Keep drone-related stocks in your sights

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Drones are going mainstream. But drone stocks still have a ways to go.

Ever since Amazon.com Inc.'s chief executive Jeff Bezos last year raised the possibility of using drones to deliver packages to customers, the idea of widespread pilot-less flight has really entered the popular imagination.

Already, the technology has some military combat and surveillance applications, and is being used for crop dusting and aerial photography, where operators keep the machines in their sights.

But a broader rollout is coming. Many observers also expect drones to be used for search and rescue operations and infrastructure monitoring. Others believe the technology could be adapted to the cargo shipping industry.

The U.S. Federal Aviation Administration (FAA), which is looking into regulations for the commercialization of drones, calls unmanned aerial systems "the most dynamic growth sector within the aviation industry."

The Teal Group, an aerospace consultancy, estimates that annual spending on research and testing of drones will rise to more than $11-billion (U.S.) by 2022 from $6.6-billion in 2013. Total spending on drones is expected to rise to $89-billion over the next decade.

The skies are about to get crowded: The FAA estimates that within five years there should be roughly 7,500 commercially viable drones.

Some investors are no doubt wondering if the extensive rollout of drones makes companies like Amazon.com a tempting buy, given that the new technology could cut delivery costs and appeal to more customers, if only for the novelty factor.

But the better opportunity is with the drone makers themselves.

If you want a proven track record of putting unmanned planes in the skies, then weapons manufacturers are your best bet right now. Northrop Grumman Corp. and Israeli-based (and Nasdaq-listed) Elbit Systems Ltd. have produced fighting drones with names like Global Hawk, Fire Scout, Skylark and Hermes.

Even though drones form only part of their business, the stocks have been performing remarkably well: Elbit has risen 50 per cent since the start of 2013 and Northrop Grumman has risen 87 per cent, or more than double the gain of the S&P 500 over the same period.

Despite the rally, the stocks look cheap next to their annual earnings. Elbit trades at just 12.5-times trailing earnings while Northrop Grumman trades at 15.6-times earnings, which is hardly reflective of drone-fever.

But if you prefer drones that carry less harmful payloads, such as pizzas and books, these are early days: Until the FAA releases a rule book, expected soon, commercial uses in the United States are really just a dream.

In Britain, drone makers have a head start, in that they can test their unmanned aircraft in segregated air space.

Either way, the key players are mostly university researchers and small companies, backed by entrepreneurs and venture capitalists.

Just two examples: Aeryon Labs Inc., based in Waterloo, Ont., makes the Scout and SkyRanger for military and commercial surveillance.

And San Diego-based 3D Robotics Inc. has produced a suite of "multicopters" – three-armed flying machines with a series of small propellers, designed for aerial photography. In December, the company received a $6-million investment from the Mayfield Fund, which noted that drones are "now evolving into a commercial-grade platform that will disrupt many different markets."

If the drone race heats up as expected, you can be sure that other companies will join, followed by initial public offerings and consolidation once sales start rolling in. Things should get very interesting.