How Risky Is It To Invest In Drone Stocks?

Once largely used by individual enthusiasts and photographers, drones are increasingly becoming key commercial, research and military tools.

With a proliferation of drone startups over the last several years, the technology has also caught the attention of investors looking for the next big thing in aviation.

The question, though, is just how risky drone stocks are and whether they will generate reliable returns for shareholders.

What Are the Opportunities in Drone Technology?

In many ways, it’s quite natural for investors to be interested in drones. In 2022, the global drone market was valued at about $22.4 billion. By 2031, that number is expected to grow to over $165 billion. This translates to a compounded annual growth rate of about 25% through much of the next decade.

Furthermore, drones are expected to facilitate growth in a wide range of different businesses. Walmart, UPS and Amazon are all investing heavily in drone technology to facilitate fast, automated product deliveries.

In agriculture, drones can be used to remotely spray fertilizers and pesticides and even plant seeds.

Another very real opportunity for drone companies can be found in the defense space. Increasingly, drones are becoming fundamental to battlefield operations.

In the ongoing war between Russia and Ukraine, for example, drones have proven to be extremely important for both battlefield reconnaissance and actual strikes. By the end of the year, Ukraine estimates it will produce up to another 2 million drones to help with its war effort.

If future conflicts resemble the dynamics of the war in Eastern Europe, companies making drones for military use will likely see demand skyrocket.

Between a rapidly growing market, ample investment from large businesses and the potential for lucrative long-term government contracts, it’s clear that there are real opportunities in the drone market. As with many new technologies, though, it’s crucial not to let excitement get in the way of sound investing decisions.

What Are the Drawbacks of Buying Drone Stocks?

At the moment, there are two major drawbacks to investing in drone stocks.

The first is that it’s extremely difficult to tell which smaller companies will come out on top in the race to commercialize drone technology. In a market with so many startups, competitive pressures and a lack of clear, established moats may make it difficult for investors to choose good stocks for the long term.

The second difficulty is the fact that many younger drone companies are either unprofitable or trade at very high valuations that imply extremely rapid growth rates.

A prime example of the latter type is AeroVironment, a drone startup that specializes in drone defense applications. Shares of the company’s stock trade at over 55x forward earnings and 40 times cash flows.

Even though AeroVironment operates in the comparatively stable defense sector, this valuation suggests a rate of earnings growth that may be difficult for the company to maintain.

Between a young market full of startups and high valuations, it may be hard for investors to find good values in predictable companies in the drone space. This makes investing in smaller drone companies a fairly risky proposition.

Even though there are likely some excellent businesses among the pack, investors run the risks of choosing the wrong companies for long-term growth or overpaying for those that are already performing well.

Compounding these problems is the fact that drones have suffered from a high level of hype for several years. In 2019, for instance, Uber teased the idea of using large drones for a flying taxi service that was supposed to begin operating by 2023.

Investor enthusiasm for such projects may help to account for the high valuations of drone stocks, but the real benefits of drone technologies are likely to be found in improving more mundane tasks.

As with any market in which hype is a major component, there is a chance that drone stocks could deflate if investor enthusiasm for the technology wanes.

There are already some signs of cooling enthusiasm. In 2023, fewer IPOs and less interest from venture capital caused the total amount of funding for drone companies to fall to just over half of its 2022 level. Though many existing drone startups still command premium valuations, this may be a sign of reduced investor confidence in drones that will eventually begin to affect publicly traded stocks.

Are There Safer Ways to Invest in Drones?

Although pure-play drone stocks still appear fairly risky, more conservative investors may prefer to invest in more established companies that are adding drone technologies to their existing businesses. Amazon, UPS and Walmart are key examples of such companies when it comes to commercial deliveries.

By reducing delivery costs and times, drones offer the potential to help these businesses grow and potentially improve their earnings over the long haul.

Another blue-chip stock with a decent amount of drone exposure is defense and aerospace giant Northrop Grumman. The company, already well-versed in creating stealth aircraft, has engineered unmanned drones that can cruise at high altitudes over long distances without being detected by radar installations.

The company’s drones could generate as much as $100 billion in additional contract revenue from the United States military and create a foundation for it as a go-to drone defense company.

It should be noted, though, that investing in larger, more established companies using drone technology is unlikely to produce the kind of radical gains that drone startups can.

Returning to AeroVironment as an example, the stock has nearly doubled in price over the last year. Northrop Grumman, by contrast, is up a comparatively modest 16.7%.

So, How Risky Are Drone Stocks?

Investing in drone stocks is associated with elevated risks now because of lofty valuations, limited profitability and high competition.

The deeply fluid dynamics of new markets make it difficult for investors to decide which companies will develop strong economic moats, while general enthusiasm appears to have made drone stocks quite expensive.

Similar dynamics have played out among AI startups and, before that, companies investing heavily in the metaverse.

That isn’t to say, however, that there aren’t opportunities in drone stocks. Investors who are comfortable with elevated risks may be able to generate proportionately large returns, as evidenced by AeroVironment’s run over the last year.

For more risk-averse investors, though, sticking to large, blue-chip companies that can use drones to improve existing businesses may be a less volatile way to gain exposure to drones without investing in pure plays on the technology.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.