As we expected, Axon (AAXN) reported better than expected Q2 results. Whereas we thought those better than expected results would push the stock higher, the exact opposite happened. AAXN cratered after its second quarter results hit the tape. We believe the sell-off is unnecessarily short sighted and creates a compelling buying opportunity for long-term oriented investors.
(Source: Axon IR)
The sell-off is triggered by near-term turbulence in profitability which will inevitably fix itself in the long term. Gross margins are getting killed at the company’s Software and Sensors segment (body cameras and Evidence.com solution). Why? Largely because of the free trial program. The company is giving away a substantial amount of products and services for free. That causes COGS (cost of goods sold) growth to outpace revenue growth.
But that is just short term. The free trial program was never supposed to be a profitability driver, but rather a means for AAXN to grab a ton of market share quickly. And that’s happening. Demand for AAXN’s suite of products remains robust.
The free trial program ends next year, at which point gross margins in the Software and Sensors segment should seamlessly jump back up to around 45% or higher (2016 levels). Longer-term, management thinks those gross margins will trend towards 60%. Meanwhile, gross and operating margins on the Taser weapons side of things are actually improving, illustrating that margin expansion follows market share gains and revenue growth.
Overall, we think AAXN stock will hit $60 in 5 years or less. That represents more than 100% upside from current levels. Here is how we get there.
Software and Sensors revenue more than doubled year-over-year in 1H17. Clearly, demand remains robust for both Axon body cameras and the Evidence.com cloud solution. Demand here will continue to remain robust as law enforcement agencies increase their appetite for technology in the workplace. Moreover, revenue growth in this segment will be propped up by new products like Axon Fleet (for cars) and the Records Management System (think virtual assistant). All in all, growth in this segment won’t tally off by much. Triple digit growth this year will likely fall, but we conservatively see Software and Sensors revenue growing around 40% per year over the next 5 years. That puts Software and Sensors revenue at $350 million in 5 years, versus a TAM of $1 billion in the US alone.
Margins are getting killed in this segment for reasons previously discussed (free trial program). But the long-term outlook on margins is favorable. Axon will move past the free trial program which is eating away at gross margins. As the company does that, revenues will move considerably higher and drive significant opex leverage. All in, management is targeting 20% operating margins for this segment in the long-term. If Axon hits that goal by FY21, then the Software and Services segment will net operating profits of about $70 million.
Meanwhile, Axon’s Weapon business saw revenues grow more than 20% year-over-year in 1H17, and that is the company’s non-growth segment. The reason for the big growth is that the law enforcement agencies are getting smarter with technology, and smart weapons is a part of this transition. Growth here won’t disappear overnight. Instead, secular tailwinds in tech adoption imply that Axon’s Weapons segment should post revenue growth of around 12% per year over the next 5 years. That puts FY21 Weapons revenue around $357 million.
Margins in the Weapons segment are actually improving already, proof that Axon does deliver margin expansion with revenue scale. Operating margins in 1H17 are 34.2% versus 33.4% in 1H16. Management believes revenue scale will drive further operating margin expansion to about 40%. If AAXN gets there by FY21 on $325 million in revenue, that is operating profits of about $143 million.
In total, then, we think it’s quite reasonable (and even conservative) to look at AAXN as a company that will net operating profits of about $213 million by FY21. Applying a standard 35% tax rate, we think AAXN’s earnings power in 5 years is just shy of $140 million, or about $2.58 per share (assuming share count remains relatively constant).
At that point in time, considering the company’s huge $1 billion TAM, we still think AAXN will be treated as a growth stock. As such, we believe the stock will be awarded, at the very least, a multiple in-line with the S&P 500. Applying the current market average 24.6x P/E multiple on $2.58 in EPS gets us to a price target of $63.
Bottom line: the AAXN growth narrative is hitting some road bumps due to near term profitability concerns, but the company will phase past those profitability concerns in FY18. Revenues will continue to grow due to robust demand, while margins will adjust significantly higher due to operating leverage. This is creating a favorable disconnect between earnings power today and earnings potential tomorrow. Investors who choose to focus on earnings power today are missing the big picture. Investors who choose to focus on earnings potential tomorrow may be in for a very profitable ride upward over the next several years.
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.