A Drone Stock With Plenty of Runway Ahead

In 2012, Fortune magazine called Amazon.com (NasdaqGS: AMZN) CEO Jeff Bezos “the ultimate disrupter”—with good reason.

He turned the book industry on its ear when he launched Amazon.com from his garage in 1995. Since then, Amazon has grown far beyond books, peddling everything from its Kindle Fire tablet to pet food and toilet paper—forcing traditional retailers to rethink their entire online approach. It has also branched out into myriad other areas, like providing cloud computing infrastructure.

Robotic Delivery: Resistance Is Futile

Today, the company accounts for 10% of North American e-commerce, and it has never been afraid of embracing revolutionary technologies to slash delivery times and undercut the competition.

In early 2012, it made its second-biggest acquisition ever when it bought Kiva Systems, a maker of small orange robots that whiz around warehouses, collecting items and delivering them to a human for packing and shipping, for $775 million.

This technology was already in use by Amazon itself and other retailers, including Staples (NasdaqGS: SPLS), Crate and Barrel and The Gap (NYSE: GPS), at the time of the purchase. According to Kiva, its robots boost worker efficiency by up to four times.

Perhaps it should have come as no surprise, then, when Bezos appeared on last Sunday’s episode of 60 Minutes—on the eve of what turned out to be a record Cyber Monday—to reveal Amazon’s latest attempt at creative disruption: delivery by unmanned aerial vehicles (UAVs), commonly known as drones.

Bezos’ plan highlights the disruptive nature of drone technology, which has so far rewritten the book on surveillance and anti-terrorism techniques. His interest is an indication of its commercial potential, as well.

Here’s how Amazon’s service, called Amazon Prime Air, would work:

  • Once you place your order, Amazon’s drones—called “octocopters,” because they’re held aloft by eight small rotors—would pick it up and launch from a nearby warehouse;

  • Each drone could carry packages of up to five pounds, a weight that includes 86% of Amazon’s orders, according to Bezos. They would have a range of about 10 miles.

  • Amazon claims the drones could drop the package at your doorstep within 30 minutes.

  • The company says the service could be up and running in four to five years.

2015: A Pivotal Year for Commercial Drones

Despite the idea’s obvious appeal, Amazon will have to clear a lot of hurdles before it deploys its airborne delivery squadron, including the safety, legal and privacy implications of flying them over cities. Unlike the military’s UAVs, Amazon’s craft will be fully automated, guided by GPS.

Other question marks include how they will fly in bad weather, the limitations of battery life and even the potential for thieves or vandals to shoot Amazon’s drones down.

Right now, a major obstacle is a lack of commercial drone regulations in the U.S. The Federal Aviation Administration (FAA) is working on a framework, but it’s not expected until 2015 at the earliest. Until then, the agency will review each case individually. In September, the first FAA-approved commercial drone flight occurred from a vessel operating above the Arctic Circle.

Regardless, the technology is undoubtedly here to stay, and its use is growing: drones already shoot commercials and track wildlife in parts of the world, and a drone is even used to scare geese away from beaches in Ottawa, Canada.

In Japan, drones are regularly used for spraying herbicide and fertilizer over crops and, in a foreshadowing of Bezos’ Sunday announcement, Domino’s Pizza (NYSE: DPZ), used a small drone to deliver two large pizzas in Guildford, U.K., in May.

Even global delivery giant FedEx (NYSE: FDX) has considered going pilotless. In 2009, CEO Frederick Smith said that the company looks forward to the day when it can switch its fleet to drones, which he saw as safer and cheaper to operate than manned aircraft. No doubt FedEx would welcome further savings at its air-delivery business, which has seen lower volumes as clients opt for cheaper but slower options.

Raytheon Makes the Sensors Drones Need

According to market research firm Teal Group, global spending on drones will hit $11.9 billion by 2023, more than double 2013’s total of $5.2 billion.

Much of that spending will continue to go toward UAVs that are used for military and surveillance purposes, leaving suppliers like Raytheon Corp. (NYSE: RTN) as the main avenues for investment.

In a May 4, 2012, article in our Personal Finance newsletter, Investing Daily Managing Director John Persinos, who has long experience in the aviation industry, issued a buy call on the stock.

He liked the fact that Raytheon wasn’t in the competitive business of making UAVs but instead supplied the sensors, something it did particularly well because of its long history of making radar equipment and sophisticated missile guidance systems.

“Raytheon’s sensors are prized by the military for their unique ability to penetrate cloud cover. Raytheon continually develops lighter, high-reliability sensors—exactly what the military covets most,” Persinos wrote.

Nineteen months after Persinos recommended Raytheon, the shares are up nearly 64%. Investors who followed his call have also been benefited from the company’s $0.55-a-share quarterly dividend, which it raised from $0.50 with the May 2013 payment. The stock yields 2.5%.

Raytheon also boasts a p/e ratio of 15.3, below Boeing (NYSE: BA), at 23.5, and just slightly higher than Lockheed-Martin’s (NYSE: LMT) 14.8.

The company’s focus on sensors should help it benefit as drone use becomes more widespread. For example, it has developed a hyperspectral imaging sensor currently used on the Predator drone that can pick up light across the electromagnetic spectrum, allowing it to glean the composition of objects on the ground through their unique spectral signatures.

Military uses include detecting buried roadside bombs, but a recent Popular Mechanics article sees potential applications for mining and agriculture, as well.

International Growth Ahead

In the third quarter of 2013, Raytheon’s sales were spread out roughly evenly between its four main segments. The company’s drone sensors are developed by its Space and Airborne Systems division, which also produces radar and other sensors for aircraft, spacecraft and ships.

Its other three segments are:

  • Integrated Defense Systems, which specializes in air and missile defense, radars and technology for managing command, control, communications, computers and intelligence. This business also produces air traffic management systems, sonar devices, torpedoes and electronic systems for ships.

  • Intelligence, Information and Services, which provides computer-security products; and

  • Missile Systems, which makes defensive and offensive missiles for air, sea, land and space.

The company continues to report steady results, despite the impact of sequestration and the recent government shutdown on U.S. defense spending.

In the third quarter, Raytheon’s revenue declined 3.4% from a year ago, to $5.84 billion. On an adjusted basis, earnings per share fell 1.2%, to $1.60 from $1.62. That topped analysts’ expectations of $1.33 a share in profits on $5.81 billion of revenue.

The company ended the latest quarter with a backlog of $32.2 billion, down from $35.0 billion a year ago.

Raytheon also updated its financial outlook for the full year. It now expects sales of $23.6 billion to $23.8 billion, up from its July forecast of $23.5 billion to $23.7 billion. It feels adjusted earnings will rise to $6.10 to $6.20 a share, up from $6.00 to $6.10.

The company continues to expand its international business in an effort to offset weaker defense spending at home. According to CEO David Wajsgras, overseas clients now account for about 40% of Raytheon’s backlog.

That total looks set to grow: yesterday, Wajsgras told an investor conference that the company aims to finalize $4 billion to $5 billion of orders from Middle Eastern nations, mainly involving missile defense systems, “within weeks.”