Spruce Point is pleased to issue a unique investment research report on Axon Enterprises, Inc. ("Axon," "AAXN" or "the Company"), formerly known as Taser International, a provider of conducted electrical weapons and law enforcement technology solutions.
Q1 hedge fund letters, conference, scoops etc
Spruce Point Believes Axon Enterprises (Formerly Taser) Is A “Strong Sell”: 40% -60% Downside Risk
Axon Enterprises (Nasdaq: AAXN), the maker of the Taser stun gun, has been positioning itself more as SaaS provider of analytics through body cams to law enforcement agencies. With a history of SEC inquires, delinquent filings, and material weaknesses, we believe Axon will shock investors with significant earnings disappointment and increasing cash burn as it fails to scale beyond these niche businesses. Furthermore, we believe investors misunderstand Axon’s exposure to China tariffs, which will constrain margin growth, and its aggressive revenue recognition policies, which have pulled forward revenues. As part of our research, we spoke with a law enforcement expert at one of the 5 largest police departments in the US, a former Axon product executive, and aleading global competitor. With its shares and valuation trading near an all-time high, and analysts price targets of $72 (implying 9% upside), we think the risk/reward is terrible and believe investors should brace for 40% –60% downside risk ($27.50 -$40.00).
Recent Financial Results Signal Growing Strain
- Taser’s core stun gun product is mature with limited domestic unit growth opportunities. A new Taser 7 introduction, over three years in development, is unlikely to materially change this trend aside from a short-term benefit
- Meanwhile, its faster growing Software and Sensors (including Axon Cloud) is experiencing a slowdown, while its margins are alsocontracting. We believe these trends will continue as costs escalate from offering unlimited video storage, and competition increases
- Now 5 years into the Taser 60 program introduced in 2014, and with the Taser having a 5yr expected life, we believe its earlymover advantage is being eroded by competitors pricing and solutions on the software and sensor side. Axon’s best gains are now behindit
Senseless Equity Capital Raises And Need For Borrowing Increase A Classic Red Flag Pointing To Future Financial Challenges
- Axon’s Q1 operating cash burn was the worst in its public history. In addition, Axon quietly increased its line of credit from $10m to $100m, an odd move given it has $350m of cash on its balance sheet, no debt, and is forecasted to produce profits this year of $56m according to analyst projections
- Axon raised $234m of equity in June 2018 for no defined purpose, has spent only $5m on the plagued acquisition of VIEVU, and announced its intention to build a new HQ despite underlying Taser unit growth struggles. From our experience exposing Chinese financial schemes, capital raises for undefined purpose and suspect capex projects are significant red flags
Undisclosed Dependence on Chinese Imports Will Drag On Gross Margins, And Increase The Likelihood of Earnings Misses:
- We believe Axon has concealed its dependence on Chinese imports. It removed the word “China” from its recent 10-K, but in Q1’19 said that “tariff and customs expenses” weighed on margins without quantifying the amount or country source
- Based on import records, we believe Axon has become increasingly dependent on China imports tied to the body cam business in the past few years, and given on-going tariffs, we believe these costs will weigh on margins, and could easily cause it to miss 2019E EBITDA by 10%. Based on our field research (not disclosed by Axon), we find some evidence it has implement upwards of 5% price increases in Q1’19, yet despite this increase, gross margins were still under pressure and missed company estimates by 250bps
Spruce Point Believes Axon Enterprises (Formerly Taser) Is A “Strong Sell”
Capex Planning, Inventory and Gross Margin Disappointment Generally Linked: Axon Fits The Mold
- There are many data points to cast doubt on the accuracy of Axon’s margins beyond it having recently reported a material weakness tied to revenue recognition and cost of sales, fail to promptly address SEC comment letters, and have its CFO resign:
- Inventory: Stopped disclosing “work-in-progress” inventory and increases its reserve to inventory ratio every year. It is now disclosing “inventory optimization” as part of why Q1’2019 had negative cash flow. Inventory to cash conversion days is at a multiyear high
- Capex: Axon missed its 2018 Capex guide by ~20% and offered no guidance to start 2019. Now, with its plan for a new HQ 3.5x the size of its existing HQ, it quietly increased the project cost by 30%. Further, based on segment reporting, it appears Axon allocatesmore overhead to its slower growing Taser segment, allowing it to embellish margins in its faster growing segment
New Evidence of Aggressive, Potentially Flawed, Revenue Recognition And Undocumented Compensation Errors
- Axon released its Taser 60 plan in 2014, allowing customers to save by bundling and paying for product and services over 5 yrs. Axon increasingly recognizes revenues under “multiple performance obligation” accounting tests which gives it discretion to decidethe timing and value of revenue recognition. It claims its bundles have “stand-alone” value, and books revenue for hardware upfront. Bolstering our concerns, public contracts we’ve evaluated include no stated value for the hardware. We estimate this has inflated revenues by 6% -9% in the past few years
- Based on information directly from Axon, it admits that products such as the body cam cannot be used without Axon software. Thisdirectly calls into question its stand-alone value proposition to customers, and its choice to book the hardware upfront. We also spoke to a former senior Axon sales exec and top 10 customer: Both agreed that purchasing Axon’s product makes little sense without the attached software
- In addition, Axon has never disclosed errors or accounting issues tied to compensation expenses. However, Spruce Point has unearthed 401k plan filings at the IRS where Axon admits errors dating back to 2014. SEC reported expenses do not match IRS filings
VIEVU Acquisition To Expand Into The Body Camera Market A Disaster And More Accounting Concerns Surface
- Axon’s $17m acquisition of VIEVU in May 2018, during a company reposting period, stoked a $1.8bn increase in market value. Basedon our estimate, the market for bodycams is at best a $356m market, but the TAM is constrained, margins are shrinking and losses areaccelerating
- Axon stated significant cost synergies as part of the deal rationale. However, more than a year later, Axon still operates a separate call center for VIEVU. Based on our work, it appears that sales declined sharply after the acquisition, while losses intensified. We believe there are no synergies, and VIEVU was a defensive acquisition to buy into the NY Police Dept. We also find that Axon took an enormous inventory reserve amounting to 70% of the total amount of inventory it acquired in the transaction
- Lastly, Axon says the seller received a contingent payout based on VIEVU’s financial milestones. However, we find no evidenceitrecorded the liability on its balance sheet, and by year end 2018, the liability account was zero. This further indicates a failed deal
TAM Inflation And Likelihood To Disappoint In New Markets:
- Axon has rapidly inflated its Total Addressable Market (TAM) from $4.8bn (2016), $6.5bn (2017) to $8.4bn (2019). Yet, by closelyanalyzing assumptions, it becomes obvious that much of this TAM is largely unproven, and being exaggerated with unrealistic pricing assumptions:
- Axon Records / Dispatch: Significant entrenched competition in these critical areas will make it extremely difficult to crackthis market. Axon has given the records away for free to try to whet customer appetite. However, the purchasing decision is not always tied to police chiefs, where they have their best relationships. We believe the market is dominated by Motorola, Tyler Technologies, and CentralSquare Technologies. These three players have largely consolidated the market through acquisitions, leaving Axon no alternatives to buyits way into the market, and punting its future on a greenfield development strategy with a high risk of failure
- Axon AI: Beyond redaction, Axon has limited proven analytics here to sell that we can identify. Furthermore, Axon has mysteriously marked up its sales assumption from $50/mo to $100/mo and users from 600k to 1.1m to inflate the TAM. Axon spent $15m on two small AI acquisitions to form its AI team, and already impaired 27% of acquired technology. By contrast, Motorola spent $1 bntoacquire Avigilon, a leader in video surveillance and AI. This underscores our belief that Axon is multiple steps behind the competition
- International: Axon has repeatedly made big promises about its ability to crack these markets, with underwhelming results. Itrecently pivoted to distributor acquisitions to accelerate progress, while slowly cutting its TAM from $2.7bn (2016) to $2.4bn (2019).Inaddition, Axon’s transparency and disclosures about international sales are poor. Our research suggests it is still many years away from succeeding
Governance Concerns To The Extreme
- Axon has been embroiled in many past controversies, including numerous lawsuits, open SEC investigations, and allegations of bribing police chiefs to win business. CEO Rick Smith has seen both his father and brother leave the company under unceremonious circumstances
- While Axon appears to have used a shareholder friendly buyback to repurchase $141m of stock since 2010, insiders have unloaded $92m of stock over the same time period. With Axon both issuing and repurchasing shares, insiders now own a record low of 2.3% of thecompany
- Axon’s latest compensation scheme, while touted to be shareholder friendly and modeled after Tesla’s long-term plan to link market cap creation, is undermined by the fact the CEO immediately sold 300,000 shares in a senseless stock offering shortly after announcing the plan
- Axon’s compensation scheme ties pay to high flying tech SaaS companies with significantly bigger TAMs, while ignoring the fact that it Is a weapons manufacturer with a more constrained TAM, and significantly bigger liability risks
- Arthur Andersen served as Axon’s auditor from 1996-2002. The current Chairman of the Audit Committee was a long-time accountant and partner at Arthur Andersen, a firm that collapsed the wake of the Enron scandal from blessing aggressive revenue recognition practices. In light of our evidence that Axon uses aggressive interpretation of accounting standards to book hardware upfront that cannot be separated from software, we believe investors should be cautioned
Spruce Point Sees 40% -60% Downside Risk
Terrible Risk / Reward At The Current Share Price:
- Analysts’ average price targets for Axon is $72.30, or just 9% upside from the current price. A majority of analysts (9) are bullish, but there are five (5) that are neutral or expect Axon to perform in-line with the market. Four (4) brokers fail to offer a price target
- Analysts have bought into the narrative that Axon is a superior “razor / razor blade” model with a promising recurring revenue and cloud business. However, we believe this is a one-time boost from a move to the Taser 60 subscription model in 2014, that is nowmaturing five years into the program. All the while, future growth opportunities will remain challenging, and analysts have amnesia as it relates to Axon’s past SEC investigations, material weaknesses, and legal spats and view them as one-off “non-recurring” issues. Based on our recent findings, we beg to differ, and don’t believe that Axon is worthy of its super valuation of 7.4x, 46x, 65x 2019E sales, EBITDA and EPS, respectively
- We believe a majority of the brokers pitch Axon’s stock to retail investors. Sophisticated institutional investors have been selling shares over time, side-by-side with insiders
- Meanwhile a key executive and Board member recently departed, which we believe signals waning confidence in Axon’s future, and supports our case that Axon has a technology roadmap challenge, and constrained ability to acquire deeper penetration in its verticals. Axon’s EVP of World Wide Products, recruited from Apple, quietly left in less then two years. Brett Taylor, Chairman of Axon’s Technology Committee (and M&A Board member), also just resigned as disclosed on June 14th
- Many analysts fail to look at Axon’s two distinct businesses when evaluating the Company. However, we believe it is appropriate to do so given the different growth rates, TAMs, and margin profile:
- Taser: We view Taser as a mature business, and give an 7x-9x multiple of 2020 EBITDA, a premium to other weapons peers by acknowledging its above average margins and market dominance. However, we fail to see any sustaining upside to Taser’s margins
- Software and Sensors: Evidence of revenue accounting issues having resulted in pulling forward of hardware sales, slowing sales growth, compressing margins, and a smaller TAM than advertised, give us reason to value this segment at a discount to SaaS peer multiples at 3.5x –5.5x 2020 sales. Management is leading investors to believe it will start generating revenues from Records and AI in H2’19, but we fail to see a path to monetization and believe this will disappoint. In addition, Axon is promising improvedmargins, but with China tariffs lingering and storage costs exploding, we fail to see any material upside
- Factoring in the excess cash, we estimate a price target of $27.50 –$40.00 (40% -60% downside)65
Fundamental Challenges In Expanding Product Offering & International Growth Will Lead To Significant Disappointment In Achieving Exaggerated TAM
Company Background
- In 1991 the Smith brothers formed AIR TASER Inc with Jack Cover (inventor of Taser predecessor). After nearly going bankrupt marketing other electroshock systems, the company renamed itself TASER International, introduced the TASER M26 and would later pay police officers to train other officers on the use and efficacy of the product. The success of this strategy lead to an IPO on the Nasdaq in May 2001 and a dominant market position
- In 2005, TASER International began to offer Taser Cam, a camera that would become activated when safety was disengaged. The product had some moderate success before the company unveiled its first body camera in 2008. The body cam would experience growing success as a result of its ability to exonerate law enforcement personnel, particularly in the wake of a growing number of high profile shootings and incidents receiving national media attention
- In 2013 TASER opened an office in Seattle and would later announce the formation of a division known as Axon. Axon comprised the company’s technology business, including body cameras, digital evidence management, and analytics. On April 5th, 2017 TASER would rebrand itself as Axon Enterprise to reflect its expanded business and distance itself from the stigma attached to the TASER name.
- In 2018 the company raised capital (“re-IPO”) in an attempt to reposition itself as a SaaS business model and set the goal of becoming an end-to-end police technology partner to law enforcement globally
Placing Axon’s Historical Product Success In Context
Axon’s product origins trace back to the TASER, a passion of CEO Smith after experiencing the loss of two friend’s lives resulting from gun violence. The body cam would later emerge from the TASER Cam, an additional feature on an earlier TASER model. Both of these products can be characterized as predominately hardware solutions. In both instances Axon enjoyed significant earlymover advantage and historically weak competition given the newness and niche nature of the product categories.
See the full report here by Spruce Point Capital Management
