|Shares Out. (in M):||58||P/E||0||0|
|Market Cap (in $M):||3,900||P/FCF||0||0|
|Net Debt (in $M):||-330||EBIT||0||0|
|Borrow Cost:||General Collateral|
Axon Enterprises (“AAXN”, the “Company”) is materially overstating the profit from their key cash-flowing Weapons segment (~70% of consolidated revenue and over 100% of profits) through an aggressive accounting policy they have utilized for subscription plans. As sellside consensus has misinterpreted the 40%+ cumulative revenue growth in the Weapons segment over the last 2 years as secular growth (rather than accounting chicanery), I estimate consensus revenue estimates will prove ~30% too high for this division once the revenue “pull forward” the Company has recently benefited from dissipates. Additionally, I believe market expectations for AAXN’s software segment will prove far too optimistic.
Per background, AAXN’s Weapons business largely sells Conducted Energy Weapons (“CEWs”, colloquially known as “TASERs”) to domestic police officers. 73% of CEWs are sold to domestic law enforcement officers, 13% are sold to international police departments, and the remaining 14% are sold to domestic professional users (federal agencies, corrections officers, etc.). Approximately 20 years after AAXN’s first TASER release, AAXN has largely tapped out the domestic market. According to the Company’s own estimates, AAXN has an installed base of ~450k units domestically versus 600k total police patrol officers in the US. Penetration of the remaining 25% is very slow-going given how fragmented the market is. For context, ~95% of the police districts by count employ only ~37% of the total sworn officers in the U.S. and there are over 11k police departments with 100 or fewer cops.
The business model is as follows: AAXN sells a police force TASERs (often with warranties) which the force needs to periodically replace. They also sell test cartridges and active duty cartridges that are needed to use the weapon. Historically, AAXN’s customers have purchased their TASERs upfront with cash and replaced them on average every 8-10 years. As AAXN began to tap out the installed base opportunity domestically, management began looking for ways to reduce the replacement cycle of the weapons to drive growth. They devised a subscription plan wherein, instead of paying 100% cash upfront for a CEW, a police force could pay a per month “subscription fee” per officer and effectively pay for a TASER, a five-year warranty, and a certain number of cartridges over a five-year period in 60 equal monthly installments. The police force would receive the TASER weapon and many of the cartridges at the beginning of the contract.
Police forces loved the subscription plan because: (1) they effectively got free financing from AAXN (the 60 monthly payments are ~equivalent to the upfront cash purchase price) and (2) they were able to move this expenditure from their capital budget to their operating budget. Once the monthly payment plan was approved and in the operating budget, subsequent TASER purchases were easy to make and required limited re-approvals. AAXN has been willing to effectively finance their customers for free because management believes the subscription plan will provide more revenue predictability and will shorten the replacement cycle, betting that the pre-approval for spend embedded in operating budgets creates an incentive for customers to sign up for a new five year plan to get the next generation CEW at the end of their contract period.
While the transaction seems to make economic sense for both parties, the accounting and financial implications are materially misunderstood by the market. AAXN has decided to recognize revenue from these subscription sales based on when the Company delivers the good or service to the customer. Since the TASER weapon, battery, and most of the cartridges are shipped to the customer upfront, AAXN recognizes the vast majority of the revenue from a TASER subscription plan upfront.
Historically, many customers refreshed just a portion of their installed base of CEWs each year because they could not afford to refresh all of them at once. Under the subscription model, however, customers are incentivized to refresh their entire installed base all at once because they can spread the cash flow impact over the five subsequent years. Thus, the upfront revenue recognition accounting treatment has materially overstated and pulled forward Weapons revenue. The following quotes from management (who were relatively open about this when the subscription plan first rolled out and was not yet a significant driver of the P&L) best explain this phenomenon:
“I think one thing we are seeing at least early on is that people are buying more weapons upfront. So instead of buying, say, one-fifth of their arsenal each year for five years, they buy them all up front because the cash flow impact is the same. They can sort of upgrade their entire installed base at the same time.” – ex CFO, November 2016 (who left shortly after the subscription plan rollout)
“…Which also really helps the upgrade program because a lot of these guys are like well -- for somebody who is upgrading -- oh, I've got 500 TASERs. Now I want to upgrade them, but I can only afford to do 100 this year. We say great, guess what? If you can just put us in your budget, we will give you the 500 now. Then that unsticks the deal because otherwise they are thinking well, geez, now we have got to support two different weapons in the field, two different types of training.” – CEO, November 2016
Not only has AAXN materially pulled forward CEW revenue, but I also believe that they have pulled forward a large amount of cartridge revenue by shipping subscription plan customers five years’ worth of cartridges upfront in order to recognize all of the cartridge revenue upfront.
Historically, I believe that trends in cartridge units sold were a good proxy for trends in AAXN’s total CEW installed base, since the total “ammo” used per officer per year should not change much over time. In fact, most cartridge sales are tied to training cartridges – not combat cartridges – which the police forces use to periodically train their officers. Unsurprisingly, prior to the rollout of the subscription plan, cartridge units sold grew steadily at a low- to mid-single-digit clip as AAXN increased its international penetration of CEWs and modestly increased the US installed base. This slow growth in cartridges occurred irrespective of the volatility in CEW unit sales:
Mysteriously, AAXN’s cartridge units sold increased by ~42% cumulatively from 2015 to 2017. I believe AAXN used their “at time of shipment” revenue recognition policy for subscription plans to inflate cartridge revenues by shipping subscription plan customers a substantial portion of the cartridges they were entitled to receive over the five-year life of the plan upfront despite the customers not needing most of these cartridges for multiple years. This idea is supported by historical comments made by management and a careful analysis of the cartridge unit trends superimposed over the subscription plan launch (my emphasis added below):
Q: “Weapons overall was very strong in the quarter, both handles as well as cartridges. Can you elaborate a little bit more on what drove that? Were there any large one-time orders, especially on the cartridge side? Any more color there, whether it was domestic or international, etc.?”
A (CEO): “Really these subscription payment plans are really being well received. I think our three largest orders all came in on some sort of subscription plan, and in those we've bundled together for the customer. One thing they liked is that we are sort of taking a lot of the unpredictability out of the cost. So we include things like warranty and service, but also five years' worth of cartridges in many cases, or at least in some of those plans. So that can also help drive the cartridge volume. So it is primarily domestic, I would say, is what was driving most of that volume.”
Q: “Got it, but then just from an accounting standpoint, do you actually send out the cartridges right away? Or is that just you are recognizing the revenue for those and will send them out as the contract progresses?”
A (ex CFO): “Typically we would be sending the cartridges out with the handles. They have a shelf life that is certainly the life of the weapon itself, so there is no issue with delivering them up front.” November 2016
Note: % of Units on subscription left blank in Q2 '16 (first quarter of program) as company never disclosed figures
Why does this matter now?
While all of this could have been figured out through careful analysis of AAXN’s filings in late-2016, I believe we are nearing an inflection point in reported Weapons revenue for the following reasons:
Sales of CEWs on a subscription plan have remained stable at ~40% for the last three quarters, suggesting AAXN may be nearing peak subscription penetration. Q2 ’18 is the last “easy” comp (28% of units sold on subscription in Q2 ‘17)
Cartridge units sold declined YoY in Q1 ’18 for the first time since the subscription plans were launched (-11% YoY), potentially suggesting the cartridge “channel stuffing” has peaked
Consensus expectations for Weapons segment revenues and profits have risen dramatically, as investors have interpreted the recent growth in Weapons revenue as sustainable
Normalized Weapons Profitability
Despite the share of CEW units sold on a subscription plan leveling out at ~40% for the last few quarters, I assume AAXN eventually achieves 50% penetration through its subscription program and that all of these police forces convert to a 5-year replacement cycle due to this plan. I then assume that the midpoint of management’s historical 8- to 10-year replacement cycle holds true for the remaining installed base to get to a weighted average replacement cycle of 7 years. I estimate this segment should do ~$190mm of normalized revenue:
I believe my estimates are at the high end of likely outcomes due to the following conservative assumptions:
I assume US officers utilize the same number of cartridges per officer as international customers despite management’s historical comments that international customers use far more test cartridges per officer
All subscription plan customers renew with a new plan after their initial 5-year plan rolls off
My ~$190mm normalized revenue estimate is markedly below consensus estimates, which I believe are 25-35% too high:
Note that since AAXN has pulled forward a lot of its future revenue (in 2017, reported revenue was ~$45mm more than my estimate of normalized), there should be a corresponding period in the relatively near future where Weapons revenue comes in below my normalized mid-cycle estimate.
To value AAXN Weapons, I take my normalized revenue estimate, assume AAXN can sustain its current margin structure (despite the negative operating leverage of lower revenues), and assign a multiple of 20x after-tax earnings which yields ~$16.20 / share:
AAXN’s total annual international revenue is ~$60mm, which has grown on average ~$10mm / year for the last four years (the vast majority of which is Weapons). I believe that AAXN’s international business will continue to be a modest contributor to AAXN’s future growth and have assumed as much above, but I believe it is unlikely to materially accelerate from its current growth trajectory over the coming years (despite management’s recent bullish commentary) for the following reasons:
In many European countries (including the UK), it is a cultural norm for police officers to be unarmed. This hurdle will be hard to overcome
In the UK, police budgets are in decline
AAXN likes to talk about its opportunity in Italy, but Italy has been contemplating TASER deployments since as early as 2014. The Italian trial is only occurring in 6 cities and only 30 test CEWs have been allocated per city according to press reports. If they do move forward with more meaningful purchases, all indications point to a slow and modest ramp
Country rollouts tend to be slow and methodical – the UK is AAXN’s largest international market and has been slowly increasing its CEW usage over many years
There is less need for CEWs internationally due to lower violent crime rates. The intentional homicide rate (per capita) in the US is ~4x that of the UK, Australia, and Italy
AAXN bulls are excited about the Software & Sensors segment. This business sells body-worn cameras to police officers (at near break-even) and provides a cloud-based evidence storage platform called evidence.com. Using this razor / razor blade model, AAXN has been quite successful in getting police forces that use AAXN body cameras to sign up for a subscription to the cloud storage platform. Consensus ascribes very healthy revenue multiples to AAXN’s subscription revenues based on the belief that the Company will continue to materially grow the platform through continued penetration of the evidence.com opportunity (both domestically and internationally) and succeed in garnering share with new product launches like the records management system (“RMS”) platform. I am skeptical of these growth opportunities and address each below.
While AAXN has done a great job penetrating the largest police forces in the US with their subscription plan (38 of the top 50 metros before the VIEVU acquisition), I believe much of the low-hanging fruit has already been won and incremental subscriptions will be harder and harder to achieve. Consider the following:
AAXN has ~227k officers on their evidence.com subscription platform, the vast majority of which are domestic given limited international penetration to date. Of the 600k officers in the US, over 200k are in the top 50 metros. The remaining ~400k officers are spread across more than 12,000 agencies. Most of AAXN’s evidence.com seats are coming from these top 50 metros. Further penetration is predicated on converting the very long tail of small customers, which should be considerably costlier and more time-consuming to convert
Despite TASERs being the gold standard in sub-lethal policing in the US (with no real CEW competitors), they are still only ~75% penetrated after being on the market for ~20 years. In-dash police cameras have just ~50% penetration in the US after being on the market for 20 years
Whereas there is no real CEW competition, evidence.com does have real, well-funded competition with market share
Many police agencies have chosen to store video evidence on legacy on-premise storage systems; this will likely continue and will cut the TAM for cloud-based storage solutions. After adjusting for an estimate of camera replacement demand, I believe only ~85% of AAXN’s camera sales have converted to cloud subscriptions despite AAXN being the #1 cloud storage provider. Many competitors have much lower subscription attach rates. WatchGuard, for example, has sold ~30k body worn cameras over the last three years, yet has minimal subscription revenue [side note: WatchGuard filed for IPO in October 2017]. Ultimately, I believe the “cloud attach rate” for body-worn cameras industrywide is well below 85%
The international opportunity for evidence.com is likely much smaller than the US opportunity and perhaps even smaller than the international CEW opportunity given the lower propensity to sue internationally. Despite many years attempting to grow the CEW business internationally, it is still only ~20% of CEW sales. Moreover, as mentioned above, the violent crime rate is much lower in the international markets that AAXN is targeting than it is in the US, which meaningfully diminishes the need for body cameras.
I believe the market is using materially over-optimistic assumptions to value AAXN’s Software and Sensors segment. To illustrate, even if one assumes…
600k body camera installed base, roughly in-line with my estimate of AAXN’s worldwide CEW installed base, despite credible competition in body cameras and no competition in CEWs
90% of the body camera installed base signs up for evidence.com, which would be an uptick from my historical 85% estimate
The company is able to increase evidence.com ARPU from its current ~$30 to $39
40% subscription EBIT margins
5% subscriber churn
$800 customer acquisition cost per subscriber, in-line with the recent historical average, despite the likelihood that acquisition costs rise as the Company taps out the large police forces
16x fully-penetrated EBIT
…I still only get to ~$16.50 / share in value for Software & Sensors:
I believe most of these assumptions will prove way too optimistic, but use them in my valuation to highlight the extreme overvaluation of AAXN.
While many police agencies have antiquated Records Management systems (”RMS”), I believe that this will be a modest opportunity for AAXN for the following reasons:
Key competitor Mark43 has a cloud-based RMS platform that has had significant traction to date. Mark43 has a multi-year head start on AAXN in delivering cloud-based RMS. As of March 2018, Mark43 had been deployed at 13 public safety agencies, including Washington, DC, Seattle, Jersey City and Camden. Customer feedback on Mark43’s product has been quite strong
Based on a careful review of public procurement documents, I believe Mark43 is charging ~$800 / officer / year for their product, whereas AAXN is talking about charging $1,500 / officer / year
No one in the industry I have spoken to has seen AAXN’s RMS, including industry consultants who are often engaged by police forces to help assist in RMS transitions. It is very early-stage and unproven
Large cities with police forces exceeding 1,000 officers tend to go with on-premise software, even though those systems can cost millions of dollars and have terrible track records in some cases. For the large forces, on-premise systems are cheaper to own over the long-run and provide more customization than cloud-based approaches. New York City, for example, uses Omniform, an RMS system that the city designed for itself. The Los Angeles police force uses Niche
Most mid-size police forces want to buy CAD (computer-aided dispatch) and RMS from a single vendor. While AAXN has talked about developing CAD, that product is behind even the early-stage RMS product
RMS is highly complex and requires meaningful customization and implementation work. Each police agency is a "snowflake" - they all require RMS to integrate with a variety of localized systems with non-standardized interfaces (i.e. their platform to run license plates, etc.)
I estimate ~40% of the top 25 domestic police forces have recently refreshed their RMS platforms, making them unlikely to buy again in the near future
I value AAXN on a sum of the parts basis using the methodologies highlighted above for Weapons and Software & Sensors. I also give AAXN credit for a $100mm valuation of the RMS segment, a premium to the ~$80mm of capital that their closest competitor Mark43 has raised despite Mark43 already having a finished product and significant contract wins. After layering in the Company’s net cash balance following the recent offering, I get to a total value of $40 / share, or ~40% downside from the ~$67 latest close: