Axon: great business, too expensive

• Axon is transforming itself form a hardware provider to a software company that also produces devices.

• Axon’s products and services are becoming more valuable, as the need for transparency and accountability among police forces increases.

• The company enjoys significant competitive advantages over its competitors due to high switching costs.

• The current market price already fully incorporates future growth and profitability. Investors interested in the company should wait for a lower price.

Article written by Adriano Milani

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.

In fact, the company also sells body cameras and other video-related hardware, 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 Systems (RMS).

Source: company presentation

Tailwinds

Axon benefits from several tailwinds linked to the current socio-economic environment. 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).

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. These trends also increase the need for transparency and accountability, which I believe is the key factor, as Axon’s technology becomes more and more useful/essential for police forces.

Competitive advantages and future growth

Taser

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, and around 70% of US patrol officers carry a TASER device, according to company estimates. 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.

Source: author’s work on company filings

On price increases, Axon can take 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 relationships 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.

Source: author’s work on company filings

On new markets, potential areas of expansion are 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. I will assume this sector will also support part of future growth.

Software and Sensors

Axon reports its camera & software business under a segment labelled “Software and Sensor”, which increased steadily as a % of total revenues in recent years and is approaching a 50% weight.

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.

Source: author’s work on company filings

The company indicated a 25% gross margin as its long term target.

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.

Source: company presentation

The platform profitability is very high, as it enjoys even higher switching cost 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.

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 (ARR), 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, I think it is fair to assume a continuing increase of 5% per year going forward.

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

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.

Expanding to RMS and CAD

Axon is currently investing 18% of its revenues in R&D, and is expanding its software offering with services such as Records Management Systems (RMS) “Axon Records” and Computer Aided Dispatch (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 upselling to even a small percentage of existing customers would bring benefits to the bottom line, considering that there is no hardware cost associated with the services.

Targeting new markets and introducing new products, Axon is expanding its total addressable market (TAM). Axon self-declared TAM went form 8 billion in a December 2019 presentation to 27 billion in June 2020 (right, 6 months later). Notice the switch from value-added features to value-added product and markets. While such a jump should be met with a healthy dose of skepticism, it signals a clear focus on expanding the business.

Source: December 2019 company presentation

Unfortunately, Axon newest presentation lacks the granularity of its predecessor, but we can make a quick comparison and try to make sense of the new numbers. Tasers’ TAM went form 1.8 billion to 5 billion, probably a consequence of including non-law enforcement customers (which overall account for 46% of the total 27 billion) and possibly some more aggressive considerations towards international markets. I believe the reasoning might be similar, and more aggressive, for cameras and software, which tripled from about 3.5 billion to 11. Records and dispatch were bumped from 2.5 billion to 4, and Fleet from 600 million (domestic only) to 3 billion. The remaining 4 billion are made of new product not previously mentioned. Overall, I think it is reasonable to assume that Axon TAM is actually expanding, but maybe not as dramatically as the company suggests.

Source: June 2020 company presentation

Other considerations

A recurring revenue model

Axon is trying to move its entire business towards a recurring revenue model, including Tasers: customers could still buy them the traditional way, paying upfront, but the company offers a 5-year subscription plan, which conveniently allows for spreading payments, and it is more and more preferred among law enforcement agencies.

Source: company presentation

CEO compensation linked to shareholder value

Since 2018 the CEO and co-founder Rick Smith 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 presentation

The highest milestone in terms of market capitalization imply a share price close to $200.

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

Axon has also been able to generate positive free cash flow in recent years, and quite consistently since 2011, with the exception of 2016-2017 when it invested heavily in expanding its camera and software business.

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

Axon raised about $ 300 million in a public offering of common stock in mid-June 2020. The move was a bit surprising to me, 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.

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.

Covid-19 impact

Covid-19 does not seem to have had much impact on the company businesses. Theoretically, the need for social distancing makes product such as Tasers and Evidence.com more appealing as ways to prevent physical contact.

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.

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, and it is reinvesting a meaningful portion of its sales in the effort. 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.

Article written by Adriano Milani

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