A Portfolio of Drone Exposures

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Submitted by Thomas Keane as part of our contributors program.

A Portfolio of Drone Exposures

The term unmanned aerial vehicle (“UAV”) or “drone” is one very much at the forefront of popular media and technology at present. That drones are set to revolutionize surveillance and operational tactics in both a commercial and military sense, is a widespread belief among enthusiasts. Of course, the investment community has also taken a stance, with many retail and institutional investors backing the aforementioned perception. Looked at in a little more detail however, to say that drones are about to revolutionize these spaces is a little too vague. The scope in terms of size, range, application and ability is huge, and investors must take this into consideration when deciding where to allocate capital so as to gain the right combination of risk and reward. Fortunately, the industry can be broken into three generalized categories, each of which looks to hold opportunities. Investors must ask, which of these categories offers the greatest promise?  And which company in these categories could be the most rewarding to add to a UAV portfolio?

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Large military drones

Many look at drones as a relatively new technology, but as far as military applications concerned this is very much not the case. The history books speak of unmanned balloons filled with explosives being used as early as 1849 in Venice, and the first large-scale production, purpose-built drone — the Radioplane — was built and sold by Reginald Denny to the British military in World War II.

Fast forward to modern day, and the incumbent military aircraft providers all build and produce a particular type of drone intended for military use. In the recently released US military budget, reported by the Pentagon in March this year, military spending remains relatively flat as a whole but drone spending is set to increase dramatically during 2015 with the space afforded a $59.7 million increase over the 2014 budget. So where can investors allocate capital in order to take advantage of this increase? One of the most intriguing opportunities looks to be Boeing (BA). On a general front, the company looks like promising bet over the next 4 to 5 years without its military drone revenues, which recently reported second-quarter passenger jet deliveries rising more than 7% through an increase in its 787 demand. Company expects a close to $5 trillion demand for more than 35,000 new airplanes over the next 20 years, and has consistently shown it is able to generate a sustainable cash flow and maintain a stable operating margin. So when the drones come into this? Military sales have, over the past couple of years, been relatively poor compared to commercial sales for the company. This could be about to change however, as a new generation of combat UAVs is about to hit the market. The current combat UAVs are becoming obsolete, and Boeing has developed what looks like it could be a market leading product. Through its wholly-owned subsidiary Insitu, has developed a number of currently in use UAVs — the ScanEagle and the RQ-21 Blackjack — but is also working on a project called Phantom Eye. The U.S. Air Force is funding this experimental stage UAV, and it is slated to be a successor of the Boeing Condor, the record-breaking UAV designed and developed in the 1980s. The company expects this new development to be a liquid hydrogen fuelled surveillance drone that can hover at high altitude for as long as 10 days. If this is achieved, it would exceed the current hover time by just short of eight days, and as such, a considerable advantage over its main competitor ? the Northrop Grumman (NOC) built Global Hawk.

Small commercial drones

This is the space that many predict will be the fastest-growing area of the UAV industry over the next decade. Current FAA regulations make it very difficult for companies to use the commercial drones in the US, but this is set to change by September 2015. The FAA had been ordered to draft regulations that will allow commercial entities to incorporate a range of UAVs into their operation, and the applications seem almost endless. One way to gain an early exposure to the industry that analysts believe will generate $100 billion revenue over the next 10 years is through AeroVironment, Inc. (AVAV). In June this year, oil and gas incumbent BP (BP) announced it had received the first commercial license from the FAA for the use of drone’s in US airspace. The drone now flies above largest oilfield in North America in Alaska using high-tech sensors to create 3-D computerized models of roads, pads and pipelines for industrial application. The company that designed and manufactured the UAV — AeroVironment. AeroVironment is already be Pentagon’s top supplier of small drones, but with military operations winding down in Iraq demand for its Raven, WASP and Puma models have declined. For this reason, fresh revenue streams such as that offered by the commercial BP contract could be key to the company’s growth and sustainability. Being a first mover in this space offers the company a huge advantage over numerous other start-ups attempting to gain a portion of the aforementioned $100 billion, making AeroVironment an attractive exposure to the nascent industry.

Tethered drones

As mentioned, the FAA has been ordered to draft regulations for the legalization of UAVs by September 2015. This, however, looks optimistic, with reports already suggesting that the FAA is behind schedule. This lag, possibly up to anywhere between two and three years, offers an opportunity for those companies that design development and manufacture tethered drones. Tethered drone, as its name suggests, is a UAV that is attached to a grounded base by long cable feed. The tethering allows them to bypass the FAA regulations, and as with their non-tethered counterparts, there were already in extensive use in the military space. One company, is seeking to bring his tethered drones to the commercial space to take advantage of the FAA delay ? that company is Drone Aviation (DRNE). Through its wholly-owned subsidiary Lighter Than Air Systems (“LTAS”), the company develops two primary forms of tethered drone and is currently executing strategy to roll drones out in the commercial space. The first, the “Blimp in a Box” system, is already used by the U.S. Army and The U.S. Army Space and Missile Defense Command to provide and extend secure communications for to 20 km in areas where no communications exist. The commercial alternative, which can be launched and operated within 15 minutes in order to provide instant support an emergency scenarios or surveillance in instances where a large crowds exist is already in use by a number of transport departments and correctional facilities. Drone aviation expects to expand its customer base over the next 15 months to include police departments, national parks, and a range of other potential customers. The second of the company’s technologies is a quad-rotor copter. Again already in use by the US military, the quad-rotor copter has many of the same applications as the small commercial drones mentioned in the previous section, but it’s tethering makes it both legal and much more efficient (it is powered from the ground and so can remain airborne for much longer and at much lower cost than non-tethered alternatives). The increased mobility, it can also be attached to a moving vehicle and programs to follow the vehicle whilst in motion yet remain stable when the vehicle stops. Drone aviation expects this technology to provide immediate aerial surveillance and communications solutions for various applications ranging from disaster management the daily highway monitoring police support.

In short, drone aviation offers an exposure to the nascent UAV industry at a time when many other companies will not be able to generate revenues as a result of FAA guidelines.