Spruce Point Capital Releases A Strong Sell Research Opinion On Axon Enterprise, Inc. (Nasdaq: AAXN)
Tuesday, June 18, 2019
- Management's SaaS-Driven Growth Story Is Highly Unrealistic And Likely To Disappoint: Axon successfully took significant share of the Taser and body-worn camera (BWC) spaces by entering both markets as a first-mover just as demand in each exploded. Management is now effectively claiming that, by pairing artificial intelligence (AI) with control of BWC video storage for client police departments, it can achieve similarly rapid growth by displacing deeply-entrenched players in the records management system (RMS) and computer-assisted dispatch (CAD) spaces. However, police departments are generally heavily entrenched with existing CAD and RMS providers, many of which already provide end-to-end solutions including CAD, RMS, case management, etc., and which are extremely sticky.
We believe that management's plan to offer an end-to-end CAD / RMS solution by next year is extremely aggressive given the complexity of developing viable CAD / RMS solutions from scratch, particularly for a hardware company with no real software experience. Few attractive M&A targets remain for Axon in CAD and RMS, as competitors have spent billions of dollars acquiring the highest-quality players in each space through the past ~5 years. As management's aggressive RMS / CAD rollout timeline underpins its near-term growth forecast, we believe that Axon is set up to disappoint investors as it fails to capture significant (or any) RMS / CAD business through the coming years.
In addition to its unrealistic software and AI aspirations, Axon has repeatedly promised significant international growth, but management has failed to deliver on these claims and offers limited transparency into its international business. It recently pivoted to distributor acquisitions to accelerate international growth, but at the same time slashed its TAM from $2.7bn (2016) to $2.4bn (2019). Our field research suggests that Axon is many years away from scaling its business abroad.
- Aggressive Revenue Recognition And Undisclosed Dependence On China: Axon released its Taser 60 plan in 2014, allowing customers to save by bundling and paying for product and services over 5 years. Axon increasingly recognizes revenue under "multiple performance obligation" accounting tests which give it discretion over revenue allocation and timing. It claims its hardware/software bundles have "stand-alone" value, and books revenue for hardware up-front, but allocates no stated value to certain hardware on its public contracts, obscuring the quantity of revenue which may be subject to accelerated recognition. Furthermore, our research reveals that Axon's hardware must operate with its software, which calls into question its "stand-alone" value. We estimate aggressive revenue polices have front-loaded revenues by 6% - 9% over the past several years.
Furthermore, we believe that Axon has concealed its dependence on Chinese components just as Chinese imports have grown increasingly subject to tariffs. Management 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 that Axon has grown increasingly dependent on Chinese imports for its body cam business through the past several years, and through the troubled acquisition of VIEVU. We believe associated tariffs will weigh on margins and could easily cause Axon to miss 2019E EBITDA by 10%. Based on our field research, we find some evidence that Axon has attempted to implement undisclosed price increases upwards of 5% in Q1'19. Yet, despite this increase, gross margins were still pressured and missed company estimates by 250bps.
- Valuation Predicated On Transformation Into A Steady-Growing SaaS Company: Analysts have bought into management's narrative that Axon is on its way to becoming an AI-powered end-to-end safety platform, complete with recurring SaaS revenue from a healthy cloud business. However, we believe that its ongoing move to a subscription-based model represents a one-time boost for its existing hardware products, and that future software-oriented opportunities will strongly disappoint. Axon's Q1'19 cash burn was its worst since coming public, and it increased its line of credit capacity from $10m to $100m despite having $350m of cash and no debt.
Analysts' average price target for Axon is $72.30, just 9.5% above current levels, and conveniently overlook its past SEC investigations, material weaknesses, and legal spats. Unlike most of the Street, we believe it is important to evaluate Axon's two distinct businesses when valuing the Company. We view Taser as a mature business and value it at a 7x-9x multiple of 2020 EBITDA – a premium to peers in the weapon space, acknowledging its above-average margins and market dominance. Alternatively, we value the Software and Sensors segment at a discount to SaaS peer multiples at 3.5x – 5.5x 2020 sales, based on evidence of revenue accounting issues, slowing sales growth, compressing margins, a smaller TAM than advertised, and its lack of a clear path to material RMS and CAD sales. In addition, while Axon is promising improved profitability, we believe that tariffs and rising storage costs leave the company with no material upside to margins. Factoring in the excess cash, we estimate a price target of $27.50 – $40.00.
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