Is Engaged Capital’s Request For AeroVironment, Inc. (AVAV) Board Declassification a Bullish Sign for Investors?

In a letter disclosed in a statement on Monday, Glenn W. Welling‘s Engaged Capital urged the declassification of AeroVironment, Inc. (NASDAQ:AVAV)‘s board of directors. The investor said that at the 2014 Annual Meeting, its non-binding proposal for the declassification of the board received the support of 70% of votes, while excluding the insiders, the percentage of votes in favor amounts to 92%. “It is evident to us that the independent shareholders of AVAV, the true owners of the Company, overwhelmingly support the declassification of the Board,” Engaged said in the letter addressed to AeroVironment’s board of directors.

AeroVironment, Inc. (NASDAQ:AVAV)

As a side note, a classified board involves several classes of directors, each of which stands for election every year. It was initially used as a measure to protect the company against a hostile takeover, but has lately become a measure applied for different reasons, such as ensuring a board stability and reducing the turnover of directors.

Engaged Capital holds an equity portfolio of $139 million and has been involved in a number of activist campaigns involving companies like Jamba, Inc. (NASDAQ:JMBA), Rovi Corporation (NASDAQ:ROVI), and Silicon Image, Inc. (NASDAQ:SIMG), among others. Earlier this year, Mr. Welling was appointed to the board of Jamba, Inc. (NASDAQ:JMBA) and Rovi Corporation (NASDAQ:ROVI). In December 2014, the investor sent a letter to the board of Silicon Image, Inc. (NASDAQ:SIMG), urging it to unlock shareholder value, but the company was bought by Lattice Semiconductor (NASDAQ:LSCC) earlier this year.

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Engaged Capital has not disclosed holding shares of AeroVironment, Inc. (NASDAQ:AVAV) since its 13F filing for the end of the third quarter of 2014, when it reported ownership of 25,000 shares. In an amended 13D filing in November, 2013, the investor reported ownership of some 1.03 million shares. The latest round of 13F filings showed a significant outflow of capital from AeroVironment, as 10 funds reported holding $27.90 million worth of stock, versus 11 funds with $56.64 million a quarter earlier. The largest shareholder among the funds we track is David Park’s Headlands Capital, which owns 420,000 shares. Billionaire Jim Simons‘ Renaissance Technologies cut its stake by 50% to 208,200 shares.

AeroVironment, Inc. (NASDAQ:AVAV) is a $607 million supplier of unmanned aircraft systems (UAS), tactical missile systems and related services within the US Departement of Defense. In its first 13D filing, in July 2013, Engaged Capital said that it believed that the company was undervalued because its share price did not fully reflect the potential for earnings and cash flow from its UAS segment and its cash investments. The investor added that AeroVironment had an advantaged position to pursue growth opportunities in the UAS market. Since Engaged’s first filing, the stock of AeroVironment has gained more than 25%, although it is trading significantly below its 52-week high of $36.45 reached a year ago.

In the letter disclosed on Monday, Engaged Capital suggested that the board declassification should start at the next annual shareholder meeting, but there is a requirement for a vote of two-thirds of the common stock to support the proposal. In this way, the only possibility for the decision to be approved is for insiders to support it. On the other hand, the directors and officers of AeroVironment, Inc. (NASDAQ:AVAV), can defeat the declassification process that is supported by the independent shareholders, who are “the true owners of the company,” Engaged added.

Why is Engaged Capital’s statement regarding AeroVironment, Inc. (NASDAQ:AVAV) important? First of all, the involvement of activist investors can often increase the shareholder value of a company. However, what’s also important is that tracking the moves of investors can give us an idea about the hedge fund sentiment, which is often overlooked, because hedge funds’ have underperformed the market since the last financial crisis. Unfortunately, most investors don’t realize that hedge funds are hedged and they also charge an arm and a leg, so they are likely to underperform the market in a bull market. We ignore their short positions and by imitating hedge funds’ stock picks independently, we don’t have to pay them a dime. Our research has shown that hedge funds’ long stock picks generate strong risk adjusted returns. For instance the 15 most popular small-cap stocks outperformed the S&P 500 Index by an average of 95 basis points per month in our back-tests spanning the 1999-2012 period. We have been tracking the performance of these stocks in real-time since the end of August 2012. After all, things change and we need to verify that back-test results aren’t just a statistical fluke. We weren’t proven wrong. These 15 stocks managed to return more than 145% over the last 34 months and outperformed the S&P 500 Index by 85 percentage points (see the details here).

The outflow of capital during the first quarter shows that hedge funds have turned bearish on AeroVironment, Inc. (NASDAQ:AVAV), as the stock lost around 4% year-to-date and underperformed the Aerospace & Defense industry by almost 10 percentage points. Moreover, among small-cap companies, AeroVironment is the only loser in terms of year-to-date returns. However, if Engaged Capital manages to push further with its intentions to declassify the board, there is a high chance that shareholders will view it as a positive sign and the company will attract more attention from institutional investors in the future.

Disclosure: none