AXON ENTERPRISE INC AAXN
August 17, 2017 - 8:27pm EST by
LimitedDownside
2017 2018
Price: 21.48 EPS 0.28 0.54
Shares Out. (in M): 53 P/E 76.7 39.8
Market Cap (in $M): 1,135 P/FCF 76.7 0
Net Debt (in $M): -62 EBIT 21 47
TEV ($): 1,126 TEV/EBIT 52.9 24.1

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Description

I think the fair value of Axon’s Weapons business plus its net cash exceeds the current market cap of the company, meaning you are getting its rapidly-growing, high-margin, recurring revenue SAAS business for free.

I think both businesses are extremely attractive and think the overall company should compound in value at a high rate of return for a long period of time.

Axon currently has a $1.2 billion fully-diluted market cap and a $1.1 billion EV.

Weapons Segment

Axon’s legacy core business is selling Tasers into police departments.  This is one of the more entrenched businesses I have ever come across.  The company is in 17,000 of 18,000 (~95%) of police departments nationwide and is basically a monopoly in the domestic ‘Conducted Electrical Weapons’ (“CEWs”) space.  Out of the ~600,000 patrol officers in the U.S., ~400,000 carry a TASER today.  Revenues have compounded at a 17% rate over the past 4.5 years, Gross Margins are ~70%, EBIT Margins are ~35% and CapEx has historically been ~2% of Sales.  The company has vigorously defended its IP, putting three potential competitors out of business over the past few years.  Moreover, the business is increasingly shifting towards a more consumables/recurring revenue model which should add another layer of stickiness.  The value proposition to the customer is strong (Tasers supposedly prevented death/serious injury >178,000 times since 2000, ROI less than a year) and agencies overwhelmingly like the product.

The two articles below do a good job of explaining the company’s dominant market position as well as its aggressive sales strategy.  While the media and competitors don’t seem to like the company’s tactics, the relationship they have with police departments is one of their competitive advantages and helps put them in the pole position to win business for their body-worn cameras and evidence management software offering

 

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(In theory, the average police officer uses 3 cartridges per year: 2 for training and 1 in the field)

In the second quarter of last year, the company rolled out its ‘TASER 60’ program.  This program allows an agency to buy a TASER weapon over 60 months.  The goal of the program was to shift the purchase from a Capital Expenditure for the agency (which may involve city councils and complicated budgeting processes) to an operating expense line item.  An agency pays for $22 to $31 per month and gets the TASERs upfront.  Essentially management is attempting to accelerate the upgrade cycle from 8-10 years for a Taser down to 5 years, which should effectively double replacement sales over time.  The introduction of this program may have pulled forward some Weapons sales into the past twelve months, and it appeared that domestic sales growth did slow quite a bit as they lapped this rollout in 2Q17.         

In 2015, the company introduced its ‘Officer Safety Plans’ whereby a customer enters into a five-year subscription agreement for their software that includes upgrades of the body cameras every 2.5 years and a TASER CEW at any point within the contract period.

On the 1Q17 call, management noted that the ‘TASER 60 Plan’ represented 20% of unit volume in the quarter and Weapons under the Officer Safety Plans represented another ~15%.  Combined, weapons under these two programs dropped to ~25% of unit volume in the second quarter.

Over the past few years the company has changed its go-to-market strategy.  Whereas 80-90% of its sales in this segment used to go through distributors, it’s now almost entirely through its own salesforce.  This has reaccelerated growth and has allowed them to offer these two financing/bundling programs.

Despite the introduction of the Taser 60 program pulling forward some sales, management still thinks the segment can grow its top-line 15%+, conservatively, over the medium-term.

On the domestic side, the Weapons segment is fairly mature and penetrated.  Management would make the comment that San Francisco and Boston still don’t have Tasers and this is an opportunity.  But the real growth opportunity is the international business.  On the 4Q16 call they mentioned that ~80% of their International Sales came from their Weapons segment.  International revenue growth has accelerated recently and management believes they are hitting an inflection point.  They are mostly present in English-speaking countries (Canada, U.K., Australia), but have expanded to a number of other countries (Germany, France, Italy, Mexico, Brazil, South Korea, Singapore) as well.  CEO Rick Smith was fairly positive on the outlook for the international business over the next 18 months on the 2Q17 call.  He personally spent most of 2015/2016 visiting customers and building the international pipeline.  Additionally, the U.K. Home Office Minister just approved the Taser X26 model in May which should open up the market. 

 

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The new CFO mentioned on the 1Q17 call that he is currently conducting a deep dive into Axon’s existing cost base and required spend on new growth initiatives.  He claims to be focused on driving leverage in the business as they grow the top-line.

Putting this all together, the Weapons segment did $222 million in LTM Revenue and $79 million in LTM EBIT.  At a 38% tax-rate, that’d translate into $0.88/share in unlevered earnings.  I think this business should be able to do over $1.00/share in unlevered earnings in 2018.  I think the growth prospects, economics and entrenched position of this business warrants a 20x (unlevered) P/E multiple, particularly when ex-growth peer Motorola Solutions trades for 19x EV / NOPAT.  Alternatively, a DCF gets me to a value well north of $1.1 billion for this business.

Adding the ~$1.53/share in Net Cash I expect them to have by Year-End 2017 gets me to a value of above where the shares are trading at $21.48.

This would seem to suggest you are paying nothing for the Cameras/Software business and are receiving it as a free option.  The question then becomes, is the potential upside from the future value of the Cameras/Software business worth paying just a fair price for the core Weapons business?


Software / Sensors

The Software and Sensors business is currently comprised of selling Body Cameras and Evidence Management Software.

The Body Cameras are pretty self-explanatory.  Axon sells its ‘Axon Body’ and ‘Axon Flex’ body-worn cameras (as well as its ‘Axon Dock’ and ‘Axon Fleet’) for a few hundred dollars apiece.  As you would expect, this business has attracted a lot of competition following the riots in Ferguson, MO in 2014.

While the hardware may be a bit of a commodity, the real value is in the evidence management software.  The evidence.com cloud-based software allows an agency to securely store and track access to any type of digital evidence including Axon cameras’ video, digital photos, videos from still cameras, audio files, reports (officer reports, witness statements), and download records from all TASER devices.

Network effects potentially stem from sharing evidence with DAs, prosecutors and other agencies, and becoming an integral part of the workflow for a police department.

Plans range from $15/month to $100/month with the ‘Ultimate’ and ‘Unlimited’ Plans the most popular.  ‘Ultimate’ is ~$60/month and ‘Unlimited’ is ~$10 more per month.

Combined, the cameras/software business has $446 million in Future Contracted Revenue.  The company has booked 169,000 evidence.com seats with a ~$30 monthly ARPU, leading to ‘Annual Service Revenue’ (similar to Annual Recurring Revenue for other SAAS businesses) of $55 million as of 2Q17, up 159% y/y.  Lifetime Value ÷ Customer Acquisition Cost has averaged around 5x over the past nine quarters.  Given the mission-critical nature of the software and the early stage of the product offering, churn to-date has been negligible.  For the SAAS investors out there, management will likely start shifting focus to their ‘Magic Number’ (last quarter marketing spend ÷ this quarter’s increase in ARR) instead of their LTV/CAC metric.  Apparently their Magic Number metrics would put them in the top decile of SAAS companies.

On a reported basis, the segment generated $91 million in LTM Total Revenue and lost $51 million in EBIT. 

The software revenue carries 75-80% Gross Margins, while the Body Camera hardware margins dipped to 4.7% on a TTM basis.  Notably, Body Camera Gross Margins were actually negative in the most recently-reported quarter.

Management has been investing aggressively in sales and marketing and R&D to grow this segment.  They think that once they reach ~350,000 evidence.com licenses they will be at scale.  Long-Term EBIT Margin targets for this segment (blended hardware and software) are officially 20%.  Notably, the company effectively raised its long-term margin target to 30% at the Oppenheimer conference last week.  They also hinted at an upcoming investor day in November of this year where they’ll formally provide clarity on their targets.

To put today’s 169,000 booked seats and management’s 350,000 seats “at scale” in context, there are roughly 600,000 patrol officers in the U.S. (~800,000 total police officers) and ~400,000 vehicles.  Management estimates the TAM outside the U.S. is an additional 1 million cameras/licenses.

Axon has been winning roughly 70% of the market for body cameras / evidence software, with the market share of wins among the larger departments closer to 80%.

Axon’s existing relationship with nearly every police department in the country positions them well to be the dominant player in the body cameras and evidence software space.  There are also 30,000 TASER instructors in the field and the company’s ‘Axon Academy’ has trained over 300,000 officers (~100,000 with cameras, ~250,000 with TASER)

Management believes their software-first focus and talent are sources of differentiation and competitive advantage.  Over the past few years, the company has invested a lot in R&D and the Seattle tech headquarters of their Software business has received a lot of attention.  https://www.geekwire.com/2015/photos-inside-spaceship-themed-seattle-office-of-police-body-camera-maker-axon/ .  They’ve announced a number of key tech hires and have Bret Taylor (former CTO of Facebook) and Hadi Partovi (CEO of code.org) on their board.  They’ve even put up billboards in Silicon Valley offering prospective engineers free Tesla Model 3s to work for them.

Motorola, the scariest potential competitor, seems to be taking its time getting into the space in a meaningful way.  They just hired a new head of software from Microsoft and they’re giving him 6 months to get settled and articulate some type of strategy.

What I find fascinating is that Axon has had a number of “win-backs” from police departments that went with other providers for cameras/software.  Given the entrenched position you develop by offering evidence management software, winning contracts from competitors is a pretty clear sign of a superior product.  Albuquerque, Atlanta, Houston, Phoenix and Alameda County police departments have all had problems with competitors and chose Axon instead.

If you talk to police chiefs of major cities, they will tell you that within 5 years every police department in the country will have body cameras.  There’s lots of literature online about the merits of body-worn cameras on police officers, but the most interesting point for me is that the mentality among police officers has totally shifted from reluctance a few years ago to embracing the cameras today.

 

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ARPU Upsell

Similar to Adobe attempting to upsell its Creative Cloud users with ancillary services such as Adobe Stock, Axon has a very large opportunity upselling additional software/functionality to its evidence.com licensee-base.

Once a police officer has a body camera and an evidence.com license, the company will try to upsell them additional features/software.  Recently, the company introduced its ‘Signal Sidearm’ capability that automatically activates the body camera as soon as a weapon is pulled out of the holster.  It’ll also send a notification to the police department when it’s been done.  This service will cost an additional $10/month.  The company also has an in-car ‘Axon Fleet’ product.  Management has commented that the revenue per user over the contract term roughly doubles when agencies add Fleet to their body camera program.  Soon the company will introduce ‘Axon Record’, a Records Management System for packages with their existing evidence.com software that cost $150/month.  This will essentially act as ERP software for the entire police department.  With no associated hardware costs, getting any number of existing customers to subscribe to this software would be a huge boost to the Software and Sensors segment margins.  In theory this product could be sold to more than just police departments.  Management has also been discussing some AI-based offerings.  You can see their vision for the future here: https://www.axon.com/info/future

Interestingly, speaking with Axon’s customers, they are fairly receptive to these new offerings.  I think there could be a real opportunity to increase the ARPU of the typical evidence.com license meaningfully over time.


Customer Value Proposition

  • “When field tests have been conducted as part of the process, our win rate stands at nearly 100%”

    • Speaking with Axon’s customers confirms that officers overwhelmingly choose Axon when they are able to conduct a field trial

    • Customers note that the customer decision-making process focuses on:

      • #1: Security

      • #2: Quality of Video

      • #3: Ease of use for the officer (both the software and the hardware)

    • In addition to have a superior software team, Axon invests more in security than competitors by an order of magnitude

I would also note that the customers seem to have a very favorable view of the company and its customer service.  Additionally, the cameras and the software are developed/refined in collaboration with police departments that are deemed Axon’s “development partners”


National Free Trial

In conjunction with changing its name from Taser International to Axon back in April, the company introduced a national free-trial offering for its body cameras and evidence.com software.  Essentially, the average discount on a deal for the company has been ~20%.  As a marketing tactic, the company has positioned this discount instead as a free one-year trial (with the goal being getting the police department to sign up for the full 5-year contract).  While the market may take this as evidence of increased competition in the cameras/software segment, I think it’s a clever marketing ploy.  The press releases put out by their competitors (Vievu, Watchgaurd) hint at the genius of this strategy:

  • Vievu, a smaller competitor owned by the police supplier Safariland, said in a statement that the free camera effort was a publicity stunt that “is at best unethical and at worst illegal.” Along with the heavy internal expense of using cameras, the company warned of lock-in: that using Axon’s software for a year will effectively force police to commit to its services for the longterm, “or face exorbitant switching costs.”  John Collins, a Vievu spokesperson, said the offer is “analogous to asking someone to get a free tattoo on his or her face—you’d better be sure you want it because it is very difficult to get rid of it once you do.”

  • Watchguard: In our opinion, the offer is a trap, not a trial. The offer made by Taser for a "one year free trial" of their body camera and storage is a trap, not a trial.  Taser knows that once law enforcement agencies use their camera, it will capture video that will become case evidence.  This case evidence will be subject to various retention requirements which can last for up to seven years.  The trap is that Taser provides no option for agencies to manage this evidence outside of their paid subscription service.


Gross Margins

The Assumptions embedded in management’s Software and Sensors 20% Long-Term EBIT Margin targets are Gross Margins of 60%, SG&A 25% of Revenue and R&D 15% of Revenue.

The market likely doesn’t believe this long-term target as LTM Gross Margins in the combined Software and Sensors segment were 40.3%.  However, I would make a few points:

  • 2Q17 Gross Margins were negatively impacted from shipments on multiyear contracts, with heavily discounted upfront cameras and docks and allocation to contingent hardware which is recognized over the life of the contract

    • Q2 was also impacted by $0.6m of cost to migrate from AWS to Microsoft Azure

  • Management is guiding Hardware Margins to revert back to “in excess of 25%” by Q4 and Software Gross Margins (which dipped down to 70% in Q2) to revert back to above 75%

  • Gross Margins should further improve with the adoption of ASC 606 accounting guideline at the end of 2017

  • Management on the 1Q17 call made the comment that Hardware Gross Margins should increase towards 50% over the medium-term

    • While I’m skeptical of this claim, I would point out that the market does not seem to understand how a typical booking works

      • The chart below shows the illustrative revenue recognition for an ‘Unlimited’ booking

      • 80% of domestic video hardware contracts include the TASER Assurance Plan feature where customers prepay for future camera upgrades

      • While Axon may bid aggressively on the hardware, the discount is fully recognized upfront.  ASPs/Gross Margins on the next body camera delivered in 2.5 years will be much higher

    • Continued winning of new cameras contracts will weigh on near-term Gross Margins despite being very valuable to the company over the next 5 years

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Potential Future Value of the Software and Sensors Business

So what’s the potential future value of this “free option”?  I really don’t know, but my guess is it’s likely closer to over $1 billion than zero.

I think the company can get to 350,000 paid seats in the next 3 years.  At 350,000 seats and a $35 monthly ARPU, that’d get you to $147 million in Annual Recurring Revenue.  SAAS investors seem to like to apply EV/Revenue multiples on these types of businesses.  A 4-7x EV/Revenue multiple on that revenue stream would get you to $590 million to $1.0 billion in value for just the software business (i.e. 49-84% upside on the stock if you’re paying a fair price for the Weapons business).

Alternatively, you can attempt to model out the business.  We can debate whether or not the 20% long-term EBIT Margin targets are realistic.  The two big swing factors are Hardware Gross Margins and Sales & Marketing Expense (a function of customer growth and CAC).  The company would need to keep LTV/CAC around 5-6x to have a chance to see those types of margins at that scale.  Taking that $147 million in Revenue plus $80 million in Hardware Sales, at a 20% Segment EBIT Margin, would get you to $45 million in EBIT.  Tax-Effected and at a 22x (unlevered) P/E multiple would get you to $620 million in value.

It’s not difficult to imagine a more aggressive scenario.  What would 400,000 licenses at a ~$45 ARPU and a 30% EBIT Margin be worth?  Likely more than a billion, and certainly more than the market is currently pricing in.

[I’m hesitant to share my model because it will assuredly be wrong, but I build out the software and sensors segment revenue based on bookings, assuming a breakdown of license & storage/future contracted hardware/initial hardware/warranty somewhat similar to the illustrative example above.  The other main input to get to revenue is ARPU.]

Anyway, I don’t know what the Software and Sensors business will look like in 3 to 5 years, but my best guess is that it will be very valuable.


Identifiable Reason for Mispricing

Due to the losses in the Software & Services segment, Axon appears to be trading at a P/E multiple of 72x.  Additionally, reported EBIT Margins have come under significant pressure (from 20.3% in 2013 to 8.5% LTM).  Combined with the average investor perception that Axon is selling body camera hardware into an increasingly competitive market, I think there’s a number of identifiable reasons why the stock is mispriced.  I’ve also been told that legacy “industrial” shareholders who liked the legacy Taser business but aren’t thrilled with all of the investment-spend in the tech business have been selling.


Short Thesis

I am cognizant of the large number of shares sold short (18 million, 36% of the Float).  While I have not spoken with any of the bears, I believe I can identify a number of reasons why the shorts are interested.  What is interesting is that the short interest took a spike up following the Ferguson riots (and Taser stock price appreciation) in 2014.  Since then, the focus for the company has shifted much towards software and consolidated revenue has increased by over 100% from 2014 to 2017E (the increase in revenue being some crude proxy for the increase in the value of the firm)

What I think the shorts see is:

  • Hardware Gross Margins heading to zero and competition increasing

    • The shares sold off sharply late last year when it was disclosed that competitor Vievu (Safariland) undercut them by 50% on the large NYPD contract

    • I don’t disagree that hardware margins may stay pressured, but I don’t ascribe much value to the body camera hardware

  • Prior CFO Dan Behrendt resigned last November and sold most of his shares

  • Rumors of not only aggressive sales tactics but selling to hit quarterly targets:

    • http://www.star-telegram.com/news/local/community/fort-worth/article12443984.html

      • March 4, 2014: Taser salesman Andrew Grayson informs Halstead that the company will give a discount if the contract is signed by March 31. Halstead responds: “Close of the month? I do not wear a cape or have x-ray vision you know… I’m working it but losing millions to the Academy project hurt us bad.”

      • March 16: Grayson reiterates the March 31 deadline. “Our CFO and exec team agreed to the huge discount and net terms in order to get it in this quarter … I feel there is a 99.9 percent probability that this deal will be taken off the table — even if 24 hours short. That said, what can we do to help convince the city manager to sign with you prior to that? Let’s get creative!”

  • 2005 SEC Investigation (Accounting, disclosures pertaining to medical safety of the company’s products)  / Lawsuits over the dangerous nature of CEWs

    • The SEC ended up not instituting any enforcement proceedings

  • Large inventory build (management claimed this is fast-moving products but acknowledged it may see very limited inventory write-downs in 2H)

    • The increase in inventory in Q2 was attributed to supporting the potential high demand for cameras and docks for the national free trial program, as well as to support the increase in volume across all products and to improve customer fulfillment

    • The company also noted that they’re in the process of simplifying their international tax strategy which has required them to carry two full sets of inventory

    • The company has guided to inventory declining from $61m as of June 30th to below $50m by the end of the year

  • Lack of cash generation this year to-date as the inventory build, spending on Sales & Marketing and R&D and cash flow dynamics from Taser 60 Plans weigh on cash flow (recognize revenue of Weapon on sale-in, receive cash over 60 months)

    • Free Cash Flow Conversion in recent years has been excellent

    • Management will likely start breaking out R&D spend on new initiatives that are currently not yet producing revenue

  • Bloomberg headline P/E multiples of 72x a stock price chart with “broken technicals”

  • ‘Blackfish’-type negative documentary: ‘Killing Them Safely’

  • Patent Lawsuit with Digital Ally

    • https://www.axon.com/legal

    • After speaking with an intellectual property attorney, I’m comfortable with this risk but happy to discuss in the messages

 

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