such as Aerovironment Inc. (NASDAQ:AVAV).  The California based company is a leading manufacturer of unmanned aircraft systems and aerial vehicles. Recently, Aerovironment announced it received a $4.1 million order from the United States Air Force for its Switchblade loitering munition systems and services.  The system provides beyond line of sight precision strike capability to dismounted troops.  Aerovironment will work with Alliant Techsystems Inc. (NYSE:ATK) to produce and deliver the systems.

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Although government contracts can give defense names a boost, unseen problems can also cause headaches for defense contractors and shareholders.  The Air Force recently announced it decided to stop acquisition of the Global Hawk Block 30 drones, developed by defense contracting giant Northrop Grumman Corp. (NYSE:NOC).  The Air Force also plans to shelve 18 Block 30 drones, claiming it will save the Pentagon $2.5 billion.  Although shares dipped on the news, Northrop Grumman has remained mostly flat for 2012.  Year-to-date, shares are up 2 percent.  However, over the past three years, shares have gained 80 percent.

Aerovironment is the most drone-based publicly traded company, but there are headwinds facing the new FAA Reauthorization Act that investors should consider.  Several rights groups such as The American Civil Liberties Union and The Bill of Rights Defense Committee are demanding the FAA hold a rule-making session to consider privacy threats due to the increase in domestic drone use.  The petition regarding the matter states, “The use of drones implicates significant Fourth Amendment interests and well established common law privacy rights.”  Furthermore, the Pentagon recently announced $487 billion in spending cuts over the next decade.

Shares of Aerovironment have dropped 14 percent this year and are nearing technical support at $25.  However, more diversified defense companies such as Lockheed Martin Corp. (NYSE:LMT) have gained 8.5 percent this year, while Boeing Co. (NYSE:BA) has declined only 1 percent.  Both major defense companies also payout dividends, whereas Aerovironment does not.  Byron Callan, analyst for Capital Alpha Partners, explained that the biggest defense firms were mostly unaffected by the recent budget cuts, because those companies’ dividend payouts were quite generous.

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To contact the reporter on this story: Eric McWhinnie at staff.writers@wallstcheatsheet.com

To contact the editor responsible for this story: Damien Hoffman at editors@wallstcheatsheet.com