Axon: Great Business, Too Expensive (NASDAQ:AAXN)

Axon’s (AAXN) economics are great, but the stock is too expensive for it to be a good investment at around $80 per share. I like the business, and I will explore why I would love to own the stock at the right price, but my estimated intrinsic value is $ 74 at best, which leaves me with no margin of safety at today’s price.

What does Axon do?

Axon’s legacy business is selling Conducted Electrical Weapons (CEWs) – its TASERs – to police departments, mainly in the US. The company name itself used to be “Taser”, and changed to “Axon” in 2017 to underline the shift to the camera/software businesses.

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Source: company website

In fact, the company also sells body cameras and other video-related hardwares, and offers a cloud platform for storage of digital evidence, named Evidence.com. These businesses are tightly linked, as the increased use of cameras produces more video evidence, which drives the demand for data management solutions. In the company’s own words: “Body camera programs address a transparency and accountability problem. They create a giant data management and storage problem. Axon’s camera and software solution solves both”. Lastly, Axon is currently launching additional services bundled with its cloud platform, such as “Dispatch”, a system that process 911 calls, and a records management system.

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Source: company presentation

Tailwinds

First a quick overview on the current socio-economic environment, which I believe gives Axon several tailwinds. Smartphones diffusion makes virtually every protest or violent event involving police officers recordable, whether police forces like it or not. Citizens’ videos of officer’s violent conduct are likely to miss the initial actions that led to the situation, and are easier to put out of context. Law enforcement agencies benefit from the adoption of cameras, as they improve behaviours of both police officers and citizens, allowing officers to defend themselves against false accusation and providing higher quality evidence against criminals. Furthermore, it responds to the public expectations of more transparency and accountability from police officers. Additionally, the number of sworn officers in the US has been rising since 2013 at a pace of around 15-20 thousands officers per year, according to FBI Uniform Crime Reporting data (available up to 2018).

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Source: Statista.com, based on FBI Uniform Crime Reporting data

As of today, around 800.000 sworn officers are reported by datausa.io and by the National Law Enforcement Memorial Fund website. Although it is not a given that the number of US officers will keep increasing (notice the sharp decline between 2011 and 2013), I think this is likely to happen, as we see growing tension among the US population, due to general trends such as increased income inequality and stronger response to violent episodes associated with discrimination. I believe these trends also increase the need for transparency and accountability, which in my view is the key factor, as Axon’s technology becomes more and more useful/essential for police forces.

Competitive advantages

Taser

Axon legacy business still looks quite profitable and with significant barriers to entry. The company has a dominant position in the CEWs market, to the point that the “TASER” brand is synonymous with the product category as a whole. In the US, it faces virtually no competition, with a market share above 90%: 17.000 out of 18.000 US police agencies buy TASER devices. Revenues for this segment have been growing at around 10% yearly since 2017, and with the US police market almost fully penetrated, further growth depends on Axon ability to increase prices and expand to new markets. I believe Axon is well positioned on both fronts.

Description: https://static.seekingalpha.com/uploads/2020/8/10/49282389-15970567873681366.png

Source: author’s work on company filings

I think Axon will be able to increase prices over time, taking advantage of the lack of competition and of its significant competitive advantages over potential entrants. On the product side, it has patents to protect its technology and a well-established brand. On the demand side, customers face high switching cost when considering adopting an alternative product, as the costs linked to a potential failure are normally higher than the benefits. Furthermore, Axon created a wide network of relationship with police agencies across the US, which would be very difficult, and costly, for a competitor to replicate. Axon healthy gross margin in its Taser segment is also a signal of barriers to entry. Historically close to 70%, it has dropped toward 60% since 2019, but management commented that this is a temporary effect caused by the switch to their 5-year bundled offers (Taser + camera + Evidence.com), which carry a lower gross margin upfront, and increase in years two through five. Additionally, Axon has launched a new Taser model and has been granting credit to customers who wanted to upgrade in advance, partially “refunding” for the remaining useful life of the previous model. Management expects gross margin to return at 70% in the long run.

Description: https://static.seekingalpha.com/uploads/2020/8/10/49282389-159705678755037.png

Source: author’s work on company filings

Regarding the expansion to new markets, the company can target international police forces or adjacent US markets such as federal agencies and prison and correction facilities. Internationally, Axon has had some success so far, but limited to 15-20% of total revenues. The largest share of export is towards the UK, Canada and Australia. International sales are mainly composed of Tasers devices, and management commented that it is harder to sell cloud solutions in certain locations, such as mainland Europe. So I expect Axon to slowly but steadily progress in its international expansion, at least with its Tasers. As for further expansion in the US, the company specifically mentioned departments of corrections as a relatively big, untapped market: it accounts for about 542.000 officers and usage of Tasers and body cameras is minimal. Theoretically, Axon’s technologies offer several advantages for prison officers: a reduction in use of force, complains, but also staff assaults. Overall, I think this sector is still attractive and will support part of the future growth.

Software and Sensors

Axon’s most glamour segment, its camera & software business, is even more promising than Tasers, and is growing fast. Reported as “Software and Sensor”, it increased steadily as a % of total revenues in recent years and is approaching a 50% weight.

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Source: author’s work on company filings

The company has used its strong relationships with police departments to position itself as a leader in those segments too, and it is currently serving with its cameras 47 out of 69 major US cities.

Source: company presentation

Axon main hardware product is its wearable body camera, “Axon Body”, but it sells also in-car cameras and other devices. However, there is competition from the likes of Motorola and Panasonic, as the hardware itself is a bit of a commodity, so profitability is not very high. The company indicated a 25% gross margin as its long term target.

Description: https://static.seekingalpha.com/uploads/2020/8/10/49282389-15970567873633385.png

Source: author’s work on company filings

On the software side, all digital evidences captured through Axon cameras are stored in the cloud platform Evidence.com, which also accepts data from other sources. The platform has registered a steady increase in number of users, which is driving growth in recurring revenues.

Description: https://static.seekingalpha.com/uploads/2020/8/10/49282389-15970567880078335.png

Source: company presentation

The platform profitability is very high, as it enjoys even higher switching costs than those linked to Taser weapons: case evidence stored on Evidence.com is subject to retention requirements that can last for several years, and changing for another software would require re-training and bearing significant risk. Once law enforcement agencies start using Axon’s platform, it becomes very difficult to change for a competitor, even if it’s cheaper or it offers better performance. This, coupled with its leadership in market share, gives Axon a strong competitive advantage and a healthy gross margin.

Description: https://static.seekingalpha.com/uploads/2020/8/10/49282389-15970567875740912.png

Source: author’s work on company filings

Future growth depends on wider adoption of the platform and revenues per user. Axon does not disclose anymore the number of users it has on the platform, but it closed 2019 with 465.000 licenses, an increase of 34% compared to 2018. While there should still be plenty of room to grow, it is fair to assume that the rate of such growth will slow down as they approach the number of Taser devices in place (about 700.000, increasing as well). Dividing annual recurring revenues, as disclosed by the company, by the number of users, we can track Average Revenues Per User (ARPU). Axon has shown a trend of rising ARPU over time, and although it has been a bit of a bumpy ride.

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Source: author’s work on data from Axon’s letters to shareholders

The drop in Q2 2018 is related to the acquisition of camera-competitor Vievu, according to management comments, and ARPU would otherwise have been growing sequentially. I think the business is solid and going forward it can continue to grow ARPU at 5% per year rate.

Expanding to RMS and CAD

Axon is expanding its software offering with additional services, which I believe will contribute to some extent to future growth, although not as much as the pre-existing businesses. The two main new services are a Records Management System (RMS) “Axon Records” and a Computer Aided Dispatch (NYSEARCA:CAD) “Axon Dispatch”. Records helps officers in creating paperwork such as incident reports, while Dispatch collects 991 calls and helps efficiently deploying officers to the scene, also providing them with critical information. Axon could potentially sell these services to more than just law enforcement agencies, but that does not seem to be its strategy, for the moment. For instance, a CAD might serve more than one jurisdiction, and might not be limited to dispatching police, but also fire, medical emergency and so on. Axon is currently targeting customers that fit in the “single jurisdiction – police only” category, which sounds reasonable, as that is where the company has its stronger relationships, but it might be difficult to expand further away. Additionally, other providers already serve both segments, and Axon will likely face significant competition. However, Axon’s strategy is to bundle the RMS and CAD functionalities with its Evidence.com license, and even upselling to a small percentage of existing customers would bring benefits to the bottom line, considering that there is no hardware cost associated with the services.

CEO compensation linked to shareholder value

I like to see management’s interests aligned with those of the shareholders, and this seems definitely to be the case for CEO and co-founder Rick Smith. Since 2018, his salary is set to $ 25.000 per year, and the real compensation comes from a 10-year stock options plan. The plan is structured so that he is paid if the company meets a series of targets (on revenues or EBITDA), but each target is linked to an increase in market capitalization, meaning he gets his compensation only if the shares significantly appreciate. He can receive a maximum of 12 tranches, each granting him a bit more than 500.000 shares, with a strike price of $ 28.58.

Source: company press release

The highest milestone in terms of market capitalization implies a share price close to $200, which is good to see, keeping in mind that it is hypothetical and potentially far away in the future.

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Source: author’s work. The calculation does not account for treasury shares buyback, which would reduce the dilution effect.

Positive free cash flow and low leverage

My overall positive view of the company is also based on its cash flow and leverage metrics. Axon has been able to generate positive free cash flow in recent years, with the exception of 2017, when it invested heavily in expanding its camera and software business.

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Source: author’s work on company filings

The company has no debt, a revolving credit facility for 50 million and around 550 million in cash and short-term investments, for a very healthy balance sheet.

Equity raise

What I did not like, as a potential equity investor, is the recent offering of common stock. Axon raised about $ 300 million in mid-June 2020, a surprising move in my opinion, as the company had an already healthy balance of 340 million in cash and short-term investments at the time, no debt obligation to meet and the above-mentioned positive of free cash flow generation. Management merely commented that the additional funds will give them optionality, citing the need to keep investing in the business, build up inventory and potentially be flexible with their customers in terms of payment schedule. It still seems to me that the previous cash balance was sufficient to handle all these situations: the inventory increase came at a cost of 34 million, and free cash flow was negative for “just” 20 million in the quarter, meaning they had enough cash to survive more than 15 similar quarters. I checked the balance sheet for unusual jumps in key accounts, which I did not find.

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Receivables have jumped as percentage of sales in recent years, but this seems to be a consequence of the switch to bundled offerings, and the trend is stabilizing. Additionally, Axon has a Beneish M-score of -2.77, which suggest it is not manipulating its accounting.

Valuation

I valued Axon in two ways. First, I modelled a DCF assuming the company will manage, in 10 years, to grow its revenues to 1.7 billion and to expand its EBITDA margins to 27%, then discounting the resulting cash flows on a 10% required rate of return. Adding back cash and short term investment, and subtracting the value of stock option, which I roughly estimate at 300 million, gives me a share value of $ 40.3. Then I checked this against a potential market multiple in 5 years. I assumed Axon will be priced at P/S of 6.7, which is the average P/S of other software companies that I have selected as peer group. This is a lower multiple that what Axon has been trading in recent weeks, but it is consistent with my expectation that the company’s growth rate five years from now will be lower. The resulting share value is $ 73.9, still below the current market price. I would consider the market multiple to be more reliable than the DCF, because it goes only 5 years into the future, instead of 10 (plus the terminal value), and because most investor would probably use a discount rate lower than my IRR of 10% in a DCF calculation, so $ 40,3 is likely to be too conservative.

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Description: https://static.seekingalpha.com/uploads/2020/8/10/49282389-15970567872995248.png

Source: author’s work

Although it is difficult to put a precise number on a fast growing company like Axon, I believe this very promising business is already trading at a price that fully incorporates its future success. This leaves the potential investor with little protection in case things take a bad turn. I prefer to pass on the company for the moment, waiting for a better price to potentially provide me with an entry point.

Summary

Axon is a very interesting company: It enjoys significant competitive advantages in its Taser segment, and even more so with its software Evidence.com. It is focussed on growing both geographically and in terms of product offerings. However, the market is currently fully pricing such growth, and possibly a bit more. I think a lower price is necessary to buy the stock, as the current growth rate might not be sustainable for a meaningful number of years, and new markets such as RMS and CAD might be difficult to dominate.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AAXN over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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