Bandits at 10 o'clock high!

Having been raised on syndicated episodes of Baa, Baa, Black Sheep, that's how I imagine Wall Street's reaction to AeroVironment's (NASDAQ:AVAV) Q1 2009 earnings report. While the Street was scanning the horizon for flat earnings and sales, AV attacked from above, reporting earnings 22% higher than expected ($0.22 per share) on revenue 7% greater than predicted ($53.6 million.)

As a result, AV achieved complete tactical surprise, and its shares surged. After scoring back-to-back "up" days post-earnings, shares of AeroVironment now cruise 19% above their pre-earnings altitude.

A pleasant surprise
As you may recall from our pre-earnings Foolish Forecast, AV's retooling of the radio frequency on its UAVs this past quarter was expected to slow down unit production, resulting in essentially no sales or profits growth over Q1 of last year. Instead, sales grew 9%, and profits were up 25% year over year. As for the rest of the "important numbers," they look like this:

Cash flow
Inventories grew 26% year over year, outpacing sales growth. As a result, free cash flow ran negative for the first fiscal quarter, but considerably less so than last year. Total negative free cash flow for the quarter: $5.3 million.

Backlog, which AV defines as "unfilled firm orders for which funding is currently appropriated to us under a customer contract," grew 76% from last year's Q1, to $108.9 million. That's much faster than sales grew in the quarter, and it suggests we'll soon see AV's afterburners kick in, sending sales soaring much faster than the 9% rate we saw in Q1.

Even so, AV is sticking to its usual -- and usually conservative -- projection of 20% to 25% revenue growth this year. Management continues to expect to earn an operating margin of between 12% and 14%. For the record, Q1's take landed dead center in the middle of this range -- 13%. That keeps the company neck-and-neck with Shadow-caster Textron (NYSE:TXT) and MAV-maker Honeywell (NYSE:HON) in the race for operating profits.

Lagging behind in this trio's contrails are UAV comms-specialist L-3 (NYSE:LLL) and Desert Hawk manufacturer Lockheed Martin (NYSE:LMT), which both earn less than an 11% operating margin. Even further behind: Fire Scout-er Northrop Grumman (NYSE:NOC) and ScanEagle-scout Boeing (NYSE:BA), both pulling down single-digit margins.

The rest of the story
So much for what we learned from the press release. Now it's time to get the backstory on all this good news, as we turn to AV's post-earnings conference call with analysts -- courtesy of our friends at

Presto-change-o! Your wish is AV's command
Perhaps the most startling news contained in AV's release this week concerned its recent DARPA-award to develop a "hover/perch and stare" UAV. This miniature airplane can fly to a target location, land there, and keep an eye on things from a perched position. When it's done, it can take off from its perch and fly back to base.        

As you may recall, AV only announced its win on this contract three weeks ago. Now CEO Tim Conver tells us: "we are developing and have now demonstrated a new aircraft based on our one-pound Wasp that can perform vertical take-off and landing, hobbler, perch and steer machines in a very stealthy manner" [emphasis added].

Turbulence in the cash flow
There's plenty to like about AV: Superb margins, surging backlog, strong sales growth, and great management -- smart enough to identify a growth market in UAVs, and then target niches both below and above where the Big Boys are flying. But AV has PR people to talk about that. As investors, it's our task to dig up the dirt that investor relations might not be as quick to publicize as its successes. So where's the downside to AV's report?

Right here, actually
Over the past 12 months, AV generated $10.7 million in free cash flow. That's a positive number -- which is good. But it's less than half the net earnings AV reports under GAAP.

That's bad, and it's going to get worse. Discussing this year's capex requirements, CEO Conver confided that: "CapEx ... will probably creep up as we go through the year. CapEx was 4% of revenue for the quarter and I expect 5% to 6% for the year." If you posit $264 million for fiscal 2009 sales (22.5% higher than fiscal 2008), 6% capex comes to about $15.8 million -- approximately twice what AV spent on capex last year.

Now granted, the surge lies in "expansion capex" -- expenditures necessary to facilitate future growth. So as quibbles go, I suppose you could call this one "minor." Fortunately or unfortunately, minor quibbles are all I've got left.

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