The military drawdown in Iraq and Afghanistan has propelled manufacturers of unmanned aerial vehicles to turn their attention to domestic applications, but a slow pivot and the federal budget crisis have caused one company to run into some turbulence.

AeroVironment Inc. has relied heavily on military contracts, supplying 85 percent of the military’s 25,000 small drones. Those sales account for 80 percent of the company’s revenue and the ongoing federal budget impasse has caught AeroVironment in a squeeze.

The company reported lower-than-expected earnings last month, in large part because year-end uncertainty over the federal budget delayed orders from the military. Compounding that, the across-the-board budget cuts known as sequestration hit early last month, casting a further pall on the company.

“It’s already having an effect,” said Peter Arment, an analyst with Sterne Agee & Leach in New York who covers AeroVironment. “The overhang of sequestration has caused funding delays as program managers at the Pentagon try to figure out how to allocate money for their core programs.”

Shares of AeroVironment fell more than 5 percent last week, closing March 27 at $18.10 and making it one of the biggest losers on the LABJ Stock Index. (See page 30.) The company’s shares have declined 33 percent over the course of the last year.

The slide came in the wake of a weak earnings report released March 5 in which the company reported third quarter net income of $3.87 million, a 33 percent decrease from the same quarter the previous year. Revenue for the quarter ended Jan. 26 was $47.1 million, down 35 percent. It chopped its full fiscal 2013 sales guidance by one-third.

The effect of the budget cuts on AeroVironment was unexpectedly great, said William Loomis, an analyst at Stifel Nicolaus & Co. in St. Louis.

“We did not anticipate such a dramatic shortfall,” he wrote in a note to clients.

Now, in the wake of the military drawdown in Iraq and Afghanistan and the slashing of the federal budget, AeroVironment is starting to pivot.

The 800-employee company, which manufacturers its drones in Simi Valley, is getting ready to sell domestic applications to fill the gaps. The company is developing a drone, dubbed the Qube, for search-and-rescue missions.

The Qube, which costs $50,000 per unit, could be used to take photos and videos of crime scenes and emergencies.

“We’re going into the evaluation phase,” said David Heidel, the marketing manager for unmanned aircraft systems at AeroVironment. “We see this as a big opportunity.”

Legislative help

The company’s efforts – and bottom line – could get an assist from legislation pushed by two state lawmakers who want to ensure that California, home to about a dozen drone makers, remains a leader in the field.

Assembly members Jeff Gorell, R-Camarillo, and Steven Bradford, D-Gardena, have introduced legislation that would create tax incentives directed at companies that make unmanned aerial vehicles – UAVs, or drones – in California in the hopes of boosting the state’s aerospace manufacturing industry.

For most of the companies in the state working on this cutting-edge technology, the benefits could prove to be a boon; the bill, AB 1326, would exempt manufacturers from taxes on equipment and new facilities as well as offer a tax credit for qualifying wages and new hires of up to $20,000 a year per employee.

Gorell said he authored the bill, introduced in February, after manufacturers told him the cost of doing business in California had them considering moves to other states.

At stake is a slice of a growing industry that is expected to generate billions of dollars in sales in the coming years.

Drones are being developed for multiple domestic uses, including search and rescue missions, crime scene analysis, border control and agriculture. The industry could account for $2.4 billion in economic activity in California through 2017 as long as regulatory milestones are hit, according to the Association for Unmanned Vehicle Systems International, an industry group in Arlington, Va.

“You’re talking about a great deal of applications most people have never seen before,” said Mario Mairena, government relations manager for AUVSI. “Just with the number of companies, there’s a lot of business in California.”

Gorell said sequestration and the military pullback from overseas wars have increased the need to assist the industry.

“Sequestration has pushed the aerospace industry at all levels in the direction of commercialization,” Gorell said. “You’re going to see that more than ever, with companies creating more and more of these applications for commercial enterprise. I wanted to find ways to get out ahead of this industry.”

Emerging market

Though a boom in domestic applications of drones is anticipated, it will be at least a couple of years before the playing field is clarified.

The Federal Aviation Administration has begun the process of integrating UAVs into the national airspace, but the process won’t be completed until 2015. Until then, said Howard Rubel, an analyst with Jefferies & Co. in New York, AeroVironment will continue to rely heavily on federal contracts.

“You can’t do a lot with public safety until the FAA approves it all,” he said.

The FAA recently began allowing public safety agencies to apply for permits to use drones; interest groups from 37 states, including two from California, have applied to the FAA to be among the first six to test drones for domestic use.

Among the concerns regulators face are issues raised by privacy advocates. To that end, Gorell and Bradford have authored a separate bill to put privacy restrictions on the use of drones in California.

That legislation, for example, would require police to destroy images captured by drones within 10 days unless they are required as evidence. It would also restrict when the drone could fly to collect evidence without a warrant.

Under current FAA guidelines, public safety officials cannot use drones larger than 25 pounds and cannot fly them higher than 400 feet.

The emphasis on smaller drones would play to AeroVironment’s strengths. Founded in 1971 by aviation pioneer Paul MacCready, the company is the biggest manufacturer of small unmanned aerial vehicles. It’s best known for its Raven, Puma and Wasp systems, which soldiers carry in backpacks and launch by hand to take video of enemies from the air.

But domestic uses of drones large or small still raise questions.

Jay Stanley, a senior policy analyst for the American Civil Liberties Union in Washington, D.C., said firm guidelines for drone use would remove the Big Brother image for those using the vehicles and the manufacturers.

“For those who see drones as a business opportunity, it’s in their interest to put the privacy protections in place,” he said.

Tim Conver, AeroVironment’s chief executive, said during a conference call with analysts last month that FAA rule changes could be delayed and privacy concerns need to be addressed. The company is working with customers to offer the new technology when those hurdles are cleared.

“The opening of national airspaces will enable a large new domestic and international opportunity to deploy small UAVs to great benefit in public safety applications,” he said. “We are working with early adopters now and we believe that we can help them succeed.”

Still, the commercial and public safety markets won’t be open to aerospace companies for some time, said Sterne Agee’s Arment.

“It’s going to take some time for public safety or other commercial opportunities to fill the gap from the defense downturn,” he said.

Tax breaks like the ones proposed in California could help, he said.

“They’ll look at anything that improves the investment horizon,” he said. “But their largest market is still tied to the Department of Defense budget and that remains under pressure.”