Axon Enterprise: Taking Stock Of Stock-Based Compensation

Summary

• Axon Enterprise continues to demonstrate success in its pivot to the high-margin SaaS business model.
• While overall expenses are still high, the overall bottom line still looks profitable when adjusted by removing stock-based compensation.
• The stock price is just slightly overvalued when the intrinsic value is calculated based on this adjusted net income (without stock-based compensation).

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Investment thesis

Axon Enterprise (NASDAQ:AXON) has a very good business model with high sustainable growth potential as it pivots to a high-margin SaaS model. In the latest annual report for 2021, the financial profile of its different business segments appears to have proven this thesis.

The company is currently loss-making if we just look at the net income at face value. If we drill down deeper into the detailed line items of its expenses, a large portion of the expense is due to Stock-Based Compensation (SBC). Based on a thesis that the company’s growth plans are likely to succeed, such expense may not be a concern.

My previous article provided an intrinsic value calculation of just $78.19, calculated using operating cash flow. This implied the stock to be ‘highly overvalued’. In this article, I will show that using a net income that is adjusted by removing the SBC, the resulting intrinsic value actually looks just ‘slightly overvalued’.

Overall, AXON looks like a much better stock to invest in after the intrinsic value is adjusted by excluding the SBC expense.

Company Overview

I already discussed extensively with regards to AXON’s business in my previous article. In this section, I will just briefly summarise the main points:

1. AXON has a very strong brand monopoly in the TASER brand which is verbified like ‘google’. There is no alternative to the TASER "Conducted Energy Weapon" product.
2. Riding on the success of the monopolistic brand of TASER, the company pivoted to the high margin SaaS model with recurring income.
3. Subscription bundles with recurring streams of income account for the lion’s share of AXON’s total revenue (73%).

Latest Results from Operations

Here are the results of AXON’s latest annual results from operations in 2021 compared to the previous year of 2020.

AXON Annual Report 2021

We can get the following insights from the “percentage relationship to total net sales”:

1. The proportion of sales from AXON “products” decreases slightly and this is in contrast to the proportion of sales from “services” which actually increases slightly. We discussed in our previous article that AXON leveraged the brand monopoly of TASER and pivoted into the high-margin SaaS business model. Hence it is quite expected for the company’s net sales to increasingly shift from products to services.
2. Point 1 was achieved despite an increase in the percentage relationship of ‘cost of service sales’ compared with a decrease in that of ‘cost of product sales. In other words, even with a relatively higher cost of delivering services to customers, AXON’s sales volume in services is still beating that of its products. This suggests the company made the right decision to pivot to the high-margin SaaS business model as it has proven to be able to get proportionally more revenue from delivering services through SaaS subscriptions at a proportionally higher cost.
3. Overall gross margin from products and services increased from 61.1% to 62.7%. From points 1 and 2, we understand that this is largely driven by the company’s success in delivering high-margin 'services'.
4. The company continues to incur increasingly high operating expenses to achieve its growth objectives.

Overall while point 1 to 3 shows that AXON’s investments so far have achieved positive results, it remains a loss-making company that conservative investors with a lower risk profile need to be aware of when considering AXON as an investment.

AXON’s Operating Expenditure

When a company incurred a high level of expense, it may or may not be a red flag for investors. Let’s take a look at what the company is spending on.

AXON Annual Report 2021

We can see that a large part of AXON’s operating expense is in stock-based compensation and salary increases. To expand greatly in the software segment, we expect the company to need a lot of software engineering talents which are highly sought after in the employment market.

Technologically inclined competent account managers are also needed to build good relationships with clients to ensure a high level of retention in order to sustain its recurring subscription revenue. Hence, these expenses are not unexpected.

Share-based compensation (SBC) can be a double edge sword. From this article, we understand that SBC brings some benefits such that:

1. AXON’s employees are motivated to stay with the company.
2. AXON’s prosperity is aligned with the employee’s financial interests as they hold the company’s shares.
3. The above 2 benefits are achieved without having to use cash.

At the same time, here are the downsides of SBC:

1. Since AXON needs to increase the number of shares outstanding, it dilutes the value of shares owned by current shareholders.
2. While employees are motivated to stay with the company only when they perceived the stock price will appreciate eventually. If the stock price falls drastically, they might leave in droves.

Investors need to be aware of the benefits and risks of SBC and decide whether they are comfortable with investing in companies with high SBC.

Since our thesis is that AXON will eventually succeed with its growth plans and the stock price will appreciate after pricing in the success, in this article, we will consider the downsides of SBC to be negligible.

Adjusted Net Income by Removing Stock Base Compensation

Assuming we are not concerned with the downside of SBC, we can consider adjusting the net income by removing the SBC component of the operating expenses. This will result in a very profitable ‘adjusted net income' profile as shown in this tabulation:

Calculated from Seeking Alpha data

It is visually obvious from the chart that AXON now becomes very profitable just by removing the SBC component. The average growth since 2013 is also more than 40% with a growth trend that looks more consistent with free cash flow. As such we will use the adjusted net income of $243.3M in our valuation of its intrinsic value.

Valuation

We will make the following assumptions in our valuation of the company using the 20 years discounted (adjusted) Net Income model:

1. AXON will grow at 18.8% for the next 5 years, based on the 'EPS next 5Y' growth value from Finviz.
2. AXON tapers in growth by half, therefore, growing at 9.4% from year 6 to year 10.
3. AXON matures in growth from year 11 to year 20, growing at 6.9%, the same as the latest US GDP growth rate.
4. The value of (adjusted) Net Income to be projected is $243.3 million, taken from the Dec 2021 period as discussed in the earlier section.
5. The discount rate is estimated to be 9.34% referenced from Alpha Spread.

Based on the above inputs, the present value (PV) of projected (adjusted) Net Income per share for AXON is $97.60.

Calculated by Author

Taking into account the total debt and cash that the company is holding, the final intrinsic value is $103.84.

Calculated by Author

The current price of about $112 implied the stock is slightly overvalued. (About 8% higher than $103.84)

Investment Risks

In earlier sections, we discussed that SBC can be a double-edged sword. The resulting intrinsic value calculation is based on the assumption that the downside of SBC will not occur in the company’s growth. Since nothing is guaranteed in any company’s growth trajectory, investors need to be aware of these downsides involved in the valuation.

Conclusions and Key Takeaway for Investors

AXON's TASER brand is a brand monopoly and it rode on this advantage to pivot to a high margin SaaS model. The latest annual financial results suggest the company has made the correct decision. In my previous article, I rate AXON with a buy rating with a small concern that it is still not profitable if we just consider the overall net income at face value. However, by removing the SBC component of the expense, AXON can be perceived to be consistently profitable since 2012 which presents itself as a much better stock to invest in.

Investors who are comfortable with the risks associated with SBC can consider a limit order at the price of the intrinsic value of $103.84.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.