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Axon: Some background on a lesser known company in a high visibility space
My background is in enterprise software and storage. I have spent my entire career either in sales and marketing roles or in analysis of companies that develop software for the enterprise. Until recently, I was unaware that there was a company that brought some of the attributes of IT to the public safety space. As some readers may be aware, I publish a subscription service, Ticker Target. My subscribers frequently ask me to cover new companies; it is part of the business that I enjoy. Most analysts, and I include myself in that category, are fairly blinkered. We are all about deep domain expertise to the exclusion of much else. I actually like the opportunity to learn about new businesses and new opportunities. Axon (NASDAQ:AXON) for me is one such opportunity.
I don’t want to pretend to be an expert as to what kinds of appliances and functionality solve pain points for public safety organizations. The specific features and functions that resonate with public safety organizations are quite detailed and complex and Axon as a specialist vendor enjoys unique advantages in developing products and a platform that appeal to the public safety community and its decision makers. Axon has articulated a vision of an integrated, holistic platform that delivers less-lethal and more automated security solutions. Its mission statement is that of “protecting life, capturing truth and accelerating justice.” Ok, that is more than a bit of a pollyannish commercial. But behind the anodyne phrases, Axon does sell products that seemingly are in high demand and it has created a subscription/recurring revenue model in a space that is experiencing significant growth.
Over the last 15 months or so, investors in the IT space have been dealing with the impact of the macro environment on the growth rate of most high growth software vendors. At the moment, while some data points are indicating a greater probability of a soft landing, much of the slowdown seems overdone, but it certainly has been a significant issue in evaluating IT equities. The public safety market does not have material cyclical perturbations as is depicted by the chart shown on pg. 17 of the presentation linked above. There isn’t the same kind of cyclical element to demand that characterizes IT companies. Bad actors continue with their threats in all phases of the economic cycle.
That said, Axon shares have shown more than a bit of volatility, and have participated in some of the same kind of cyclicality typically associated with IT equities. The shares shot up through the start of the pandemic and then fell noticeably through the middle of 2022. Subsequently, unlike most IT shares, Axon’s valuation took off and the shares rose by 2.5X though in the 10 months ending in April, 2023. Since then, the shares have fallen by a bit more than 20% in the wake of full year 2023 guidance that was poorly received, even though guidance was increased from levels established at the start of the year.
Should readers buy these shares? My estimate for revenues over the next 4 quarters is for revenues of $1.7 billion. It certainly could be greater depending on the parameters of the ramp for some new products as I will discuss later in this article. The company’s current enterprise value is about $12.7 billion (calculation based on $180/share, the closing price as of 7/26.). So, my estimated EV/S ratio is around 7.5X. I think the company’s 3 year CAGR will be above 25%, and could be higher depending on the ultimate success of the recently introduced models of the company’s Taser and Body Cams.
Axon has been non-GAAP profitable and cash generating for several years now. I estimate that its free cash flow margin is likely to be in the range of 15% over the next 4 quarters, with a rising trend during the period. If this were a software company, it would have a rule of 40 ratio of 40 or greater. It is still more of a vendor of hardware than software so I am reluctant to explicitly endorse using the rule of 40 analysis. That said, given the high level of recurring revenue, and the visibility this company has, I think its valuation metrics are attractive, and put its valuation at least 20% below average for a company in the mid-20% growth cohort. With quite conservative estimates for revenue growth, strong profitability, and a market leading competitive position in most of the product areas that it offers, I believe that it makes sense for growth stock investors to acquire a position in the shares, particularly in the wake of the company’s most recent share price underperformance subsequent to the guidance the company provided at the time it released Q1 results in May.
The company will be reporting earnings early next month. I think estimates are sufficiently prudent to guess that the quarter will be a beat. More importantly, depending on the visibility of the ramp for the company’s newest offerings, and particularly for the Taser 10, a raise in growth guidance for the balance of 2023 seems quite possible, although I would not advise any subscriber to buy these shares, or make any other investment, in the hope or expectation of an upside for a particular quarter. There are more than few Microsoft (MSFT) analysts who are going to have a fair bit of explaining to do; not that they are wrong, overall, but wrong in trying to call the specifics of a quarter and related guidance as a pillar in an investment recommendation.
The company has identified a TAM of $50 billion in its investor presentation (see page 14 of the investor presentation) of which a little less than half is software in the areas of digital evidence management, real time operations and productivity tools for public safety personnel. The methodology it has used in developing its estimates is as reasonable as anything else I see when looking at TAM estimates. I tend to look askance at most TAM estimates; they are unprovable and most often project a reality that is seldom realized. What I think I can say in this case is that there is plenty of growth runway potential with significant unrealized potential regardless of the specifics of the available market; basically the penetration of the company’s solutions is very low.
The company hasn’t estimated a specific CAGR for a given period, although its aspirational objective is to achieve revenues of $2 billion by 2025, which would require a 20%+ growth over the next 3 years including this one to reach that goal. It actually grew revenues by a record 38% last year. It started the current year estimating revenue growth of 20% and in the subsequent quarter it raised that estimate to 22%, despite having achieved 34% revenue growth in its Q1. Not terribly surprising, this was not well received given the material growth slowdown implied by the guide.
Software revenue grew by around 50% last year, and overall, software is now 31% of total revenue. Software growth continued at the same cadence in Q1. The math suggests that the company’s forecast for 2023 is more than a bit conservative since at this point, the growth in software alone is delivering 15 points of revenue growth to the organization while the growth of in-vehicle cameras is also at elevated levels.
When I write about the IT space these days, it is inevitable to mention AI and its sibling machine learning. There is an element of that paradigm in the product and solution bundles that this company offers. I don’t think anyone should buy these shares because of an explicit AI component to demand. I doubt that many public safety organization have made decisions to increase their funding for Axon bundles because of some recognition of the value of AI in identifying behavioral patterns that can improve policing results. That said, with more users and devices as parts of its network, the company is improving the effectiveness of what it offers, and in turn is collecting more data that can be used as part of an AI component to its solutions. While its latest investor presentation doesn’t mention generative AI, potential use cases embedding that technology seem on the horizon, at least in the imagination of this writer.
The company has a significant franchise with some marquee customers such as the NYPD, the LAPD, the Miami PD, the DOD, the DOJ, the London Met and the Toronto PD. Overall, its customer count has reached over 17,000. Its current standard offering is based on a 5 year contract, and it most recently reported that its net revenue retention was 121%.
The Axon product portfolio: Quite extensive and providing a number of interrelated solutions
While Axon has been around for 30 years, it has most recently moved beyond providing public safety hardware (Tasers) into holistic solutions. I don’t think it necessary to recapitulate its journey beyond non-lethal weapons which has been a bit tortuous over the years. I suspect most readers will at this point wonder what is Axon. The company started out in life as a pioneer in providing Tasers to public safety organizations. It has gone through a series of acquisitions and pivots. At this point, the company reports revenues in 3 categories. It continues to be a leader in providing Tasers to law enforcement and other public safety organizations.
Sales of Tasers are still the largest source of Axon’s revenues; last quarter they grew 17% year on year, and were 43% of total revenues. One component of the investment case was the recent introduction of its Taser 10 weapon. This product is supposed to be a game changer in the space. It doubles the range compared to previous models and improves accuracy and penetration. The company indicated strong interest in the new product; its guidance prudently reflects a gradual ramp and it was that guidance that led to the share price decline that has improved the valuation of the shares to a meaningful extent.
That said, the qualitative commentary from the company’s COO probably better reflects the company’s expectations for the product.
But I think in the back half of the year, you’ll see a really striking kind of demand – or I’m sorry, sales growth in TASER 10, and that will continue for the next several years. We feel fantastic about the product market fit. We feel fantastic about the customer reaction to the product. And now it’s on us to just manage the upgrade cycle from TASER 7 to TASER 10, and we have a lot of confidence that we will be able to do that very effectively.
We are only in the early stages of shipping our newest product, TASER 10, which is seeing the strongest initial demand of any TASER weapon in the history of the company.
I have seen several TASER product launches at Axon and customer enthusiasm for TASER 10 trumps any previous model
The company also is a significant provider of what it calls sensors, which are primarily body cams and in vehicle cameras for law enforcement personnel. Last quarter sensors accounted for 25% of revenues, and overall, this category has been growing at rates of well greater than 40% the last few years. About 3 months ago, the company introduced its Body 4 camera. I don’t purport to have much experience or knowledge about the functionality of body cams. So, I can simply recapitulate Axon’s description. This new camera has extended battery life, a point of view accessory and bi-directional communications. The communications functionality, integrated with other Axon services seemingly offers wearers a more effective experience. The company believes that this will be a major milestone and pivot point in terms of the functionality of body cams because of the two way communications functionality that provides law enforcement personnel with the capabilities they need to deal with some of the recent confrontations with possible offenders that have been well publicized. Its use is designed to make the policing job safer and to help improve the ability of police to be effective while maintaining levels of accountability.
Here is commentary from the company’s Chief Product Officer, Jeff Kunins:
So as you saw in the video and a bit in the shareholder letter, it’s, of course, early days, but we’re incredibly excited about the initial response both from customers, perspective customers hearing about it at Accelerate (Axon’s sales meeting/kickoff) as well as the customers that are actively trialing it. So far, there is both the meat and potatoes things of our best ever battery life and sensor and all of those things, there is the return of the POV accessory and having it unified with the core camera in a way that we have never had before. There is a ton of excitement for both of those things.
And then on the comms side, you’ve heard us talking about Respond for multiple years now in the growing really, really healthy, both sales and adoption of that in the field, even when there has only been the one way, they are consuming streams up until now. And as agencies are trialing and talking about the bidirectional, we’re getting a lot of enthusiasm for what that makes possible, and in particular, a lot of excitement for this idea of the dedicated Watch Me button on the camera.
And the reason why we think we’re getting a lot of excitement for that is, as you heard in the video and from Rick, it inverts the control or the perceived control and puts it right in the hands of the individual officer, it makes the conversation for an officer being, hey, if I need help, if I want someone to watch my back
Another significant Axon offering is its in-vehicle camera; the current offering is called Fleet 3. Fleet 3 began shipping 2021 and demand has been substantially greater than prior expectations. Last quarter Fleet 3 revenue grew by 139% year on year. The company offers Fleet on the equivalent of a software term license. Its initial reported gross margins are a bit low, particularly as some revenue comes from low margin trainings, and then escalate as users renew and wind up extending their in-camera deployment with software add-ons. One of the principle use cases for in-vehicle cameras is that of providing automatic license plate reading (ALPR). Fleet 3 provides ALPR at a competitive price with significant enhanced functionality as will be subsequently described.
I must confess that I was quite surprised to discover that Axon actually does sell software, and has a cloud offering. The cloud offering is now 32% of revenues. The company’s software is designed to enhance digital evidence workflow, to improve real-time operations, and to streamline administrative processes mainly by enabling report writing and administrative functions through the use of pre-built templates. A few years ago there were no cloud offerings in the public safety space, so the ramp has been very substantial.
The company recently introduced what it calls Axon Air. Axon Air is actually a software solution that is compatible with many kinds of drone hardware. It was developed in conjunction with Vimeo, a company that provides video hosting and sharing. The company has also introduced Axon Respond. Respond offers users a set of functionality that helps to manage the process of responding to incidents. It is used with other Axon offerings such as it body and vehicle cameras, it can be used with Axon’s Dispatch offering and integrates location data and video feeds.
In the last several years, Axon has substantially pivoted to a recurring revenue model. The company offers multiple subscription bundles that include all of its offerings including Tasers, sensors and its software. The subscription bundles have proved to be very well received by users. Last quarter recurring revenue reached $520 million which was up by 49% year on year and up by 10% sequentially. Recurring revenue is now about 40% of reported revenues and that percentage should continue to increase. The company presents a chart in its investor deck (see page of the current investor deck for details) that suggests 80% of its revenues is now tied to subscription bundles.
Axon competes for business in 3 different spaces, i.e. Tasers, cameras, and software related to public safety use cases. There are a number of other companies in the broad space of safety and security. I have linked to an overview of some of the companies in the space. Most of the competitors listed here are small and private. One public company, Digital Ally (DGLY) specializes in cameras, although not the kinds of cameras that Axon sells. WatchGuard, as it name implies, is a specialist in providing surveillance cameras, and also competes in endpoint security. It really does not have a competitive overlap with Axon’s current solution portfolio. MSA Safety (MSA) is a public company listed in the safety space, but its products, which include gas and flame detectors are far removed from the offerings of Axon.
At this point, Axon’s TASER appears to be market leader, and indeed, so far as I can determine, none of the alternatives listed in the link manufacture Tasers or equivalent non-lethal weapons.
The two major competitors in the Body Cam space are Axon and Motorola (MSI). The latest body cam introduced by Axon, its Body 4, would appear to offer users some specific advantages compared to the Motorola product. Motorola, is of course, much larger than Axon, and is the largest company involved in the public safety space, but it has a very broad portfolio, rather than specializing in a couple of high growth segments. At this point, Axon’s fleet cameras are producing much of the company’s total revenue growth. Last quarter in-vehicle cameras were 10% of revenues, and revenues for those devices rose by 2.35X year on year, and rose by 43% sequentially.
Much of the growth is a function of the adoption of what is called ALPR (automatic license plate reading) by public safety organizations. ALPR is used in commercial apps. I called out some use cases for Samsara (IOT) using ALPR when I recently wrote about the successes that company is having. Given the huge success that Axon has had with its fleet cameras it wouldn’t come as a surprise if it chose to adapt its technology to compete in the commercial space.
Axon’s latest model of in-vehicle camera, Fleet 3, has a number of feature/functions that enhance it offering compared to those of other competitors; it can read across 3 lanes of traffic simultaneously at high speeds. The claim is that Fleet 3 usage delivers 8X more reads to an agency compared to traditional solutions. In addition, Fleet 3 has been designed to integrate into an Axon’s extensive systems of connected hardware and software. The following is a quote from the company, COO, Josh Isner:
So everything that we’re doing is designed to create value that will find a place somewhere where we’re displacing inefficiency in the current budget or in some cases, competing products like what we did with our ALPR service, that historically, agencies might pay $18,000 to $20,000 per vehicle to put a bespoke ALPR dedicated hardware camera system. We’ve turned that into a virtualized service offering, which just sits as a layer on top of our existing in-car camera. So our in-car camera is cost competitive, all on its own and provides really great value. And now they can choose to turn on ALPR just as a software service layer running on top. So I hope that’s helpful.
It is this kind of functionality/competitive advantage that has apparently made the Fleet 3 so successful in the market, with growth currently running at triple digit levels.
The public safety software segment is large and quite diverse. Axon only competes in a few specialized areas. For example, in this linked analysis, Zoom Video (ZM) and Everbridge (EVBG) are listed as competitors, but their software has no overlap with that of offered by Axon. Even within the Evidence Management category there are many competitors as this listing suggests. I think it is almost impossible to determine which offering solves the most pain points, integrates into other parts of a holistic public safety offering, and has the best price performance. Last quarter, Axon Evidence continued to grow substantially. It is now about 34% of the company’s total revenues up from 31% in the year earlier period. Overall, in the company’s Q1, Evidence software grew by 48% year on year, and by 4.5% sequentially.
Overall, it appears based on the surveys that I have accessed, that Axon is a share gainer in most of its categories, and this is before the substantial impact of product cycles which should have material impacts on the company’s competitive positioning with Tasers and with its Body Cam offering. No doubt there are segments of the Axon offering that aren’t current share gainers, and in particular, the company’s Taser segment and its bodycam offering showed sequential revenue declines last quarter as part of the impact of material product transitions. But it seems more or less inevitable that both of those segments will be achieving robust growth based on product cycles in 2H.
Axon’s business model: It is already quite profitable
Axon already has an attractive business model with a high level of recurring revenue, strong gross margins and reason opex ratios. Non-GAAP gross margins last quarter were about 60% of revenues compared to 61% in the year earlier period and to 62% in the prior sequential period. The decline in gross margin was a function of mix, mainly a function of a spike in low margin training revenues. In addition, the strong growth in Fleet 3 puts pressure on gross margins as it is a subscription product which tends to defer the recognition margins.
Non-GAAP SGA expenses were 29% of revenue last quarter, compared to a like amount the prior sequential quarter and to 30.6% the prior year. Research and development expense was 15.5% of revenues last quarter compared to 15.7% the prior sequential quarter and to 14.4% in the year earlier period. Overall, the company’s non-GAAP operating margin was 14.5% of revenue in Q1, compared to 16% in the prior sequential quarter, and to 16% of revenue in the same quarter of 2022.
The company has about $1.2 billion of gross cash on its balance sheet, and with the spike in interest rates, its interest income doubled sequentially. The company is generating free cash flow, although in Q1, the increases in other assets and liabilities drove free cash flow negative. For the full year 2022, the company’s free cash flow margin was 10%. While the company doesn’t specifically guide to an adjusted free cash flow margin, based on its record of cash conversion to EBITDA, the free cash flow margin this year should be about 12%-14% and is likely to rise consistently as revenues from its newest products become significant.
The company does use stock based compensation. Last quarter, stock based comp was 10% of revenue compared to a similar percentage in the year earlier quarter. I use dilution in looking at the expense of share based comp. Dilution over the past year was 2% and that is what I project going forward. That yields average weighted shares for the next year of 75.4 million shares and that is what I use in my valuation analysis.
Wrapping Up: Axon’s Valuation and a recapitulation of the investment case for the shares
Axon is an interesting company which competes in several components of the public safety space. It is doubtless best known for its Taser non-lethal weapons and that is still a significant component of the company’s business. But beyond Tasers, the company is a leading supplier of bodycams and for in vehicle cams that are used to read license plates. And the company has a significant software component in its revenue with solutions that target evidence management, and also address report writing and other administrative functions.
The company has achieved substantial growth in recent years as public safety has become a distinct priority for spending at all levels of government. The company has strong product differentiation in its spaces. There is not an exact analog for Tasers, and the latest evolution of the company’s cameras also offers substantial competitive advantages. While it is harder to evaluate the positioning of the company’s software offering, it is clearly one of the leading vendors in the space and has achieved significant revenue growth.
While again, it is a bit difficult to evaluate, the company appears to have one of the most comprehensive platforms in the public safety space. While I could not describe it as an “AI” company, its solutions do collect massive amounts of data, and in some instances this data is being turned into actionable insights and into additional functionality. That said, I would be surprised if this company’s growth rate will see much of an impact from the use of AI and machine learning.
The company’s investor deck presents a 3 year CAGR of 20%+. I think the odds are that the company will exceed that forecast based both on current revenue trends which showed growth of 34% last quarter despite an absence of growth from the Taser and the bodycam segments. The company has major new product cycles in both segments and indications seem positive. If some of the commentary made by management is to be credited, the new TASER 10 is a game changer. Not personally having much to do with Tasers or bodycams, I can only look at the commentary the company has provided. That said, it appears that both products will enjoy steep ramps that will drive revenue growth well above expectations by the end of this year and for several years thereafter.
As mentioned, Axon’s EV/S is currently about 7.5X. That is above average for a company with 25% growth. It is actually below average if the company’s free cash flow margin can reach the 20% range as I project.
While I most often follow software companies, and Axon is only partially a software company, I have looked at other companies such as Samsara that combine software and hardware to develop a complete solution for a given business segment. Axon shares appeal to me because it has best of breed technology that it has taken steps to integrate across a platform. The results of that are still developing and have the potential to accelerate the company’s growth over the long term and to provide more of a competitive moat.
The company’s shares have languished since it provided guidance that upset investors. The guidance was very conservative, to be sure, and relates to the company’s concerns about its revenue ramp for new products. I think long term investors are not going to be too concerned about that kind of conservatism. Investors and analysts, used to dealing in the world of “immediacy” can often deceive themselves as to realistic revenue ramps. For example, while I have little doubt that Microsoft’s various generative AI offerings such as Copilot will see success and to some extent, Copilot is a game changer, as results for this past quarter and short term guidance suggest, ramps are rarely vertical.
In addition to the company’s product cycle ramps, the company has achieved what can best be called startling results for its Fleet 3 product and has chosen to not forecast that kind of growth into the future. The company made the point that Fleet 3 is replacing far more expensive in-car cameras that are less capable. Fleet 3, the company indicates, is being used as an active sensor connected to cloud software as part of an Axon ecosystem. The CFO explained that until now, the company’s revenue growth in in-vehicle cameras had been constrained by shortages of camera supply. That is another reason why I imagine that the company will be able to better its current revenue target.
With a reasonable valuation, based in part on a very conservative outlook, a strong competitive position in a market far less cyclical than that faced by many IT companies and with 2 product cycles that seem likely to produce sustainable upside for several quarters, the shares seem to me to have significant appeal to investors in high growth IT companies. It seems unlikely that the company will ever be known as an “AI” stock, but there are many other growth opportunities. I believe that the company will be able to generate significant positive alpha over the coming year.