AXON ENTERPRISE, INC. quarterly report, Q2 FY2018

Business Context and Reporting Period

Axon Enterprise, Inc. develops and sells conducted electrical weapons, cameras, sensors, cloud-based evidence management software, and related public-safety technologies. The filing is an unaudited Form 10-Q for the quarter and six months ended June 30, 2018. Reportable segments are TASER Weapons and Software and Sensors.

Axon adopted ASC Topic 606 on January 1, 2018 using the modified retrospective method, increasing opening retained earnings by $19.0 million. Prior-period revenue and expense amounts were not recast.

Financial Performance and Position

Metric	Q2 2018	Q2 2017	Six months 2018	Six months 2017
Net sales	$99.2 million	$79.6 million	$200.4 million	$158.9 million
Gross margin	$63.1 million; 63.6%	$45.6 million; 57.3%	$127.6 million; 63.7%	$94.3 million; 59.4%
Income from operations	$5.3 million; 5.3%	$0.8 million; 1.0%	$18.9 million; 9.4%	$6.2 million; 3.9%
Net income	$8.5 million	$2.3 million	$21.4 million	$6.9 million
Diluted EPS	$0.15	$0.04	$0.38	$0.13
Operating cash flow	Not separately provided	Not separately provided	$16.1 million	$(12.5) million

Q2 net sales increased 24.6%; six-month sales increased 26.2%. Product revenue grew to $157.7 million for the six months, while service revenue increased to $42.7 million from $24.5 million.
Q2 Software and Sensors revenue increased 45.0% to $38.6 million; six-month revenue increased 58.3% to $76.3 million. Evidence.com and cloud-services revenue increased 65.7% for the six months to $40.6 million.
Q2 TASER Weapons revenue increased 14.4% to $60.6 million; six-month revenue increased 12.2% to $124.1 million.
Operating expenses increased 29.1% in Q2 and 23.4% for the six months, driven by higher SG&A and research and development spending. R&D increased 42.4% in Q2 and 32.1% for the six months.
The six-month effective tax rate was negative 7.9%, including a $6.1 million discrete tax benefit primarily related to stock-based compensation windfalls. Management estimated a 22.8% full-year effective tax rate before discrete adjustments.
Cash, cash equivalents and restricted cash totaled $310.0 million at June 30, 2018, including $307.5 million of cash and cash equivalents. Cash increased $231.5 million from year-end 2017, primarily from a $234.0 million net follow-on equity offering.
Accounts receivable and contract assets increased operating-cash usage by $24.8 million during the six months, primarily from Officer Safety Plan and TASER 60 customer balances.
Axon had no borrowings under its $10.0 million revolving credit facility. Letters of credit reduced available capacity to $7.3 million. The facility matures December 31, 2018.
Total assets were $642.4 million and total liabilities were $193.6 million at June 30, 2018. Deferred revenue totaled $138.0 million, and remaining performance obligations were approximately $750 million.

Material Changes Versus the Prior Comparable Period

Growth shifted toward recurring and software-related revenue: 52.4% of Q2 revenue and 54.2% of six-month revenue came from contracts with multiple performance obligations, compared with 43.8% and 43.0%, respectively, in the prior periods.
Gross margin expanded primarily from cloud-storage scale benefits, reduced non-recurring data-migration costs, and ASC 606 revenue-and-cost matching for bundled hardware and services.
International revenue increased 52.5% in Q2 and 56.7% for the six months, representing 21% and 22% of revenue, respectively, versus 17% and 18% in the prior periods.
Axon acquired VIEVU on May 3, 2018 for estimated consideration of $17.3 million. VIEVU contributed $2.2 million of revenue and a $1.2 million operating loss after acquisition through June 30. The company also recorded $0.6 million of expense for assumed purchase commitments exceeding expected demand.
Axon issued 4.645 million common shares in May 2018 at $53.00 per share, generating $234.0 million of net proceeds.
The company approved a CEO performance award covering 6.4 million stock options. Two operational goals were considered probable, resulting in $0.5 million of related stock-based compensation expense through June 30; no awards had vested.

Guidance, Outlook, Risks, Contingencies and Unusual Items

No formal revenue or earnings guidance is provided in the filing. Management expects R&D expense to continue increasing as it invests in CEW technologies, cloud-connected products and Software and Sensors capabilities, with anticipated operating leverage over time.
Management reported 305,200 cloud-based software licenses and annual recurring run-rate Axon Cloud and Sensors and Other revenue of $92.7 million at June 30, 2018.
The company expects to recognize 15% to 20% of its approximately $750 million remaining performance obligations over the next twelve months and the remainder over five to seven years. Recognition is subject to delayed deployments, budget appropriations and contract cancellation clauses.
Axon is transitioning toward multi-year subscription and recurring-payment arrangements. These arrangements may require upfront hardware and fulfillment costs while customer cash is collected over time.
A material weakness in internal control over financial reporting related to account reconciliations and monitoring of the U.K. subsidiary remained unremediated as of June 30, 2018. Management implemented additional reviews and migrated the subsidiary to standard systems, but remediation testing was not complete.
Axon was defending seven active product-liability lawsuits involving alleged wrongful death or personal injury. Management stated that the matters were not reasonably expected to materially affect results, although litigation outcomes are inherently uncertain and insurance may not cover all losses.
The FTC requested information concerning the VIEVU acquisition, and Axon is cooperating with the non-public investigation.
Other contingencies include patent litigation, an arbitration claim seeking approximately $0.6 million, a consumer class action concerning TASER products, $2.7 million of letters of credit and $14.1 million of surety bonds.
Axon recorded a judgment exceeding $7.8 million against Phazzer for willful infringement, but collectability was in doubt because Phazzer reported insolvency; related appeals remained pending.
Management was still evaluating the effects of the Tax Cuts and Jobs Act, GILTI accounting, and future accounting standards, including lease accounting expected to materially affect the balance sheet.

Important Facts for Investors to Verify

Reconcile year-over-year trends under different revenue-recognition standards, since 2017 amounts were not recast under ASC 606.
Assess the sustainability of the 2018 tax benefit and the estimated 22.8% underlying effective tax rate.
Monitor conversion of the $750 million performance-obligation balance into recognized revenue and cash, including municipal appropriation and cancellation risks.
Evaluate recurring-revenue growth, cloud-license additions, bookings, renewal rates and the relationship between software growth and rising R&D spending.
Track the VIEVU integration, purchase-accounting adjustments, customer retention contingencies and the FTC investigation.
Review the material weakness remediation and subsequent internal-control testing.
Consider dilution from the CEO performance award, other stock-based compensation and outstanding options.
Follow product-liability, patent, arbitration and consumer litigation, including insurance coverage and the collectability of the Phazzer judgment.