Axon Enterprises (formerly TASER International) is best known for the electroshock weapons it near monopolistically provides to police departments internationally. Axon has recently diversified into the growing police body camera segment with a line of body cameras that they are offering free (for a year) to police departments nationwide. The firm has also built an evidence management software system called Evidence.com. The site is designed to create efficiencies in the notoriously wasteful departmental paperwork system in place in virtually all US police precincts. Evidence.com seamlessly integrates with Tasers and Axon body and vehicle cameras, providing timestamped weapon usage logs and synchronized video footage from multiple perspectives whenever a Taser or handgun discharge takes place. The integrated platform has proven extremely compelling, and Taser and Axon hold 95% and 70% market shares in their respective markets.
Thomas Harris, formerly of Ernst & Young and Clarke Henning, wrote up a long on the stock in September. Since his idea was posted, Axon's price has jumped 84%. Harris believed that Axon's R&D spend on Evidence.com and the body camera rollout was obfuscating the value of the company's Taser cash cow. SumZero sat down with Harris to discuss his idea.
Kevin Harris, SumZero: What about Axon initially caught your eye as a value investor? What catalyzed your entrance into the position?
Thomas Harris: Reviewing Axon in April of last year, I noticed a couple of things. First, revenue growth was a terrific 35%. Second, operating margins had fallen to 11% in 2016, from a stable 20% from 2012-2014. I had a hunch. Was the company making smart investments, thereby sacrificing its short term operating margins, in order to generate high revenue growth?
I dug into the segment information. Over the past 5 years, the Taser segment was incredibly profitable, with 33% operating margins, and 15% revenue growth. Sounds like a great business.
The second segment, the Axon segment (S&S), was losing money. Combined, SG&A and R&D expenses were higher than its revenues! It may sound strange that I was excited about a business burning through cash. But I was excited. This second segment was obscuring the high profits of the Taser segment. Furthermore, the Axon segment had grown revenues at an incredible 80% rate over 5 years. Conceivably, these investments would pay off in the long term.
The story got even better. The Taser segment had ~95% US market share. The Axon segment had ~60-80% market share in a completely new market. After more research, I became comfortable with the theory that SG&A and R&D expenses could be reduced significantly in 5-10 years.
The stock price was way below my intrinsic value estimate, so I purchased a large position.
KH: What is the market missing? What do you credit for the stock’s recent surge?
TH: The market is horrified by Axon's profit numbers. P/E ratio is 400x. EV/EBIT is 90x. Until you understand the business, it’s hard to see value here. The market sees SG&A and R&D as expenses, which is true according to GAAP. But we can also think of them as reinvestments into the business. Tom Russo refers to this as “capacity to suffer”.
Another factor: these two businesses are an odd couple. The Taser business is profitable, stable, and growing steadily. But investors who are turned on by stable profits are probably turned off by a cash burning Camera and SaaS business.
A new Software-as-a-service (Saas) business is radically different from a conventional company like Taser. At the beginning, cash burns like crazy because of Customer Acquisition Costs (CAC). You have to spend on Sales, Marketing, and Promotions if you want to get subscribers. Once customers are acquired however, the business can be extremely valuable over the life of those customers.
Considering SaaS unit economics, I think Evidence.com should be extremely profitable in the future. For example, Customer acquisition costs are likely to decline once Axon has penetrated most police departments. Currently, Axon cameras and Evidence.com are brand new products in a brand new market, so lots of Sales and Marketing costs are needed for field tests, pilot programs, purchase proposals, etc. These costs should decline rapidly when PDs repurchase cameras in the future.
I think the stock has surged because short sellers are covering. Short interest was 30% for the past year. Over time, consistent revenue growth made the short thesis less and less credible. Q4 results were probably the straw that broke the camel’s back.
KH: What key metrics should investors be paying attention to as your thesis matures?
TH: Investors should be watching revenue growth and operating margins. Management has shifted focus from growth to profitability. They called for 3-4% improvement in operating margins in 2018. If they are unable to do this, we should view their explanation with a healthy dose of skepticism.
The company provides detailed statistics every quarter on its sales, by product. It is a good idea to track unit sales, and Evidence.com seats booked.
KH: Given its reliance on government contracts, how vulnerable is Axon to changes in regulation? What are your views on the NYPD picking a different camera supplier?
TH: Axon is does not benefit from regulation, so the company probably won’t be affected by changes to existing regulation.
Let’s think about whether new regulation could be harmful.
I cannot imagine the government banning Tasers from police, because they save so many lives (as an alternative to guns). Could government ban civilian use of stun guns for safety reasons? I guess so, but Taser sells to police. Civilians make up practically 0% of Taser sales. If anything, government regulation against the civilian stun guns would shield Taser from low end competition, creating a wider moat for the business.
For Axon, could government ban public video recording? That sounds draconian. More likely, they would provide stricter rules on the recording and management of video evidence. Once again, these factors might widen Axon’s moat.
The biggest influence from government would be a radical cut in police spending. Politically, I’m doubtful that we will see this. Civilians have demanded transparency, so removing body cameras would lead to public outrage.
The loss of the NYPD account was major news.
But the overall market situation is great for Axon. Even assuming Vievu gets 22,000 cameras in New York, Axon still has ~65% market share in the top 90 cities in the US. Also, Axon has had success with large accounts overseas. Axon won a 22,000 order with the London Metropolitan Police, and more recently, 11,000 order with the Victoria Police in Australia.
Stalin said “One death is a tragedy, one million is a statistic.”
In Axon’s case, one loss is a tragedy, fifty wins is a statistic.
To Mr. Market, the NYPD loss was a shock to the system. Often, these vivid events blind investors to the strength of the underlying business.
KH: Most investors associate Axon with their formerly eponymous electroshock Taser gun. Could you detail their other product offerings and the growth opportunity in bodycams and Evidence.com?
TH: Axon body cameras are worn on the chest by police. They collect video evidence. These videos can help police save money and stress of fighting false accusations. Moreover, videos provide strong evidence for the prosecution.
At the end of each shift, police officers place their body cameras in a docking station. This uploads their videos to the Axon’s cloud software, Evidence.com. On Evidence.com, the officers can process the videos, and use them for evidence.
Axon created their body camera many years ago, but demand skyrocketed after the Ferguson incident and Black Lives Matter movement in 2014.
The Total Addressable Market is every patrol officer, starting in the US, and perhaps throughout the developed world.
KH: Taser stun guns are almost standard issue in US police departments, but are a well-patented proprietary system/technology. Do you think that Axon’s body cameras will enjoy the same moat?
TH: Axon has a strong moat too, but it’s different.
I think body cameras will be standard issue in US police departments, just like Tasers.
Axon’s switching costs are strong:
- Officers use Axon body camera on every shift. At the beginning of the shift, they put it on. During the shift, they push the button to record videos. After the shift, they upload the videos to Evidence.com and use the software for their reports. Warren Buffett loves to see this type of habitual use.
- Axon body cameras are mission critical to police. They provide evidence that can lead to prosecution. They protect the officer from false accusations. When police fail to record a shooting, it is met with public outrage. The last thing an officer needs is a cheap body camera.
- Retraining costs
- IT costs to move videos from Evidence.com to a new system
These factors turn the idea of switching from Axon into a high risk, low upside proposition. I expect these switching costs to be very strong going forward.
KH: How significant is the risk to Axon’s camera business from competitors like Vievu?
TH: Axon makes the best body camera. But realistically, camera hardware is a commodity product. It is hard for Panasonic to jump into making Tasers. It is much easier for Panasonic to jump into making body cameras. Furthermore, many police departments already use dashboard cameras in their patrol vehicles, so there are naturally competitors from that industry.
That said, Axon has a substantial lead in body cameras designed for police, and more crucially, their cloud software.
Vievu has been a decent competitor, but that fact is highly dependent on the NYPD account. According to my research, New York alone makes up almost 20% of the market share of the top 90 US Police departments. Aside from that account, Vievu has only 5% market share in the top 90 PDs. Vievu has 6, Axon has 49. (This is according to my own research, updated to the end of 2017.)
Axon’s products are more expensive. These purchase decisions face public scrutiny, especially after the 2014 Ferguson incident and Black Lives Matter movement. I doubt that PDs would pay more for a lower quality product.
I read field test reports to compare Axon with its competitors. In 2016, Cincinnati PD tested Taser vs. Vievu on the following qualities: Field of view, Video quality, Night recording, Audio quality, Entering metadata, Mounting, Docking, Redaction, Digital evidence sharing.
Axon beat Vievu in every single category.
Although the NYPD win was great news for Vievu, not all news has been positive. Chillicothe Police Department had half of their Vievu cameras die within the first 6 months. They switched to Axon. The Miami-Dade Police Union accused Vievu cameras of dropping frames. Vievu later admitted that their cameras dropped 5.4 frames per minute.
While Vievu can provide a mediocre body camera, this equipment is mission critical for PDs. Vievu only finished developing its cloud software in 2015. Evidence.com has been operational since 2009. The competition has a lot of catching up to do.
No other competitor in North America has more than 5% market share.
KH: What are the biggest risks associated with your thesis? What could go the most wrong?
TH: Revenue could decelerate more than expected. Conservatively, Taser still has slow growth ahead in the US, where ~65-70% of 600,000 patrol officers have Tasers. International expansion should add to this growth. But, it’s possible that US demand will stagnate, and that international expansion will slow. For Axon, revenue could decelerate if the remaining police departments have trouble with funding, or simply decide that they don’t need body cameras.
Another risk is the patent lawsuit with Digital Ally. A function called Axon Signal automatically alerts the body cameras in the vicinity to start recording whenever a weapon is drawn. Digital Ally claims that this violates their patent. If Digital Ally wins this lawsuit, it is hard to estimate how large the damages would be. Digital Ally trades at less than $17 million market cap. Let’s assume that the damages are somehow double or triple this market cap. This is not something that is likely to bankrupt Axon. Still, it is a risk.
There are also black swan risks with every investment.
KH: What are your views on the launch of Signal Sidearm and Axon Fleet? Will these systems mutually reinforce each other?
TH: Axon Fleet is a minor factor in my thesis. Competitors’ cameras were already in patrol cars, especially among Highway Patrols. In order to compete for those accounts, Axon had to develop a solution for patrol cars as well. Axon may end up taking market share from its Fleet competitors, but my expectations are low.
Signal Sidearm is an important function, which ties together Axon’s products. There is an opportunity to add value by syncing all of Axon’s products. This will increase switching costs.
The new product with most potential is Axon Records, a Records Management System (RMS). Management describes the incumbent RMS technology as a digitization of the same outdated police paperwork from 100 years ago. I imagine the film trope of the detective going back to the office to type up reports late into the night. Apparently, it’s still like this, but with laptops instead of typewriters.
Axon Records would use the videos to radically improve police paperwork. It would also create a Nation-wide database for digital evidence. The database would be searchable, help to automate paperwork, and improve sharing of information. Axon has been building its Artificial Intelligence capability to develop both Evidence.com and Axon Records. As more police departments connect to the system, it could create a network effect. When you consider the long term possibilities of Prosecutors and Citizens sharing in this database, there is great potential to add value to the legal system.
My thesis has never assumed that these products would have an impact. My takeaway is this: some unknown portion of SG&A and R&D has be invested into developing these new products. This supports my idea that expenses related to Axon body and Evidence.com can be cut significantly.
I also love the company’s innovation, and the attempt to add value in the long term.
KH: Where else do you see value in the market today? Where else does your fund focus?
TH: I focus on high quality businesses within my circle of competence. After that, I try to be flexible about where I find opportunities. I like it when investors hate the stock for irrational psychological reasons, which I can identify and rebut through research and logic.
For now, my best ideas are in Technology and Industrials.
Booking Holdings (formerly Priceline) is a core holding. I first wrote about it in 2016, when it was trading at $1400. I think investors underestimate Booking.com’s long runway in emerging markets. Because of strong network effects, and the asset light nature of the business, growth should be incredibly profitable in the long term.