Drones are coming

Drones and footage from the cameras they carry have become familiar sights over the past decade, from scenes of the battlefield to a hobbyist attempting their first flight. Yet Unmanned Aerial Vehicles (UAVs) have only scratched the surface of their Commercial potential. Like the Internet and GPS before, drone technology is evolving beyond its military roots to encompass a broad array of business applications. Regulations are coming into focus to govern expanded use; and once in place, we expect them to unlock UAV demand in industries such as construction, agriculture, energy and mining. Police and fire departments are tapping drones’ observational capabilities, adding to government demand beyond the military. We estimate the combined Commercial, Consumer, Civil government, and Military drone market could reach a cumulative $100bn between now and 2020, rivaling the size of the helicopter market, with ripple effects to areas such as insurance, camera makers, and component manufacturers. The full economic benefit may be a multiple of that, as other organizations benefit from the savings and efficiencies of unmanned flight.

Why drones matter

Drones offer three main benefits to commercial and government users:   Efficiency  Cost reduction  Safety The benefits vary by use case, but drones often provide all three. In the Military market, for example, Pentagon leaders strive to keep soldiers out of harm’s way as much as possible. But they also want more cost-effective ways to complete missions, and drones often offer substantial capability at a fraction of a manned aircraft’s cost. The same is true of the much more nascent Commercial market. In clean energy, for example, drones can decrease the time, risk, and labor involved in wind turbine inspection, which currently involves workers being hoisted off the ground to rappel down turbines and inspect their blades.

Sizing the market

We believe the efficiency, cost, and safety benefits—along with coming regulatory clarity and relaxed export restrictions—will drive growth in four core markets for UAVs.

Commercial

($21bn global market from almost zero today) The Commercial segment holds the most potential for growth, in our view, with a tripledigit CAGR over the next five years and a $21bn TAM. Commercial drones offer greater autonomy, range, and support systems than Consumer versions, and we see applications in industries from construction and agriculture to journalism and real estate. Increased Commercial use is also likely to spawn offshoot markets in areas such as drone insurance. The Commercial market is emerging and opaque, with many privately held manufacturers like PrecisionHawk, Aeryon Labs and DJI. However, we see public companies increasing exposure to this segment, including GoPro, AeroVironment, Trimble, and Lockheed Martin. We profile six private and public companies that are using drones in these capacities.

DJI inspire drone

Consumer

($14bn global market; mid-teens CAGR) Consumers like drones for the enhanced photography and video capability, as well as simple recreation. While the Consumer market is the largest non-Military market today, it is also still early in development relative to other consumer electronics, leaving substantial growth potential ahead. We think Consumer will grow from a $1.6bn market in 2015E to a $3.3bn market by 2020; a 16% CAGR and a cumulative opportunity of $14.5bn through 2020. DJI is currently the largest vendor in the retail drone market, followed by Parrot. We expect a GoPro mid-2016 launch of its Karma drone to eventually challenge DJI’s leadership in the segment, but expect GoPro to gain only mid-single-digit market share in 2016.

Civil Government ($3bn domestic market from almost zero today) A focus on improving the effectiveness of public services, such as police, fire, Coast Guard, and border control, creates demand for UAVs from Civil Government. We estimate a TAM of $3bn in the US alone, with a triple-digit CAGR over the next five years and growth possibly developing sooner than that of the Commercial segment because government users can more quickly adjust to regulations. Defense contractors like Northrop Grumman and Boeing have a natural entry to this market. The Civil Government segment is also likely to support demand for small Commercial UAVs that are modified for government purposes. NASA is leading a critical $2.8bn effort from FY2017 through FY2021 to develop a national airspace management system that integrates UAVs.

Military ($70bn global market, low double digit CAGR) The largest segment will remain Defense for some time, where over the next five years, we see $20bn in unclassified US military spending, $10bn in US classified, and a $40bn total international market (of which we believe US exporting contractors could capture approximately one third). UAVs allow the military to enhance combatant safety while also reducing system costs. Key UAVs offer impressive specs, but at prices much lower than their manned counterparts. Unmanned looks to clearly be one of the fastest growing components of the Defense budget over the long term. We see Northrop Grumman as the largest single beneficiary of growth in global Military unmanned spending, with market share moving from 18% in FY2015A to over 50% in FY2020E.

Our TAM methodologies  Methodology: We evaluate Consumer, Commercial, Civil, and Military end markets for UAVs. For relatively established markets like Consumer and Military, we project future revenues. Sizing is based on a 5-year cumulative revenue TAM, using 2016-2020 for Consumer and FY2017-2021 for Military (consistent with the Department of Defense’s FYDP timeframe). To size less mature end markets such as Commercial and Civil, we calculate the cumulative potential addressable market upon reaching full penetration. We anchor assumptions to the present, and therefore calculate TAMs based on the world as it is today. This means pricing is held at current levels, end-market conditions are reflective of today’s environment, and we assume no replacement demand. In these markets, we also assume efficient allocation of unmanned resources, where UAVs are used at full capacity and efficiently. These assumptions lead to conservative estimates for the potential of UAVs, but provide a foundation for relative and absolute analysis of end market applications.  Market sizing: In established markets like Consumer and Military, we expect $87bn in UAV sales over the next 5 years. We estimate that newer markets such as Commercial and Civil government create a potential for $23bn in new sales, which we think will take longer to fully materialize, but which we believe will grow rapidly from a base of almost zero today. We think it is likely these new end markets will reach between 25% and 50% penetration over the next 5 years. This adds approximately $12bn to our $87bn 5-year forecast for established markets, yielding a global 5-year opportunity of $100bn. There are numerous other small Commercial markets not sized in this report that could present upside.

Competitive landscape: It’s still early  Today, drone manufacturing for Commercial use is dominated by a single large firm, DJI, with numerous small private firms attempting to carve out a niche. While the market and entrepreneurs are in the nascent stages of recognizing the potential value of UAVs for Commercial applications, companies are offering UAV products for a growing number of Commercial uses. Similar to government counterparts, Commercial UAVs offer cost savings, risk reduction for people in dangerous professions, and improved performance over manned alternatives in certain environments.

While early, we think that non-military drones will be as big as civilian helicopters today. Honeywell projects that civilian helicopter manufacturers will deliver 4,000 – 4,500 units over the next 5 years, which we estimate to represent between $20bn and $30bn in revenue, depending on the product mix. We think the current climate means that civilian drones will eventually rival the civilian helicopter market in size.

DJI dominates manufacturing, but fragmented US market begins to compete: The immaturity of the Commercial UAV sector means that it is an opaque market with numerous small privately held companies competing for market share with Chinese manufacturer DJI, which currently claims a 70% market share, according to Reuters. Lufthansa announced a partnership with DJI on January 26, 2016 to offer a comprehensive suite of services ranging from insurance and pilot training to data analysis and flight operations. FLIR Systems manufactures thermal cameras for DJI drones.

Military players have historically been fairly inactive in the Commercial space. But recently, Lockheed Martin has developed the Indago to compete in Commercial and Civilian agency rotorcraft markets and AeroVironment offers non-military versions of its small UAV line in addition to its Qube quadcopter. Parrot is the only other large publicly traded firm that manufactures UAVs for Commercial/Consumer use, with drone revenues of €183.4mn.

GoPro has significant exposure to UAV cameras and plans to launch its own line of Consumer/Commercial UAVs in 1H16. Intel recently announced similar intentions for selling drones with sense-and-avoid technology made by Yuneec (a Chinese company in which it has invested $60mn). In addition to public companies, DJI, 3D Robotics, PrecisionHawk and Aeryon Labs are privately held UAV manufacturers in the space.

Who is going to own and operate the drones?  The nascent Commercial unmanned industry is having a user identity crisis. Should consumers – farmers, surveyors, utility companies, etc. – buy and operate UAVs themselves, or will an emerging industry of ‘drones-as-a-service’ providers grow to fill that need? The answer will probably depend on the end market, but as a whole, we are seeing companies opt to hire pilots and UAVs rather than acquire and fly the aircraft themselves.

Companies in end markets where the potential operator has large capital investments seem to prefer hiring specialized drone service companies. We think these firms view drone work as noncore. In contrast, firms that are inherently service oriented, such as surveyors or maintenance companies, are integrating UAVs into their core business model.

Beyond core business focus, we see capacity and price point as important determinants for companies considering drones. For many, drones are too expensive, especially when not used at full capacity. A single UAV can accomplish more than most users require. There is also the issue of piloting – current regulations require owners to have sufficient experience to fly legally and productively. We think relative frequency of use, price point, and piloting demands are likely tailwinds to the growth of a ‘drones-as-a-service’ industry.

Regulations slow product adoption today Thus far, the Federal Aviation Administration (FAA) has moved more slowly than anticipated to create a regulatory framework for Commercial drone operations. The FAA missed its September 30, 2015 Congressional deadline to draw up rules for widespread Commercial UAV use. While the FAA expressed an intention to finalize rules in 2016, we think there is a possibility the regulations slip into 2017.

In order to fly commercially, prospective users must obtain a Section 333 exemption and Certificate of Authorization from the FAA as an exception to the blanket ban on Commercial drone use. Only 3,900 exemptions have been granted, but this is growing rapidly from the 24 permitted at the end of 2014. Still, operators are largely prohibited from flying in ways that deliver the greatest returns (i.e., more autonomously, beyond line-of-sight, over people, and at higher altitudes). FAA regulations are stricter for Commercial operators who fly UAVs as high-cost tools than they are for Consumers who fly them as less expensive (but potentially more dangerous) toys. This disconnect has been a point of frustration for Commercial operators with whom we have spoken. We outline the impact of some key regulatory points:

1. Altitude restrictions constrain the ability of UAVs to survey large amounts of land simultaneously and put UAVs at risk of crashing into geographic features and man-made structures.
2. Range restrictions prevent beyond-line-of-sight operations, which we see as key to long-term use of Commercial drones, as efficiency improvements are realized with operations beyond line of sight. Over-the-horizon operations would allow UAVs to autonomously perform certain functions, like pipeline inspections and package delivery without a human operator present. This would open new opportunities to UAVs and result in significant cost savings.
3. Operator restrictions limit scaling operations of UAVs. Due to autonomous functionality, one pilot could manage several UAVs simultaneously, driving down operational costs. Today, the FAA requires a pilot for each drone; however, as the drone becomes more autonomous, it maximizes its economic potential.
4. Operations over people are currently restricted, which limits key industries like delivery and surveying work.

Technological progress slowed by FAA delay:  Without a clear roadmap, drone manufacturers have been slow to develop key technologies that might not be compliant in subsequent years, even if these technologies might facilitate uptake, expand capabilities, and enhance safety today.

The FAA’s 2015 Small UAS Notice of Proposed Rulemaking provides color on the direction of the regulations and suggests an easing of policies from the current Commercial regulations. Given pressure from industry participants and developments in technology, we believe two further areas could likely see additional easing beyond the proposal. We think the indicated ban on beyond-line-of-sight operations (which restricts a UAV’s range) could be eased in unpopulated areas for agriculture, utilities, and O&G pipeline inspections, where there is little risk of damage and significant demand. Should this be the case, we would expect rules to ensure safe operations there, and at high altitude in shared airspace, with the FAA potentially requiring flight transponders, sense-and-avoid technology, and possibly fully licensed pilots (although a pilot license is required today for all flights, plans indicate the FAA will allow people to fly UAVs who take a special course, easing potential pilot shortages). We would also expect eventual loosening of requirements on the number of drones a single pilot can ‘fly’ simultaneously (using autopilot functionality). Today, many UAVs are flown using this functionality, but must have a pilot on hand for each to take over.

Exhibit 4 presents requirements today vs potential regulatory changes in 2016/2017 (which largely reflect the FAA’s proposal and our assumption of additional easing around range and pilots). We note that our Commercial TAM assumes no change in regulations.

Pilot shortage a short-term headwind:  Even if the FAA permits Commercial operation of UAVs without a pilot’s license, we predict that many UAV service-oriented companies will likely require their operators to hold the license. Commercial-grade UAVs cost between $10,000 and $100,000 and will often operate around sensitive equipment, infrastructure, and people. Equipment and liability risk will likely drive pilot demand in most Commercial sectors. Based on current trends, we forecast the number of FAA-certified non-commercial/airline pilots to decline from 175,000 in 2014 to 145,000 in 2020, by which time UAVs will have had sufficient time to increase their market penetration. We expect total US UAV pilot demand to be 98,693 when Commercial UAV numbers reach their TAM if the FAA continues to require one pilot per drone. Most private pilots are recreational flyers with relatively high incomes, so we think few of them would exit current professions to fly UAVs. Assuming 5% might change careers to become UAV pilots would imply a potential supply gap of 91,443 pilots.

We identify retention problems for military UAV pilots and expect that these pilots may augment the existing supply of potential Commercial UAV pilots. Increased Defense UAV usage has put a strain on pilots and the military is having trouble keeping them. Specifically, in 2015, the Government Accountability Office indicated that the Air Force had only 83% of the pilots needed for current mission demands and only 35% were suitably trained. Because of the retention and recruiting problems for UAV pilots among its officer corps, the DoD is opening pilot positions to enlisted personnel. We think this will partially resolve the supply problem. As combat air patrols are planned by the Pentagon to increase by 50% over the next three years, any difficulty retaining military UAV pilots could become a tailwind for the piloting needs of the Commercial UAV sector. A surplus of military UAV pilots would support growth in the civilian UAV market much like the surplus of military pilots supported growth in the airlines after World War II.

Safety and airspace management key to deregulation: Most UAVs have built-in safety protocols that prevent accidents in the event of communications disruption. Frequency jumping communications systems prevent unintentional or malicious signal jamming. ‘Go home’ or auto-hover features are commonly available that autonomously pilot the drone in the event of signal loss. Like Military counterparts, Commercial UAVs are undergoing upgrades for increased automation. Key to this will be sense-and-avoid technology, which can prevent dangerous interactions between unmanned and manned aircraft. Transponders and sense-and-avoid technology in drones would also help create a safer airspace.

NASA, Verizon, Google, Amazon, and Harris have partnered to develop an air traffic management system to enable safe operation of unmanned aircraft in US airspace.  Airspace management remains the greatest hurdle to UAV adoption and the FAA is likely to require that an effective system be in place prior to approval of Commercial beyond-lineof-sight and integrated airspace operations. Private drone manufacturer PrecisionHawk offers an existing product called LATAS as part of the NASA Unmanned Air System Traffic Management and FAA Pathfinder initiatives. This system utilizes the 4G LTE network and Digital Globe’s database of potential obstacles for tracking and collision avoidance. The Pathfinder initiative team also includes CNN, which is helping to develop systems for confined spaces and urban areas, and BNSF Railway, with its beyond-line-of-sight point-topoint flight research. PrecisionHawk is focused on extended-line-of-sight operations, where the drone may be temporarily out of sight but is tasked to return to the launch site—a practice that is likely to become common in precision agriculture.

Loosened regulation could be a net headwind for manufacturers:  Despite the new opportunities and customers unlocked with looser drone regulation, decisions by the FAA could severely curtail the total addressable market for manufacturers, even if it does speed uptake. If regulations are loosened, some target markets like agriculture will likely become much smaller very fast since drones will come closer to reaching their full potential capabilities

UAVs that can survey 1,000 acres of cropland a day will likely quickly be replaced by those capable of surveying 100,000 from higher altitude and extended range. An increase to 2,000 acres a day would reduce our forecasted $3.6bn US Commercial TAM by $701mn. A UAV would only have to fly 40% higher to double the area recorded using a camera with a 60 degree field of view. That means that an altitude increase from the current 400ft restriction to 565ft would be sufficient to double a UAV’s coverage and halve the agricultural TAM. We think fixed-wing drone applications will be far more vulnerable to deregulation than rotary wing, which are less dependent on range and altitude for operational capabilities.

Two and a half types of Commercial UAVs

Two types of aerial vehicles dominate the civilian UAV market: man-portable fixed-wing and man-portable rotary-wing airframes. A variation of the latter category is the tethered rotary-wing drone, which feeds power and data through cables connected to ground stations, allowing high speed connectivity and extended endurance.

1. Fixed-wing aircraft – improved endurance for Commercial: Fixed-wing aircraft, which have greater range and endurance than untethered rotary-wing counterparts, are designed for beyond-line-of-sight operations. Proposed uses include pipeline inspection and crop monitoring. These UAVs sometimes require a launching device and often require greater user training; however, many are designed to fly autonomously along a predetermined flight path, reducing the need for human input to planning, takeoff, and landing. AeroVironment, Parrot, PrecisionHawk, and AgEagle specialize in fixed-wing Commercial products.
2. Rotary-wing ‘quadcopters’ dominate in Consumer and Commercial unmanned aviation, with estimated 90% share: Rotary wing aircraft, often in four-, six-, or eight- rotor configurations, are popular among hobbyists for their stability, precision, ease-of-use, and mission flexibility. These airframes commonly feature underslung cameras and have given rise to drone-based videography companies. The ability to hover makes this design highly adaptable, with proposed uses including package delivery, infrastructure inspection, and pesticide application. More propellers mean greater lift and stability for the platform, but also more draw on batteries. Lockheed Martin, AeroVironment, Parrot, DJI, 3D Robotics, Trimble, and Aeryon Labs manufacture rotary-wing platforms.

2.5. Tethered rotary-wing UAVs become portable communications and surveillance platforms: One variant of the rotary-wing UAV involves a tether—a cable that connects the UAV to a land-based power supply and can provide highspeed video relay to a ground station. Tethered UAVs may be used as temporary telecommunications or radio towers, for crowd monitoring or other endurancedriven missions. Companies like CyPhy Works, Drone Aviation Corp, and Perspective Robotics have developed tethered systems.

Commercial unmanned aviation performance factors

We expect to see some level of commoditization of UAV airframes with software, power systems, and sensor payloads as the key differentiators over the long term. As a UAV gets more expensive, these features tend to become a greater share of the overall cost. Given the availability of parts and open source software for control systems, UAV manufacturing has a low barrier to entry. Cheaper platforms may find price support due to the value of the camera and batteries employed on the platform.

Software facilitates use and adds value:  Current technology has limited the applications of Commercial UAVs, particularly in the realm of autonomy and endurance, but also in data analytics. Basic software is now open source, making the barrier to entry low on that front, but manufacturers are differentiating themselves by making their software more capable and user friendly. Manufacturers are starting to program UAVs to perform complicated tasks, including take-off-to-landing autonomous flight and complex maneuvers.

Despite rapid advances in UAV autonomy, UAV navigation systems are insufficient for operations in crowded urban environments. Although basic autopilot features can guide agricultural drones on surveillance missions over crops, we think autonomy will be increasingly important once the FAA authorizes over-the-horizon sorties.

Range and endurance limit applications of UAVs:  Endurance remains a significant hurdle for many UAV applications that require greater range, payload, and flight time. Most UAVs today use battery-powered electric motors, but small gasoline engines in unmanned Military and Commercial aircraft show some promise, along with developments in battery capacity and hydrogen/propane fuel cell technology.

Specifically on battery-powered motors for smaller drones, most employ some form of Lithium-ion technology, which is a transplant from the consumer electronics industry. These batteries are well suited for flight given their small size and light weight, but can still improve. Most important for flight is the battery energy density, measured predominantly in Wh/kg. Our Autos team in Japan forecasts (Exhibit 9) an increasing energy density profile of Li-ion batteries, which should enable longer, more efficient flights. The technology is also expected to decline in cost as manufacturers optimize chemistries as illustrated by Exhibit 10, with cost reductions making drones more cost competitive.

Cameras are the key cost differentiator between UAVs:  Cameras increasingly drive the cost of unmanned platforms, sometimes costing more than the airframe. Many companies offer a variety of optics arrays, which are used for different specialized tasks. UAVs are becoming a tailwind for camera makers and we estimate 20%40% of drone revenues are passed through to camera manufacturers, but that number can go higher with the sophisticated UAVs. Vertical integration of camera and drone may offer cost synergies and we see several drone manufacturers shifting to proprietary sensors. FLIR Systems recently announced a partnership with DJI to sell thermal imaging equipped UAVs for about $5,000, with the cost depending on resolution. FLIR’s VUE camera, which is used on the drone, sells for $1,499-$2,999. Although Consumer applications may be somewhat limited, we see greater opportunity for FLIR-equipped drones in the Commercial and Civil space. Importantly, we see this partnership as positioning FLIR to capture opportunity as DJI pushes further beyond Consumer into the Commercial space.

flir thermal drone camera

Drone Key Players

Drone Manufacturers: Northrop Grumman Raytheon Lockheed Martin Boeing AeroVironment GoPro DJI Parrot Alphabet Facebook 3D Robotics Aeryon Labs PrecisionHawk AgEagle Yuneec Trimble General Atomics Elbit Systems Israel Aerospace Industries Dassault Thales Group BAE Systems Hongdu Aviation

Sensor Payload: FLIR Systems Raytheon Curtiss-Wright Northrop Grumman Boeing Griffon Corporation Harris Corporation GoPro Sony Panasonic Canon General Atomics Ambarella Qualcomm

Data Link/Communications: L-3 Communications Harris Corporation Curtiss-Wright Cubic Corporation

Engine: Rolls-Royce Honeywell Safran Rotax

Airframe: Northrop Grumman Lockheed Martin Textron Aurora Flight Sciences Triumph Group Boeing General Atomics

Ground Station: Raytheon General Atomics L-3 Communications Northrop Grumman Lockheed Martin