High-tech firms, fresh from a Nasdaq IPO, aren't often models of reticence. If an ordinary Nasdaq newcomer grows its revenues 1%, but sees its profits slashed in half, it's as apt to headline its earnings release "XYZ Corp. Achieves Record Revenues," as not. But AeroVironment (NASDAQ:AVAV) appears to be the exception that proves this rule.

On Tuesday, the maker of small, unmanned aerial vehicles (UAVs) and PosiCharge quick battery chargers issued an earnings report headlined simply: "AeroVironment, Inc. Announces Fiscal 2008 Second Quarter Results."


But wait. Despite the snooze-inducing headline, this report actually contained some headline-worthy good news. Quarterly sales grew 19% year over year to $53.7 million, beating consensus expectations by a good 6%. And the way I read the release (optimistically, by the way -- I am a shareholder myself), similarly good sales news could keep on coming. Management reported that backlog has grown 9% since the end of last fiscal year, to $66.3 million. With all these "unfilled firm orders for which funding is currently appropriated to AV under a customer contract" in its hopper, AeroVironment (AV) predicts it will see 20% to 25% sales growth for this year, an acceleration from the pace set in Q2.

Sales are good. But were there any profits?
Profitability-wise, operating margins came in at 12.2%, comfortably above the trailing-12-month margins of a whole array of larger defense contracting rivals: Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC), Boeing (NYSE:BA), L-3 (NYSE:LLL), and General Dynamics (NYSE:GD). And profits per share came in at $0.24 -- $0.03 higher than Wall Street estimates, but a good $0.07 lower than in last year's Q2.

Hold on a sec
Wait, isn't there a disconnect here? How does 19% sales growth turn into a 23% earnings decline? The answer to that one-part question is a two-part answer:

  • Remember that AV is a recent IPO. In last year's Q2, the firm's profits got divvied up among fewer shares. More shares generally mean fewer profits per share.
  • Gross margins declined by 410 basis points to 35.2%.

Now, as I mentioned in Monday's pre-earnings Foolish Forecast, my intention was to discuss AV's free cash flow in today's column. However, management has yet to include a cash flow statement in its earnings release -- which throws a monkey wrench into my plan. So instead, let's spend a few minutes looking at gross margins while we wait for AV to publish its 10-Q containing the missing document.

Two streams
Looked at one way, AV has two revenue streams: UAVs and PosiCharge. Viewed from a different angle, however, you can say it has two revenue streams: products and services. As a general rule, AV earns better gross margins on its products than on its services (39.4% and 28%, respectively, in Q2). Both margins dipped in comparison to last year, however. Products shed 170 basis points worth of gross margin; services, 750 basis points.

That's only half the story, however. In addition to suffering the greater gross margin decline, services revenue also provided most of AV's growth in Q2. Up 38% year over year, it grew nearly four times faster than did the products side of the business. While this contributed to the company's stellar double-digit sales growth and "revenue beat," it had the unfortunate side effect of compounding the impact of slumping services margins on the firm's overall gross margin.

Foolish takeaway
Long story short, this was a good quarter that could have been better. If AV is to maintain its profitability lead over its larger rivals, we're going to need to see it post more contract wins for Wasp III and Raven UAVs, and depend less on services contracts for its growth. That may cost it the chance to crow over rapidly rising revenues -- but happily, that doesn't seem to be AV's goal.

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Fool contributor Rich Smith owns shares of AeroVironment. The Motley Fool has a disclosure policy.