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3 Reasons AeroVironment's Stock Could Rise

Monrovia, Calif.-based AeroVironment (NASDAQ: AVAV  ) dominates the production of small, unmanned aerial vehicles in America today, and it pioneered the development of fast-charging systems for battery-powered electric cars. When it comes to rulebreaking, novel-thinking tech upstarts, there are few companies that can hold a candle to AeroVironment. Some are calling the stock expensive, but here are three reasons it could beat expectations.

AeroVironment's Nano Hummingbird is a wonder of non-nature. Source: AeroVironment.

Electric cars are the future

Electric carmakers such as Elon Musk's Tesla are reporting strong consumer demand for their product. Sales of plug-in hybrid and all-electric vehicles tripled between 2011 and 2012, then came close to doubling in 2013. AeroVironment, as one of the leaders in fast vehicle charging technology with its Posicharge product, is in a great position to capitalize on that demand.

Currently, AeroVironment's Efficient Energy Systems business accounts for less than 20% of the company's annual revenues -- and in fact, EES revenues were down in each of the last two years. If the trend continues, that will certainly be bad news for AeroVironment. But if the trend should reverse, that will certainly make it easier for AeroVironment to deliver a positive earnings "surprise."

Drones are still flying

Since beginning production of small, unmanned aerial vehicles for the U.S. military, AeroVironment has produced more than 22,000 drones for America and its allies. The removal of U.S. ground troops from Iraq, however, and the imminent wind-down of U.S. involvement in Afghanistan, has many analysts counting on a reduction in demand for AeroVironment's drones.

And yet, in July, AeroVironment astounded investors with the announcement that its Unmanned Aircraft Systems revenues were up 42% year over year. Clearly, someone is still buying drones from this company. The return of U.S. troops and aircraft to Iraq, albeit in limited numbers today, holds the potential to keep AeroVironment's sales and earnings flying high.

Buyout, anyone?

I know, I know. I'm as suspicious as you are of anyone touting the possibility of a company getting "bought out" by a competitor as a reason for wanting to own its stock. But in AeroVironment's case, a buyout really might be a possibility.

Earlier this year, you see, Lockheed Martin (NYSE: LMT  ) announced the signing of a memorandum of understanding with AeroVironment, by virtue of which the two companies will collaborate on the development of AeroVironment's Global Observer large UAV -- and potentially on other UAV projects. The key here is that despite being the nation's biggest pure-play defense contractor, Lockheed Martin has historically been a bit of a non-entity in drone development.

Buddying up with AeroVironment is one way Lockheed Martin might be looking to rectify its drone deficiencies. Buying the company outright could be another -- and with AeroVironment selling for only about $500 million (net, after factoring its cash into the equation), it wouldn't be an expensive acquisition for Lockheed Martin.

Caveat investor

AeroVironment stock soared 18% in just the first six months of 2014. The downside of this strong stock performance is that, priced at 53 times earnings and 33 times free cash flow today, shares of AeroVironment don't look cheap. This is especially true when you consider that analysts polled by S&P Capital IQ think management will be hard-pressed to grow earnings at AeroVironment by more than 14% annually over the next five years.

Personally, as a value investor, I prefer to invest in stocks that sell for a total return ratio of 1.0 or less. But if you divide AeroVironment's P/E ratio, or even its price-to-free cash flow ratio, by analysts' projected growth rate, you wind up with a total return ratio of 3.8 (using earnings in the numerator), or 2.4 (using free cash flow). Not to put too fine a point on it, but these are very expensive-looking valuations.

But here's the thing: All of this is predicated on analysts being right about AeroVironment's growth rate staying in the mid-teens over the next five years. And as we've seen in recent month, analysts aren't always reliable in their predictions about AeroVironment. In fact, over the past two quarters, analyst estimates of AeroVironment's earnings have been off by an average of more than 100%.

Mind you, I'm not saying Lockheed Martin will in fact buy AeroVironment. I'm not saying AeroVironment stock is cheap, either, or that you should rush right out and buy it. But even if you think, as I do, that the stock might be a little expensive, it's good to be aware of the counter arguments.

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AeroVironment's Global Observer at dawn. Photo: AeroVironment.

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Rich Smith

As a defense writer for The Motley Fool, I focus on defense and aerospace stocks. My job? Every day of the week, I'm monitoring the news, figuring out the winners and losers, and tracking down the promising companies for you to invest in. Follow me on Twitter or Facebook for the most important developments in defense & aerospace, and other great stories.

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