Axon: A Software Business Growing At 62%

Introduction

During the last few months, I have written in great depth about the business of Axon Enterprise (NASDAQ:AXON). I've employed my foundational investment frameworks to better illustrate why I own the business and why I believe it's a compelling business to own in the decade ahead. You may review that work via the link below:

As of today, I've had an approximately 3.5-year relationship with the business, though I only recently began buying the business. I would have bought it in late 2022 and early 2023 as it hit the buy target I assigned in 2020, but I unfortunately did not have the bandwidth at the time. I did buy 13 new companies during the second half of 2022 and early 2023, and these were similar companies that we'd studied for years but held off on buying due to valuation concerns.

While this is a worthwhile introduction to our relationship with Axon, it's also a fantastic segue into the central thrust of my writing to you today.:

We will consider Axon's valuation, and we will do so specifically through the lens of its software business.

I believe this is a highly compelling way to look at the business that I've not discussed with you in the past.

In short, I believe Axon's entire valuation, as of today, could be justified by its software business, and I will walk you through the assumptions that have led me to conclude this today.

Analyzing Axon's Software Business

Our analysis of Axon's software business can be broken down into three distinct segments:

1. The nature of Axon's SaaS offering. This is important because it informs long-term free cash flow margins associated with its SaaS offering, which is essential for making a valuation judgment.
2. Its TAM.
3. Its recent growth

The Nature Of Axon's SaaS Offering

As you know from my past work on Axon, its software business acts as the connective tissue within its ecosystem, linking its various hardware assets and creating a central software-defined intelligence for the law enforcement agency employing it.

It's essentially the Office 365 (MSFT) or Adobe (ADBE) Photoshop of law enforcement software, but, instead of expense reports, product data, image creation, and charts, users of the software manage evidence, records, and data related to law enforcement activity.

Elements Of Axon's Software Suite

Interestingly, while the software does serve as the connective tissue within the Axon hardware ecosystem, it's also a quality standalone software platform. It can be sold individually, without the need to use Axon software. This idea was communicated in commentary CEO Patrick Smith shared with an analyst on Axon's most recent earnings call:

Michael Ng (Analyst): And I did want to follow up on that along with the comment that Josh made earlier about good momentum in justice. So is it right to interpret that there are customers that are buying the software or the E.com licenses that may not necessarily be part of the body camera or the TASER installed base? And if that's the case, I was just wondering if you could expand on that a little bit more and talk about the opportunity there.

Patrick Smith (Founder-CEO): Let me jump in over Josh. I'm excited on this one.

Like, for example, the country of Scotland selected us for their digital evidence management system across police, prosecutor's courts, the whole country and they are not using our body cameras. We've had some similar albeit - I'm not sure which ones we've specifically disclosed or not but we've had other international agencies move software first.

And that's something that we're really proud of. And obviously, our software teams take great pride in that as well that 10 years ago, our software was basically an enabler of our hardware. And now they're both strong on their own and our software products, especially things like Records can stand on their own, although some of the generative AI stuff I alluded to in my comments, are a true game changer.

When an agency is using our body cameras and our cloud software, our ability to unlock all the valuable data that's given in those audio, video records for our customers is pretty awesome.

And so we think we are very well positioned, and we look forward to coming back with more details. Don't want to get out over my skis but we have been doing some - we're always inventing and prototyping with our customers and we're just hearing really positive feedback on things that we've not even announced yet. So that growth engine of doing the hardware and the software enables us to do things that you can't do - if you can't do both those things together.

Axon Q2 2023 Earnings Call

In short, Axon's software suite is a compelling product inside or outside its hardware/Walled Garden ecosystem.

Below, we can see the product offering delineated:

As we can see, there are various tiers, and these tiers include different features that law enforcement agencies can leverage and employ. These tiers are sold as software as a service (SaaS) subscriptions, which translates into durable recurring revenue for Axon.

Below, we can see this durable recurring revenue depicted:

As I've shared in the past, the value of any business is:

1. How much free cash flow per share it generates.
2. The durability, defensibility, and reliability of that free cash flow per share.
3. When that free cash flow will be received.
4. And our next best alternative (such as the 10-year treasury yield).

These four variables define the value of any enterprise through a purely quantitative lens, and the above chart illustrates that Axon's free cash flow is reliable and durable, and our analysis of Axon's moats suggests that Axon's free cash flow is defensible (there are economic moats defending the free cash flow, e.g., embedding/switching costs sustaining the recurring nature of the software sales).

Now that we have a solid understanding of the nature of Axon's software product/platform, let's turn to a review of Axon's TAM.

Axon Has Barely Begun To Penetrate Its Software [SaaS] TAM

As we can see, Axon has barely penetrated its software TAM. Notably, based on the zero percentages depicted above, it's not even begun selling its SaaS offering to large swaths of the world, and this, of course, represents a giant opportunity.

On Axon's Q2 2023 earnings call, CEO Rick Smith stated that its international TAM should, over time, dwarf its U.S. business:

Josh, if I could add in a little bit as well. Just very rough, if we look at the long term, right now, international is about 1/5th of our business. At scale, international - I mean, the U.S. should be about 1/5th of our business.

The rest of the world is at least 5x larger than the U.S. market is. And so as we - we're very focused on opening these markets but police face similar challenges around the world.

Rick Smith, CEO, Axon Q2 2023 Earnings Call

With these ideas in mind, Axon has asserted that its software TAM represents a $22B opportunity, and this includes Digital Evidence Management software as well as "Real-Time Operations, Productivity & added software."

While we should always take these TAM estimates with a grain of salt and use conservative long-run estimates for growth, I'm inclined to believe that this opportunity lies in front of Axon.

I believe this because 1) government agencies are generally slow to adopt new technology, such as cloud-native software applications, so there's likely a lot of room for further adoption, and 2) Axon's software growth rate over the last 24 months, during which software sales broadly have slowed dramatically, has been almost unbelievable.

Median Software Growth Rate For Public U.S. Companies Has Slowed Dramatically

Our cloud business grew 62% year-over-year. And we are in the early days of expansion into new markets and products. Our software penetration remains low and we are finding ways to sell more software content into our installed base, executing against a $22 billion software TAM.

Josh Eisner, President, Axon Q2 2023 Earnings Call

Axon's SaaS business has grown at a 45% CAGR over the last four years, so this represents an acceleration in growth relative to its four-year average growth rate.

Additionally, our study of software broadly had indicated to us that cloud computing spend as a % of IT remains very low globally.

With all of these ideas in mind, Axon's software growth, depicted below, makes sense to me.

And I expect that Axon's SaaS sales growth will remain elevated for quite some time to come.

Let's now turn to a consideration of Axon's valuation with all of this data in mind.

Valuation

While we presently do not have visibility into what Axon's long-run SaaS free cash flow margin will be, we can infer what it will be with some degree of accuracy via a study of likewise dominant vendors of software, who have likewise substantial economic/competitive moats with which their cash flows are defended.

Free Cash Flow Margins For Some Of The Largest Public SaaS Vendors

As we can see, quality, competitively advantaged SaaS businesses generally achieve ~30% free cash flow margins or higher (for instance, CrowdStrike Holdings (CRWD) recently guided for about 35% long-run free cash flow margins).

With everything we've discussed in mind today, below, you may review my reasonable to conservative assumptions that I will subsequently input into a valuation model.

Assumptions:

Using these assumptions, we can calculate Axon's fair value (roughly) and projected future returns (more exactly):

As can be seen, we're getting about 15% annualized returns from only Axon's SaaS suite.

There's a lot more to the business than just software. And Axon has demonstrated that it's likely just getting started in terms of fielding new, compelling, rapidly growing products.

Axon Q2 2023 Investor Presentation

Concluding Thoughts

As I shared in July prior to beginning my purchases of Axon, no matter how I sliced the company's valuation, I found it to be fairly attractive.

The company is quietly becoming a SaaS giant, and, while the market has begun to sustainably acknowledge this as evidenced by Axon's current valuation, which I wouldn't say is exactly depressed, I do think there's still fantastic returns to be generated from buying Axon at these levels in the years and decades ahead.

Thank you for reading, and have a great day.

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