Market Opportunity

Axon Enterprise (AAXN), formerly known as Taser International, has captured (no-pun intended) the lion’s share of the move towards implementing body cams in law enforcement. This move has reinvigorated the company with Taser sales growth slowing to single-digits while software and sensors revenue, which includes body cams, grew at a tepid 53% in 2018.

Body cams have been a hot topic of discussion following several incidents, most notably in Baltimore and Ferguson, that garnered media attention. The opportunity to expand into body cams fell into Axon’s lap because of Axon’s existing sales channels with law enforcement agencies from the existing Taser business.

With market forecasts for body-worn cameras to grow by 38.2% through 2023, Axon is well-positioned in an exciting fast-growing market. Investors must think about balancing growth with the company’s legacy Taser business which will place a drag on top-line growth. The company as a whole posted a disappointing 13% growth rate this past quarter.

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This doesn’t pass the initial eye test, with the company trading at 58x forward earnings and 77x operating cash flow.

Data by YCharts

I expected growth rates to accelerate for Axon as the faster-growing body cam segment becomes the majority of revenues for the company. Axon’s real cash cow is its cloud solutions such as evidence.com as opposed to its hardware. The hardware is the foot in the door that results in departments subscribing to Axon’s cloud solutions.

Competitive Advantages

Axon’s primary competitive advantage is its relationships and sales channels with law enforcement agencies. This has created a strong ecosystem with high switching costs. Axon’s hardware solutions are by no means groundbreaking, but the company has valuable positioning amongst law enforcement agencies. Axon has been able to translate hardware sales in cloud storage solutions such as evidence.com.

Axon’s products are not particularly innovative. The Taser was invented in 1974, and Axon’s cameras are fairly standard. Axon has a stronghold on the market, but does face competition from companies such as Watchguard. Axon eliminated some competition by acquiring rival firm VIEVU in 2018. Watchguard issued a statement in 2017 essentially stating that Axon was using anti-competitive practices by offering police departments free cameras that would in turn bind the department to Axon’s “costly” evidence.com platform.

Watchguard’s assertion doesn’t come from a position of strength, as the nature of business calls for consolidation. The market understands this, as the primary reason the company trades at high multiples is the expectation that Axon will leverage this platform to expand margins.

Upside Scenario

The company’s long-term goal of 70% margins is crucial for long-term investors to see positive returns.

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Axon’s risk-to-reward profile faces more risk to the downside than potential upside over the coming years. Despite ambitions to become more ingrained in modern law enforcement, Axon must drive margin expansion for the valuation to make sense.

2018 2019 2020 2021 2022 2023
S&S 167 230 318 439 606 836
Taser 253 266 279 293 308 323
Total Rev. 420 496 597 732 913 1,159
Growth 18.1% 20.3% 22.6% 24.8% 26.9%
S&S Margin 52% 56% 62% 66% 68% 70%
Taser Margin 68% 70% 70% 70% 70% 70%
Op. Ex. 234 281 337 404 485 582
Profit 25 34 55 90 142 229

Discounting these future earnings by the expected market return of 8% and giving the company a generous 20x terminal multiple yield a value of $3.3 billion.

This forecast is based on projections, actual growth rates over the several previous quarters have been muted. Given the nature of the confined TAM, growth is fully baked into Axon’s stock price.

ChartData by YCharts

If gross margins continue to meander, it will force investors to question whether there are challenges that management hasn’t accounted for when guiding for 70% margins. In this scenario, expect Axon’s shares to experience severe valuation-based depreciation which could offer long-term investors a buying opportunity, should the fundamentals remain strong.

This is when investors would want to consider initiating a position in Axon, not at this moment in time when management’s optimistic guidance is fully baked into the share price.

Should margins remain flat over the coming years, and the projected growth rates come to fruition, the company will only do about $72 million in profit in 2023. At a 20x multiple, $1.44 billion or $24 per share would be a rock bottom in terms of valuation. Under $30 per share the stock is a strong buy.

Downside Risk

The current valuation gives the stock very little margin of safety. In addition, according to 2016 statistics, 47% of general law enforcement agencies use body cams. This market can only grow so much, the market may be closer to saturation than the 38.2% growth rate implies. Growth in terms of number of units is down to about 12% from 2017 to 2018. This paints a picture that is more reflective of Axon’s growth.

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Slowing unit growth would indicate that Axon’s opportunity to grow its installed base is also slowing dramatically. The company’s real moneymaker is software; evidence and cloud services now make up just under 30% of the company’s revenue.

Given the company’s relatively muted growth in recent quarters, I suspect that the stock will face significant downside following any misstep. The company is a long way from its goal of 70% margins, and any loss of confidence from the market means that current shareholders will be hosed.

Axon is another case of overstated potential. One of the company’s goals is to expand its TAM, but Axon lacks the sales channel advantages in other verticals. At the current valuation, Axon is priced to dominate a significantly growing market. Any misstep and the business is likely to trade at a much lower valuation. In the current environment, Axon is not the type of stock to own.

There’s little conclusive evidence in determining how close Axon is to maturity. While some market forecasts call for huge growth, Axon’s revenue and the number of agencies with body cams are slowing. This leads me to believe that the worst-case scenario is that Axon is running up against its total penetration. In this scenario, shareholders will be in for a ride to the downside due to stretched multiples.

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Most major cities have adopted the Axon network. This speaks to the company’s selling ability, but is more evidence in favor of the thesis that Axon is about tapped out. The discrepancy between the number of officers in the largest police forces is notable. For instance, the NYPD has about 36,000 officers, while the second-largest department, Chicago, has 13,000 officers. With the exception of Los Angeles, the large markets have already been tapped by Axon.

Axon’s story of dominating a market that will never go away and having a sticky ecosystem is strong, but the numbers simply don’t add up. Axon is an appealing business from a qualitative perspective, but don’t buy it at these valuations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.





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