Axon: Misunderstood Company With Big Upside

Summary

• Axon Enterprise is a very unique company with great promise, but still under the radar.
• Axon transitioned from an equipment company to an enterprise software company, increasing its multiples.
• Investor concerns about budgetary pressures are overblown.
• AAXN could return 75%.

Axon Enterprise (AAXN) is a very unique company with great promise, but still somewhat under the radar. After the first night of the George Floyd riots, I woke up the next morning and watched a trending Reddit video of a police station burning. The situation looked bad, much worse than the 2014 Ferguson unrest, and with unemployment across the nation high, I thought social unrest could get much worse.

My gut instinct was that AAXN will benefit as it did in 2014. To my surprise, the stock was up only 1% that morning, suggesting that few people understand the opportunity in front of AAXN. In this article, I will share my thoughts on why AAXN is an attractive stock.

Introduction to AAXN

Axon Enterprises started as TASER International in 1993 in the consumer market and ended up pivoting to law enforcement. Over the better part of three decades now, the company has been building its channel with law enforcement first with the TASER stun gun and then, starting around 2008, with Axon body cameras. It wasn't until 2014 after the Ferguson unrest that body cameras really started to be embraced by both police departments and the stock market.

Axon enjoys a market-leading position in body cameras due to its back-end software and evidence management, which the company calls Evidence.com. Axon was built on a cloud-first architecture with attractive consumer-like UI/UX which made its products effective and pleasant to use. Building on this solid foundation, the company is now expanding into records, software, and dispatch.

Over recent years, the company is trying to pivot from primarily TASER and body camera to more of an enterprise software company that's bringing these cloud-based solutions to more end markets outside of law enforcement such as federal corrections and enterprise.

Today, AAXN has four strategic growth areas:

1. De-escalation through TASR and training;
2. sensors and digital evidence management including the body camera, the in-car camera, video collected from drones, and the evidence management platform that goes along with it;
3. productivity which includes a suite of software that helps make officers more productive in their paperwork; and
4. communications which includes Axon Dispatch and Live Streaming suite of software.

The Big Debate: Law Enforcement Budgetary Pressure

Given the high unemployment caused by COVID shutdowns and increasing calls to defund the police, and since the vast majority of AAXN's revenues come from law enforcement, investors are justifiably concerned with potential budgetary pressures. Many of AAXN's customers operate on budget cycles that either started January 1, October 1, or July 1, and so it is still early to tell what will ultimately happen with customers' budgets in the next fiscal year.

However, I remain optimistic about AAXN's business for several reasons.

First, there's a lot of grant money out there to support police budgets. For example, the CARES Act was recently approved, which will put funding in the hands of law enforcement. Per AAXN's CFO, in some cases, they've already hit their bank accounts. There is also the HEROES Act which has not yet been written into law but is being circulated.

Second, around two-thirds of the law enforcement budgets in the US are tied to property taxes, which is more resilient than sales and income taxes in a downturn.

Third, in the event that budgets get cut, payroll and headcount will likely get cut first since this is by far the largest cost item for police department. In addition, given the company's long customer relationships and strong balance sheet, management believes it could lean on changing its payment plan for its typical five-year contracts to more of a back-end loaded payment plan. While this will hurt AAXN's cash flows in the short term, it could help keep the contracts flowing in and Wall Street could be more willing to look past the difficult times.

Fourth, TASERs, cameras and software solve an important current need, so spending on these items will likely remain top priority. In the current climate, police departments want to de-escalate, document interactions with civilians, and manage collected evidence in a cost-effective and useful way through software. For example, police departments are aware of the power of social media which may disseminate misleading videos alleging police brutality, so they want to be able to tell their side of the story too. In a way, body cameras are as much for the protection of police officers as for civilians.

Valuation: 75% upside

Consensus expects AAXN to grow sales mid to high teens annually, hitting $835 million in revenue by 2022. This seems very conservative given the increasing importance of its products and the company's 22-36% annual growth over the past four years.

If the company grows sales 28% a year instead, it will be on track to generate $1,114 million in revenues by 2022, which is 75% ahead of consensus. This means if the company keeps its current EV/Sales multiple of ~8x, and as it proves out it could maintain its historical growth rate, the stock could appreciate by 75%.

Additional upside could come from multiple expansion as Axon continues to transition to an enterprise software company with more recurring revenues. Currently, 72% of revenues are recurring; however, the company believes it can reach 95%. As AAXN executes, we could see EV/Sales multiples expand, though it is difficult to predict exactly by how many turns.

Two Risks

All stocks comes with risks, and two are my biggest concern for owning AAXN.

The first risk is what will happen if we enter a deep and long recession that lasts for several years. As previously discussed, I believe AAXN will do relatively well when budgets come under pressure; however, earnings will nevertheless get pressured under such a scenario, and AAXN will unlikely hit even consensus estimates. Police departments will likely want to sweat assets rather than upgrade, or be less willing to experiment with new technologies. AAXN may find itself cutting prices and giving out favorable financing terms to keep contracts rolling in. All this will compress margin, cash flow and multiples.

The second risk is competitive pressures from Motorola Solutions (MSI), which enjoys a large installed base in law enforcement and is increasingly encroaching into AAXN's camera and software business. While AAXN remains the leader in camera, MSI has a formidable software offering which enables integration of Motorola communication equipment, cameras and command center software modules. I believe, however, both can win as the market opportunity is large and growing.

Disclosure: I am/we are long AAXN. 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.