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Spruce Point Shorts AeroVironment

Spruce Point Capital Management has today released the contents of a unique short idea involving AeroVironment, Inc. (Nasdaq: AVAV), a producer of unmanned aircraft systems (“drones”) for military usage and electric vehicle chargers.

Here is the release in full:

"Spruce Point has conducted an extensive fundamental and forensic accounting review of AeroVironment, and believe that investors are overlooking significant long-term business challenges, poor capital allocation, questionable governance issues, an undisclosed whistleblower complaint, and technical factors causing temporary overvaluation.

As a result, we have a "Strong Sell" opinion and a long-term price target of approximately $24.00 - $34.00 per share, or approximately 30% to 50% downside risk.

AVAV Nearly Identical To Our iRobot Short, Another Over-Hyped Play On A Laggard In Its Industry:

Spruce Point conducted an extensive evaluation of AVAV, and find it to be a nearly identical stock promotion to IRobot. AVAV is being hyped as a play on drones, but its products are stagnant and being out-innovated by peers. Like iRobot, we find: 1) Foolish stock promoters, including a former one tied to a notorious Ponzi-scheme, 2) Poor governance + unjust insider enrichment, 3) Continuous insider selling, 4) Poor capital allocation, 4) Frequent accounting errors + warranty revisions, and 5) Nonsensical and distorted valuation

AVAV’s Recent Outperformance Makes Little Fundamental Sense And Partially Fueled By Excessive ETF Buying:

A perennial underperformer in the market, AVAV stock is +80% YTD despite management offering the lowest revenue visibility in years, and temporary growth off a depressed base last year making comps look good. AVAV trades at the highest valuation multiples in its history and at 2-3x the multiples of defense-industry peers – despite the fact that it has produced no sustained revenue or FCF growth over its history, has not undergone any fundamental transformation, and earnings visibility declines every year. We believe AVAV’s price surge has been fueled by billion-dollar inflows into the fastest growing ROBO, which at one point had AVAV as its #1 holding. We think ROBO ETF restrictions will limit additional share purchases, and it may have to sell because AVAV’s bad governance and military applications may conflict with ROBO’s ESG policy (environmental, social and governance)

AVAV’s Drones Fail In Real-World Conditions; Its Technology And R&D Have Fallen Behind:

While hope springs eternal that AVAV will one day broaden its horizons by selling its drones to businesses and not militaries, the market has overlooked the evidence that its drones work poorly even for military uses. An internal Department of Defense document released via FOIA request 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. Military test operators used words like “chintzy,” “cumbersome,” and “horrible” to describe AVAV’s drones. Other real-world users speak of routine crashes and other shortcomings, using harsh language (“even in training they f^g sucked,” “that thing really was a piece of s^t"). When the Ukrainian military received AVAV drones as aid from the US in 2016, it quickly abandoned them, citing poor performance including susceptibility to enemy jamming. We believe complaints about AVAV’s product fundamentally stem from its stale technology. R&D staffing and capex as a percentage of sales have declined over the years, while staffing for overhead functions has grown, giving a picture of a bloated company not committed to the cutting edge and a vehicle to enrich mgmt. For a decade, AVAV has made very few changes to its product line-up, with only one significant new model in the past five years. Meanwhile, it has wandered into several major technological dead ends, including an overpriced vertical-takeoff drone and two larger, higher-altitude drones that have failed to drum up any actual contracts. These failures are quietly swept under the rug through frequent revisions to what AVAV actually says it does.

AVAV Faces Poor Industry Dynamics In Both Its Businesses:

In the drone/UAS business, hype about commercial drone adoption has begun to fizzle, with competitors like 3D Robotics, Parrot, Autel, and Yuneec all going through layoffs or closing. No one has been able to make a dent in the leading position of DJI, a Chinese drone manufacturer known for high-quality and relatively inexpensive products. VC funding has also begun to dry up. Meanwhile, FLIR Systems, Boeing and Intel have all just acquired drone companies, aiming to expand the reach of their technologies, while another small competitor has started to sell spare parts for AVAV’s own products to the US gov’t – all signs of greater competition. The notion that AVAV has a long runway of growth in int’l markets is belied by the tiny relative size of non-US military spending, and, even as new int’l customers do come on board, the growth is not sustainable since military drones are durable and don’t need to be re-purchased routinely. In the long run, the US military will work toward using cheaper commercial drones, a negative for margins

In AVAV’s electric-vehicle charging business (~10% of gross profit), there is little to distinguish its products in a crowded market with few barriers to entry. Product reviewers see no standout benefits to its offerings, and large companies like GE have already exited the market. Despite working on EV charging for years, AVAV’s business and margins have shrunk!

Undisclosed Whistleblower Complaint, Compliance Record Merit Scrutiny:

If the fact that AVAV is on its fourth CFO since coming public doesn’t concern investors, then perhaps an undisclosed whistleblower lawsuit will. AVAV’s former VP of Strategic Operations – an executive important enough that his initial hire was officially announced – accused it of fraudulently obtaining gov’t reimbursement for costs connected to the non-military EV-charging business. He alleged that “false billings” cost the gov’t tens of millions of dollars. The lawsuit was eventually dropped. If true, such misdeeds would appear to be consistent with AVAV’s past issues, including a DoJ investigation of its billing practices, an unexplained recent lapse in approvals from the Defense Contract Management Agency, and unexplained violations of State Department export restrictions. AVAV’s audit fees have been suspiciously rising to new highs ever since the whistleblower complaint and imposition of an equity clawback for management's incentive bonuses adopted in 2013

Terrible Capital Allocation and Governance Echoed By Undisclosed Whistleblower Complaint:

If the fact that AVAV is on its fourth CFO since coming public doesn’t concern investors, then perhaps an undisclosed whistleblower lawsuit will. AVAV’s former VP of Strategic Operations – an announced executive hire – accused it of fraudulently obtaining gov’t reimbursement for costs connected to the non-military EV-charging business. He alleged that “false billings” cost the gov’t tens of millions of dollars. Such misdeeds would be consistent with AVAV’s past issues, including a DoJ investigation of its billing practices, an unexplained recent lapse in approvals from the Defense Contract Management Agency, and unexplained violations of State Dept export restrictions. Recent insider behavior to change bonus targets to extract incentive bonuses is even more distasteful in light of its squandered opportunity cost with excess capital (AVAV doesn’t acquire, buyback stock or pay a dividend). This behavior exists while AVAV’s audit fees have been rising to new highs ever since the complaint and adoption of an equity clawback in 2013.

Stock Promotion Runs Deep At AVAV, Valuation Can Correct 30% - 50% As Disappointment Looms Large:

Insiders have consistently sold shares (47% post IPO to 11% ownership currently), while a laundry list of rogue brokers have relentless pumped AVAV since its IPO (remember Stanford Financial or Jesup & Lamont?). Also don’t be Fooled when Mr. Motley says buy, recall they have also relentlessly pumped iRobot. True to form, AVAV has exhibited terrible FCF generation and margins, high management turnover, unwillingness to engage activist investors, and limited long-term share price upside until recent ETF buying. Even typically optimistic sell-side analysts don’t currently recommend AVAV, with zero buy ratings and an average price target of $40 (implying 17% downside). AVAV’s valuation current peak valuation of approximately 3x and 30x 2018E Sales and EBITDA will eventually normalize with defense industry peers and with its own historic valuation. As a result, we see 30%-50% downside in its share price, or $24 to $34 per share, representing a terrible risk/reward."