Axon Enterprise, Inc. — Q3 2017 Form 10-Q Summary
Business context and reporting period
Axon develops and sells conducted electrical weapons, body-worn and in-car cameras, digital evidence management software, cloud storage, and related services for law enforcement, military, corrections, security, and consumer markets. The filing covers the three and nine months ended September 30, 2017, compared with the same periods in 2016. Reportable segments are TASER Weapons and Software and Sensors.
Key financial metrics
| Metric | Q3 2017 | Q3 2016 | 9M 2017 | 9M 2016 |
|---|---|---|---|---|
| Net sales | $90.3 million | $71.9 million | $249.1 million | $186.2 million |
| Product sales | $74.0 million | $63.2 million | $208.4 million | $167.7 million |
| Service sales | $16.3 million | $8.7 million | $40.8 million | $18.4 million |
| Gross margin | $49.8 million; 55.1% | $46.6 million; 64.8% | $144.1 million; 57.8% | $120.8 million; 64.9% |
| Operating income (loss) | $(0.8) million | $11.1 million | $5.4 million | $22.4 million |
| Net income | $0.4 million | $3.8 million | $7.3 million | $11.0 million |
| Diluted EPS | $0.01 | $0.07 | $0.14 | $0.20 |
| Operating cash flow | Not separately provided | Not separately provided | $(5.8) million | $22.0 million |
Software and Sensors revenue increased 62.8% year over year to $30.8 million in Q3 and 88.8% to $79.0 million for the first nine months. Evidence.com revenue increased 89.6% in Q3 to $16.2 million and 125.8% for the first nine months to $40.7 million.
Cash, cash equivalents, and investments totaled $61.8 million at September 30, 2017, down from $89.2 million at December 31, 2016. Cash and cash equivalents were $43.5 million, short-term investments were $18.4 million, and long-term investments were zero.
Total assets were $327.6 million and total liabilities were $161.5 million at September 30, 2017. Deferred revenue increased to $112.0 million from $85.2 million at December 31, 2016. Accounts and notes receivable were $83.7 million and inventory was $52.7 million.
The company had no borrowings under its $10.0 million revolving credit facility. Letters of credit reduced available borrowing to approximately $7.3 million. The facility was extended from July 31, 2017 to December 31, 2017. The company violated its maximum leverage covenant, with a reported leverage ratio of 1.24:1 versus a maximum of 1:1; the bank waived the violation. Fixed-charge coverage was 3.88:1 versus a minimum of 1.25:1.
Material changes versus prior comparable periods
- Revenue grew 25.6% in Q3 and 33.8% for the first nine months, driven by increased Smart Weapons, cartridges, body cameras, Axon Fleet, and Evidence.com adoption.
- International revenue increased 50.6% in Q3 and 45.5% for the first nine months; international revenue represented 18.9% and 18.1% of total revenue, respectively.
- Gross margin declined materially because of higher discounting, unfavorable product mix, negative initial margins on Axon Fleet, higher cloud-storage costs, and the accounting effect of recognizing hardware costs before related subscription revenue.
- Operating expenses increased substantially. Q3 SG&A rose 29.4% and research and development rose 92.5%; nine-month SG&A rose 28.1% and research and development rose 88.7%.
- Operating income declined to a Q3 loss of $0.8 million and nine-month income of $5.4 million, compared with $11.1 million and $22.4 million, respectively, in the prior-year periods.
- Operating cash flow changed from $22.0 million provided in the first nine months of 2016 to $5.8 million used in 2017. The change primarily reflected increases in receivables, inventory, prepaid assets, and other working capital, partly offset by higher deferred revenue.
- The company completed acquisitions of Dextro and Breon during 2017 and incurred $10.6 million of acquisition-related cash outflows during the first nine months.
- No shares were repurchased under the repurchase program in 2017. Approximately $16.2 million remained available, but the 10b5-1 plan was suspended and future purchases were discretionary.
Guidance, outlook, commentary, risks, and unusual items
- Management estimated a full-year 2017 effective tax rate of approximately 32.5% before discrete adjustments. The nine-month effective rate was 16.3%, helped by discrete tax benefits, including benefits related to stock compensation and uncertain tax positions.
- Management expected cash, investments, expected operating results, and available financing to fund operations and strategic initiatives through the remainder of 2017 and the foreseeable future, while acknowledging that additional financing may not be available on acceptable terms.
- Management expected to shift more business toward subscription-type offerings. These arrangements can support customer budgeting but delay cash receipts and require upfront hardware and fulfillment spending.
- Software and Sensors bookings were $78.0 million in Q3, up 35.6% year over year. Bookings may be reduced if customers do not exercise options, appropriate future funds, or invoke cancellation clauses.
- Management expected data-migration costs to a new cloud-storage provider to be non-recurring, and expected Axon Fleet gross margins to improve in subsequent periods.
- The company was implementing ASC 606 effective January 1, 2018 using the modified retrospective method. Expected areas of impact included contingent hardware revenue, software licenses, post-contract support, and incremental contract costs.
- Material weaknesses remained in internal control over financial reporting, including accounting for income taxes, revenue recognition, cost of sales, deferred revenue, account reconciliations, and monitoring processes. Management concluded disclosure controls were not effective as of September 30, 2017 and targeted remediation before year-end 2017.
- The company was a defendant in six product-liability lawsuits involving alleged injury or wrongful death. Management stated that the matters were not reasonably expected to materially affect results, but acknowledged that litigation outcomes and insurance coverage remain uncertain.
- Other contingencies included appeals involving Digital Ally and Phazzer, an approximately $0.6 million arbitration claim by a former French distributor, and litigation involving VieVu.
- Outstanding off-balance-sheet guarantees included approximately $2.7 million of letters of credit and $5.7 million of surety bonds.
- Key operating risks included government budget and appropriation constraints, contract cancellations, product defects, cybersecurity breaches, cloud-service outages, competition, rapid technological change, international regulatory and currency exposure, intellectual-property disputes, tax uncertainty, inventory obsolescence, and dependence on third-party suppliers.
Most important facts for an investor to verify
- Whether gross-margin pressure from discounting, Axon Fleet investment, cloud costs, and subscription accounting reverses as the product mix and infrastructure mature.
- Whether the company can convert strong bookings and deferred revenue into recognized revenue and cash without increased cancellations or appropriation-related reductions.
- Working-capital requirements, particularly the growth in receivables and inventory and the resulting negative operating cash flow.
- Renewal or replacement of the credit facility before December 31, 2017 and continued compliance with leverage and fixed-charge covenants.
- Progress and final effectiveness testing of remediation for the disclosed material weaknesses.
- The effect of ASC 606 adoption on revenue timing, deferred revenue, contract costs, and reported margins.
- Potential tax-rate volatility, realization of deferred tax assets, expiration of Arizona research and development credits, and approximately $4.3 million of unrecognized tax benefits.
- Exposure from product-liability, intellectual-property, arbitration, and commercial litigation, including the adequacy of insurance coverage.