Everywhere you look, there seems to be some kind of crisis. Whether economic, health, political, financial, housing, migration or war crises – it seems as if there is no silver lining on the horizon, currently. Would it be condemnable to consider crisis investments that can even profit from such developments?

A crisis is often associated with a painful stock market crash. When thinking or talking about crises, many get afraid of falling stock prices. By highlighting every movement of the big indexes, the MSM are doing their part in these fear-mongering and scaring people out of their investments.

This is when common sense becomes “assisted thinking”.

Unfortunately, many first bravely hold on or courageously average down in hope and only realize their losses when they cannot endure the pain anymore psychologically.

Ask the “long-term” tech speculators “investors”.

But the attentive observer knows this is just an amateurish simplification that cannot stand the test of time. It is outright wrong to generalize that in a crisis all stocks have to fall as a foregone conclusion.

As one viable strategy, one could buy stocks of companies with defensive business models and comfortably sail through the storm. These established operations are expected to deliver solid cash flows and maybe even pay attractive dividends while waiting until the dust settles.

You would expect here companies especially from the consumer staples sector, like food, beverage, discount-retailers or tobacco, but maybe also pharma.

However, as I have already shown in my article “How to beat the bear market – inflation, stagflation, recession” (see here), there are always stocks that rise.

If you are a stock picker and interested in the businesses behind the stocks, there is a chance that you will be able to find one or the other gem that’s outside of everyone’s radar. Why do exactly the same thing that everyone else is doing?

Why not have a look at businesses that benefit economically in some form from a malaise or even rising tensions?

One such business is Axon Enterprise (ISIN: US05464C1018, Ticker: AXON) that is approaching its all-time high again, after having fallen by 50% until June 2022.

I am going to introduce you to the company and its business model. Most of you will know at least one of their products, especially their main one. But I guess that most of you didn’t know the company behind it.

So, what is Axon doing and is its stock worth a consideration?

Let’s find out!

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Striking the nerve of the times

Before we come to the company itself in just a moment, first let’s find out what the name Axon stands for.

The human body consists of many types of cells, among them neurons. A neuron is a nerve cell and the most elementary unit of function that transmits electrical signals via impulses in the body. Typical recipients are muscles like your brain, heart or just muscles for movement.

Neurons themselves consist of different building blocks. One such block is the axon which has the task of information transmission.

Think of a copper wire in a cable.

An axon is a bold string that splits into several finer branches which are connected with other cells they transmit the information to.

On the picture below, you see a nerve cord. The axon is the orange string (the impulse flows from left to right here) that splits into many smaller branches.

This is in very short in my own words the explanation of an axon (and certainly pretty simplified). For more in-depth information, you can read on here.

The company Axon obviously must have something in common with nerves.

And here we are!

This is how Axon Enterprise describes itself in their annual report (see here):

An axon is a nerve fiber that serves as the primary communication link in a nervous system — similarly, we see ourselves as building the nervous system for public safety.

Axon Enterprise, Annual Report 2021

Their main product – and still most important revenue stream – is the Taser, i.e. a handheld device that uses electric shock waves to disarm or incapacitate an opponent for a short period of time. It is said to be the most effective and least harmful “less-than-lethal”-device.

Of course, the intention is to only use them when other non- or less forceful means have been exhausted or when the situation is out of control.

They are by no means harmless water-pistols!

A Taser device delivers high-voltage, electric current to a suspect or victim and makes the person losing muscle control as muscle contractions become random and uncoordinated. For more information, see the links (see here and here).

Axon Enterprise was founded originally as ICER Corporation already in 1993, in Scottsdale, Arizona, USA, by Rick Smith who still is the founder-CEO of the business. Since 2017 it’s called Axon Enterprise.

Axon was founded with a special intention. Its mission was to protect life, reduce social conflicts and – as they say – “to make the bullet obsolete” and thus to prevent people from being killed in escalating situations. Or also in other words: “to de-escalate or pause a dangerous situation”.

This is still what the company is pursuing, however, in the meantime they have enlarged their offerings with some other products and services.

The business is moving more towards an extensive subscription and cloud business regarding different security offerings. Newer devices are connected to the cloud and offer information exchange for further processing.

Besides their Taser devices, which account for slightly less than 50% of total revenues, Axon is also offering:

• body cameras for security officers
• patrol car cameras
• virtual reality (VR) training services
• drones
• as well as different software and cloud solutions for
  • evidence and productivity management
  • interview recording and archiving
  • subject monitoring
  • data sharing

Here is an overview from Axon’s site (see here).

Axon is also selling whole product bundles.

Very interesting is the “razor-blade” model of the Taser devices. They use nitrogen-filled cartriges that have to be replaced after a certain amount of “shots”. From time to time, the devices themselves have to be replaced too. Hence, you not only have a subscription business with the software solutions, but factually also with the hardware.

Why so?

Can you name a competitor?

This is the point. Axon is a quasi-monopoly in its niche. Its products are patent-protected and trademarked worldwide. The strong brand name and presence make it the go-to solution for many especially public security entities like police departments.

I already wrote about monopolies and strong businesses here.

Axon doesn’t name direct competitors with similar “Taser-like” devices. Instead, they list other less-than-lethal weapons like rubber bullets, police batons or pepper spray.

Regarding their other offerings, they at least name competing companies like

• Motorola Solutions (ISIN: US6200763075, Ticker: MSI)
• Tyler Technologies (ISIN: US9022521051, Ticker: TYL)
• IBM (ISIN: US4592001014, Ticker: IBM)
• or Panasonic Corp. (ISIN: JP3866800000, Ticker: 6752)

However, there is no “second Axon” with a similar broad bundle of offerings just from a single source connected and operating via a cloud. Taken as a whole, it is not too far-fetched that many customers chose whole bundles of hardware and software services.

This is the secret behind the strong market position of Axon.

Increasing your offerings and the interconnection between them make switching costs rise with time. Especially when you have much data in the cloud and also let your staff train virtually to become comfortable with the products.

This only increases the moat of Axon.

Now, let’s have a look at the business figures and assess whether Axon could qualify as a potential investment.

A shockingly good business – but there’s a catch

You could answer the question with just a look at the chart of the stock of Axon:

Had you invested exactly ten years ago into this stock, you would have 22.6x-ed your money.

22.6x over ten years equals an annual return of mind-blowing 36%.
For example, a 5,000 USD investment would have resulted in a pre-tax value of 113,000 USD today.

This seems rather hard to repeat. Axon had a market capitalization of less than 500 million USD back then.

But the prospects, at least as it currently stands, seem to be favorable for such a business where worldwide tensions, protests, unrest and criminality are rising. I don’t need to make any listings at this point. You certainly either know from your local happenings or from the media.

Let’s first scan through their investor presentation and pick some points. You can find the slides here.

We see that revenue has more than doubled over the last five years. Revenues from Taser devices have grown with strong 17% p.a. The draught horse, however, have especially been the cloud and sensor services (where also the body cams are to be found) with growth rates of more than double of the Taser handhelds.

Add to this the net retention rate of 119% which shows you that customers are willing to not only prolong their contracts, but also to upgrade and buy even more services, it seems as if everything is on the right track.

We can also see that 80% of total revenue is recurring in nature.

But the following two charts should be concerning and showing a first crack in confidence or better credibility of management.

You don’t have to look for the needle in the haystack. It’s about the bold number first.

Here is the investor presentation from a year earlier, for a direct comparison:

^{source: Axon investor presentation August 2021 (see here)}

The TAM – or total addressable market – is said to have doubled in just over one year. That means – in easy words – that management suddenly sees a market potential that is double as big as before.

And herein lies the danger.

These TAM’s are often those empty promises or bubbles with which “visionary” management teams catch their victims and suck them into adventurous stories with false, unrealistic expectations.

However, to be fair, everyone is responsible for his / her own investments.

You should never invest just on the basis of a “good story”. The fundamentals must support all of this.

But that’s not all.

Looking one layer below the total number, we see that the TAM expectations for:

• Federal TAM grew from 1.6 billion USD (6% of 27 billion USD) to 8.9 billion
• Consumer TAM increased from 2 billion USD to 17.8 billion USD – (!!)
• international business is expected to grow from 40% of total revenues to more than 60%

While I can imagine that the first bullet point (here it is not obsolete, yet) could be realistic under the assumption that many police departments will not only upgrade, but also increase their manpower and especially increase the usage of cloud services, the second point already makes me hesitate.

Can you explain to me why the “consumer” market should suddenly offer a 9x higher opportunity which coincidentally also make the bulk of the total TAM increase (16 billion USD out of 25 billion USD)?

One cold argue with international expansion.

But in many countries – like here in Germany – a “consumer” is not allowed to own a Taser device. I am also skeptical as to other countries. And poor countries or those with an even higher criminality likely won’t become big customers, either.

Somehow, my feeling tells me that the US market is the perfect one for Axon. A rich nation with a comparatively high crime and shooting rate as well as a developed and strong public safety apparatus.

Number one in this ranking by the way is Venezuela.

To conclude until here, you shall think of Axon as being a high-growth company with massive tailwinds that only scratches the surface of its true potential.

But could there be something wrong? What about profitability? Shouldn’t this business be printing money like insane?

I will use some charts from TIKR.com to show you the developments of certain figures and metrics.

First, we see the developments off revenues and free cash flow over the last decade, because as you know operating and free cash flow are two of the first things – besides revenue – I have a very quick look at for a first impression:

We see that revenue has grown phenomenally. We have already seen in one of their presentation slides that over the last five years revenue growth was strong.

This supports the growth-company narrative.

However, free cash flow could not keep pace. This means that profitability on a free cash flow basis (as I like to use it) is suffering during this “high-growth mode”, as the next chart proves – free cash flow margins have come under pressure with time:

This could be because of the nature of a subscription business. In the beginning you have more expenditures, especially for marketing that become less with time for your loyal customers. Only over time do you collect your truly high-margin earnings.

Okay, this could be a plausible explanation.

Axon is not focussing on cash flows which I dislike. They do not really discuss it and it is no central metric for the management.

However, the next point will be crucial.

They instead prefer to look at “adjusted EBITDA” as their key measure for profitability – this is where I get very sensitive and cautious. The only positive thing I can take out of EBITDA is that it can be a first approximation for operating cash flow – but only roughly.

And only the “real” EBITDA, not the adjusted one which Axon uses.

Plus, you need to check a few things more.

On the following chart, you see how their “normal”, unadjusted EBITDA has developed in comparison to the strong revenue growth:

Ouch… In absolute terms, EBITDA over time has become lower and even went negative. More revenue, but less operating earnings? Not only that, all this despite the current tailwinds and a booming business?

What’s wrong?

The problem is stock-based compensation, i.e. shares awarded as a means of payment. This figure is not included in adjusted EBITDA (it is adjusted away), however, it has to be subtracted as an operational expense in the profit and loss statement.

We see stock-based compensations very well keeping pace with revenue growth.

To close the loop, we need to have a look into the annual report about the stock-based compensations to fully understand what’s going on. The high and rising stock-based compensation expense is a special package for the CEO which was created already in 2018. For every pre-determined goal he achieves, he unlocks certain amounts of shares he is granted.

On p. 72 in the 2021 annual report, we find under the section “CEO Performance Award” the following information:

There are in total twelve goals or tranches that can be unlocked for a total compensation of 6.3 million shares. At the time of initiation of this compensation scheme, this was a whopping more than 10% of shares outstanding that the CEO would get, in case the targets were achieved.

To put this into perspective: At current prices, 6.3 million shares are worth more than 1.1 billion USD.

What were the targets? Unfortunately, only market capitalization, total revenue and adjusted EBITDA.

What sounds like a great alignment with other shareholders, has massive flaws.

The problem is, the CEO can theoretically (and practically, as he does) run the company without any profits or cash flows as long as revenue rises and adjusted EBITDA hits certain targets.

Plus, there is no per-share focus. This means that the dilution which hurts other shareholders is completely put aside. You see on the next chart that massive dilution with more than 20% set in since the initiation of this program in 2018:

While the diluted share count was even falling slightly until the end of the 2017 fiscal year, it has gone into a bull market since then (which is negative, of course).

It is really hard for me to see a fair shareholder alignment under the described circumstances. Rather, it seems like a massive paycheck for the CEO on the back of other shareholders.

One final point – valuation

It is hard to value the business on earnings or cash flows, as they are weak. Nonetheless, we stick to the fundamentals and work with what we have.

Total market capitalization has reached 13.3 billion USD. Axon has no financial debt on the balance sheet and even a decent cash position that creates an enterprise value of 12.9 billion USD. Compared to a free cash flow of only 75 million USD in the last fiscal year or even only 60 million USD over the last twelve months.

The multiples you get are in excess of 100x.

A small thought-experiment:

Even if we take an absolute blue sky scenario, the stock seems to be priced to perfection. Let’s say they will in the future at some time achieve free cash flow margins of 20% (they have still to prove this!). With an EV / Sales multiple of 10x currently, they would be valued with a 50x free cash flow multiple (EV / Sales of 10x * 1 / 20%).

Assuming a fair multiple of 10x for a full-grown company, Axon would be priced already as if it were 5x as big as it is currently– and assuming it someday can achieve a 20% free cash flow margin.

For me, too much hot air on the valuation side, too.

Conclusion

Axon seems to be a high-quality, fast-growing business with tailwinds as a plus.

But if you look deeper, more and more cracks on the too-good-to-be-true story emerge. Not only did management increase their TAM target massively in just one year. Also do fundamentals and financials barely support current valuations.

As a last thing, the shareholder alignment factor regarding the compensation structure for the founder-CEO is at the very least questionable. It rather seems as if management wants to hold up a great growth story which the numbers fail to support.

All this, while diluting shareholders massively.

The company is interesting to watch, but not an imminent investment for me.

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on average: 5.8%

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