AXON ENTERPRISE, INC. quarterly report, Q2 FY2017

Axon Enterprise, Inc. — Form 10-Q Summary

Reporting period: Three and six months ended June 30, 2017; filed August 9, 2017. Axon develops conducted electrical weapons, body-worn cameras, digital evidence software and related services. The filing presents unaudited condensed consolidated financial statements.

Financial performance and position

Metric	Q2 2017	Q2 2016	Six months 2017	Six months 2016
Net sales	$79.6 million	$58.8 million	$158.9 million	$114.3 million
Gross margin	$45.6 million; 57.3%	$37.3 million; 63.5%	$94.3 million; 59.4%	$74.2 million; 64.9%
Income from operations	$0.8 million; 1.0%	$6.2 million; 10.6%	$6.2 million; 3.9%	$11.4 million; 9.9%
Net income	$2.3 million	$3.7 million	$6.9 million	$7.1 million
Diluted EPS	$0.04	$0.07	$0.13	$0.13
Operating cash flow	Not separately provided	Not separately provided	$(12.4) million	$10.3 million

Q2 revenue increased 35.5%; six-month revenue increased 39.0% year over year.
Software and Sensors revenue increased 101.4% in Q2 to $26.6 million and 110.3% for the six months to $48.2 million. Evidence.com revenue increased 161.0% in Q2 to $12.8 million and 158.5% for the six months to $24.5 million.
TASER Weapons revenue increased 16.4% in Q2 to $53.0 million and 21.1% for the six months to $110.7 million.
Margin contraction reflected the growing mix of Software and Sensors revenue, higher hardware discounting and non-recurring cloud-storage migration expenses. Q2 Software and Sensors gross margin was 32.7%, including negative 1.7% hardware gross margin; service margin was 70.0%.
Operating expenses increased substantially, with Q2 sales, general and administrative expense up 30.5% and research and development expense up 93.6%. Software and Sensors accounted for most of the R&D increase.
Cash, cash equivalents and investments totaled $61.8 million at June 30, 2017, down from $89.2 million at December 31, 2016. Cash and cash equivalents were $28.0 million and short-term investments were $33.8 million.
Operating cash flow was negative primarily because of a $25.8 million inventory build, a $21.5 million increase in prepaid expenses and other assets, and a $4.5 million increase in receivables. Deferred revenue increased $14.8 million and provided a partial offset.
Total assets were $316.3 million and stockholders’ equity was $163.5 million at June 30, 2017. Inventory increased to $60.7 million from $34.8 million at year-end 2016.

Debt, liquidity and capital resources

Axon had no borrowings under its $10.0 million revolving credit facility. Letters of credit of approximately $2.7 million reduced available borrowing capacity to approximately $7.3 million.
The facility matured July 31, 2017 and was subsequently extended for 90 days to October 31, 2017. Management expected to pursue a longer-term arrangement.
The facility requires a maximum leverage ratio of 1.0:1 and a minimum fixed-charge coverage ratio of 1.25:1. Axon’s June 30 leverage ratio was 1.17:1 and fixed-charge coverage ratio was 2.65:1; the leverage covenant violation was waived by the bank.
Management stated that cash, investments and expected operating results should be sufficient to fund operations and strategic initiatives through 2017 and the foreseeable future, while noting that additional financing may not be available on acceptable terms.

Material changes versus the prior comparable period

Growth accelerated in cameras, docks and Evidence.com, while legacy TASER Cam revenue declined 52.8% in Q2 and 43.2% for the six months.
Q2 gross margin fell 620 basis points and six-month gross margin fell 550 basis points, while operating margin declined to 1.0% and 3.9%, respectively.
Net income declined 37.6% in Q2 and 3.6% for the six months, despite significantly higher sales.
Axon invested $6.5 million in business acquisitions during the first six months. The Dextro acquisition was completed for approximately $7.5 million, including contingent consideration, and expanded the Axon AI computer-vision business.
The Company introduced new five-year cartridge subscription programs and continued expanding Officer Safety Plan and TASER 60 installment programs.
The $50.0 million stock repurchase authorization had $16.2 million remaining at June 30, 2017, but the 10b5-1 repurchase plan was suspended; no shares were repurchased under the program during the first six months of 2017.

Guidance, outlook, risks and unusual items

Management estimated a 2017 full-year effective tax rate of approximately 42.2% before discrete adjustments. The six-month reported effective rate was 15.0%, including a $1.4 million discrete tax benefit related to stock compensation.
Management expected future income to trend upward and anticipated realizing a large portion of deferred tax assets, but recorded approximately $4.4 million of unrecognized tax benefits and valuation allowances for certain tax credits and foreign jurisdictions.
The Company expects to adopt the new revenue recognition standard effective January 1, 2018. Management anticipated effects on discounted hardware contracts, software licenses, post-contract support and contract-acquisition costs; the adoption method and ultimate impact were not finalized.
Seven product-liability lawsuits involving alleged wrongful death or personal injury remained active, in addition to Digital Ally patent and antitrust-related litigation, an arbitration claim of approximately $0.6 million, and VieVu commercial litigation. Management did not believe the matters were reasonably likely to materially affect results, but acknowledged litigation outcomes and insurance coverage remain uncertain.
Axon reported approximately $2.7 million of outstanding letters of credit and $5.7 million of surety bonds. It also had $100.2 million of deferred revenue, consisting of $52.6 million current and $47.6 million long term.
Management identified material weaknesses in internal control over financial reporting relating to income taxes, revenue recognition, cost of goods sold and services delivered, deferred revenue, account reconciliations and monitoring. Remediation was ongoing, and disclosure controls were considered ineffective as of June 30, 2017. Management expected remediation before the end of 2017.
On July 1, 2017, Axon agreed to pay $4.3 million to terminate an Australian distributor’s rights, with accounting treatment expected in the third quarter of 2017.

Important facts for investors to verify

Whether the credit facility was replaced or extended beyond October 31, 2017 and whether covenant compliance improved.
Whether Software and Sensors hardware margins recovered from near-zero or negative levels and whether cloud-migration costs were non-recurring as expected.
Whether the substantial inventory and receivables build converted into operating cash flow without material write-downs or collection losses.
The final accounting method and financial impact of adopting the new revenue recognition standard in 2018.
Progress and testing results related to remediation of the disclosed material weaknesses in internal controls.
The financial impact of the Australian distributor termination, Dextro earn-outs and other acquisition-related contingencies.
Developments, potential damages and insurance coverage in the product-liability, Digital Ally, VieVu and other legal proceedings.
Whether bookings subject to government appropriations or cancellation clauses convert into recognized revenue.