Analysis: AXON

Yesterday we started a new position in the shares of public safety company Axon Enterprises (AXON) , whose core offerings includes tasers, body cameras, in-car dash cameras and services to support them.

Through the first half of 2022, product sales defined as taser units and replacement cartridges rose 18% compared to the year ago period, while its Software and Sensors business that houses its body camera and related cloud services soared more than 40%.

In our comments yesterday, we shared customers for Axon's products are primarily state and local law enforcement, U.S. federal civilian and defense agencies, corrections, fire departments, and emergency medical services with 80% of that revenue derived inside the U.S.

Demand is Poised to Strength

We continue to see rising adoption for both taser products as part of the shift away from lethal weapons while increasing calls for accountability are fueling the lift seen in the Software and Sensor business. As public safety has become a top priority on President Biden's agenda, we believe demand for these products is poised to strengthen in the coming quarters.

President Biden's fiscal year 2023 budget requests a fully paid-for new investment of approximately $35 billion to support law enforcement and crime prevention - in addition to the President's $2 billion discretionary request for these same programs. Of course, we'll have to see how that budget shakes out, but even if it's given a sizable trimming there is likely to be funding to spur the adoption of Axon's solutions.

According to Mordor Intelligence, the wearable, and body-worn cameras market on its own was valued at $1.62 billion in 2020 and is expected to reach $424.63 billion by 2026. In the US, roughly one-third of the 18,000 state and local police departments are purchasing cameras with more expected to do so as funds become available.

Axon sees its total available market in the US as a $37 billion opportunity across the coming years with the larger end markets being Law Enforcement and Consumer applications as well as those for Enterprise, Justice, and Federal markets. Outside the US, the same opportunity is pegged at $15 billion with the larger opportunities primarily in Europe.

To put that into some perspective, Axon is tracking to deliver $1.1 billion in revenue this year, and $1.3 billion in 2022 according to the latest consensus estimates. That paints a lofty growth picture, but it also means the company will need to penetrate the consumer market in a meaningful way. As we see it, the domestic law enforcement opportunity alone should allow ample growth in the coming quarters, especially as Axon wins more bundled contracts across its product and service offering.

Ever since the company changed its name to Axon from Taser, we've watched the transformation in its business model unfold moving the company from one that relied on individual device (taser) sales to one that includes a recurring revenue component. Services included in that mix shift are cloud-based software solutions that enable law enforcement to capture, securely store, and analyze video and other digital evidence as well as productivity software, real-time operations software and virtual reality training services.

In 2021 that recurring revenue accounted for 38% of overall revenue and that has continued to grow as its service revenue has increased in 2022. But that understates the nature of its recurring revenue given that cartridges for its taser products were 26% of its overall taser revenue in the first half of 2022. From our view, that makes the taser business model akin to the famous razor-razor blade model. And as the taser install base grows so too will the replacement demand for its cartridges.

A Level of Predictability

This multi-year transformation that has led to more predictable cash flow and earnings as the contract length for its Sensor and Services business expanded. In 2Q 2022, 108 customers signed contracts for longer than five years and about a third of the company's top 100 deals were for a decade or more. Exiting the June quarter, Axon had $3.3 billion of remaining performance obligations to be recognized with 15%-20% of that to be recognized through the June 2023 quarter and the balance to be recognized over the following 10 years.

That's a level of predictability we tend to see with defense contractors but it speaks to the nature of Axon's customer base, and it's also one that is also associated with premium valuations. It also means that a meaningful portion of the company's revenue in the back half of 2022 and the first half of 2023 is in place. As Axon's business continues to grow so too should its performance obligations and booked revenue stream, a feature we tend to like quite much.

Like other companies, Axon is focused on trimming the fat in its corporate cost structure, something that has likely occurred as it is on track this year to more than double its 2019 revenue. Those efforts paired with continued revenue growth should deliver some margin leverage in the coming quarters even as Axon continues to invest in product development. We would also note the company's track record of beating consensus revenue and EPS expectations, something we attribute in part to its building multi-year revenue stream.

While Axon has yet to give 2023 guidance, the consensus forecast calls for EPS of $2.49 vs. the $1.01 it is expected to report in the second half of 2022. Given ongoing supply chain issues that have been reported, there is some risk to that back half of 2022 outlook, and we wouldn't be surprised if Axon takes that opportunity to dial back EPS expectations for the coming quarters to handily beat them.

That potential reinforces our starting AXON shares with a Two rating. We'll look to build out this holding on either a pullback in the share price or on program wins that lead 2023 expectations to be revised higher from current levels.