In my

(Source: Seeking Alpha)

There are two reasons why the stock is up. The first reason was the excellent quarterly results provided in early May. The second reason is due to the recent rioting over the tragic death of George Floyd.

Axon strategic growth areas

(Source: Axon)

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Stocks associated with civil unrest have benefited, along with Axon, which is now breaking out to a new all-time high, doubling since bottoming out at ~$50 in March.

(Source: Yahoo Finance/MS Paint)

I would like to point out to those not familiar with Axon, the company is transforming from a sales to a SaaS business model for their TASER lineup, body cams and evidence collection software. For the FY’2019, recurring revenue was up 49% YoY.

Business Conditions

During the Q1 2020 earnings call, the Axon CEO indicated that although there were some customers delaying orders, that business was in general strong:

To date, we are seeing mixed changes to buying habits among major US city police departments — some departments are continuing to place large orders for Axon products, and communicating gratitude that we are shipping mission critical equipment. We are seeing some agencies move to standard issue on Axon devices, to reduce sharing among officers, which has boosted orders.

A small number of agency customers have delayed their body camera programs, or postponed their subscription upgrades until unspecified later dates. Thus far, the impact of these COVID-19-related order delays to our full-year projections have been more than offset by a stronger-than-expected Q1 2020, better-than-expected international TASER orders realized through May 2020, and a strengthening Federal pipeline.

Through May, Axon has been executing upon orders from countries with which Axon has not historically done business, and this widening customer base is providing new revenue opportunities. So far in 2020, Axon has received body camera and TASER orders from Latin America, Asia, Southeast Asia, and South Asia — all representing new country markets — and we are also seeing stronger-than-average order activity in the UK.

It should be noted that guidance for the remainder of the year has been withdrawn, but management is optimistic despite the uncertain times..

Despite the withdrawn guidance, Axon has several positive factors going for it, including strong revenue growth and free cash flow margin, a strong balance sheet of $345 million in cash and equivalents, and zero debt. Axon should survive the pandemic and recession quite nicely. The stock price is also undervalued in my opinion. The stock breakout is the feather in the cap that prompts me to give Axon a very bullish rating.

The Rule Of 40

One industry metric that is often used for software companies is the Rule of 40. The rule provides a single metric for evaluating both high-growth companies that aren’t profitable and mature companies that have lower growth but are profitable. Revenue growth and profitability (expressed as a margin) must add up to at least 40% in order to fulfill the rule. Analysts use various figures for profitability. I use the free cash flow margin.

The rationale for the Rule of 40 is as follows. If a company grows by more than 40% annually, then you can tolerate some level of negative free cash flow. But if a company grows by less than 40%, then it should have a positive free cash flow to make up for the less-than-ideal growth. This rule accommodates both young, high-growth companies as well as mature, moderate-growth companies. The 40% threshold is somewhat arbitrary but typically divides the digital transformation stock universe in half, separating the best stocks from the so-so ones.

For a further description of the rule and calculation, please refer to a previous article I have written.

The two factors required for calculating the Rule of 40 are revenue growth and free cash flow margin. In Axon’s case, annual revenue growth is 29%. The free cash flow margin is 14%.

(Source: Axon/Portfolio123/MS Paint)

The Rule of 40 calculation for Axon is as follows:

Revenue Growth + FCF margin = 29% + 14% = 43%

The score is higher than the necessary 40% needed to fulfill the rule of thumb, leading me to believe that Axon has good control over its financials, including growth and profitability.

Stock Valuation

There are numerous techniques for valuing stocks. Some analysts use fundamental ratios such as P/E, P/S, EV/P, or EV/S. I believe that one should not employ a simple ratio, and the reason is simple. Higher-growth stocks are valued more than lower-growth stocks, and rightly so. Growth is a significant parameter in discounted cash flow valuation.

Therefore, I employ a technique that uses a scatter plot to determine relative valuation for the stock of interest versus the remaining 150+ stocks in my digital transformation stock universe. The Y-axis represents the enterprise value/forward sales, while the X-axis is the estimated forward Y-o-Y sales growth.

The plot below illustrates how Axon stacks up against the other stocks on a relative basis based on forward sales multiple.

(Source: Portfolio123/private software)

A best-fit line is drawn in red and represents an average valuation based on next year’s sales growth. The higher the anticipated revenue growth, the higher the valuation. In this instance, Axon is positioned below the best-fit line, suggesting that the company is undervalued on a relative basis relative to its peers.

Investment Risks

There are several risks that investors should consider before investing in Axon. First of all, I view the current stock market action to be reminiscent of the Dot.com era, immediately prior to the crash starting in 2000. Back then, I quadrupled my investments in a few months. Technology stocks were hopping. But it wasn’t long before the market turned into a disaster zone with the Nasdaq index dropping by ~70%.

While Axon is undervalued in my opinion, the same cannot be said for some of its SaaS peers. Companies such as Zoom (ZM), Shopify (SHOP), Atlassian (TEAM), and Coupa (COUP) are extremely overvalued. A market crash led by these SaaS stocks could cause Axon to get swept along with the crowd.

The biggest risk to Axon’s business is that much of its business is with municipal governments that, even without the pandemic, are dealing with significant debt levels. if these customers are unable to continue making payments according to subscription schedules then revenue growth could suffer, translating into a lower stock price.

Summary and Conclusions

Axon is a leader in law enforcement technologies and is in an ideal position to support the current rioting. I also believe that the circumstances are heightened by stay-at-home directives and massive unemployment. The rioting is incident-specific, but the environment is conducive to future violence and crime. Therefore, the demand for Axon situation de-escalation technologies and evidence capture and processing will only increase as time goes on.

Given that the company’s fundamentals are strong, and in my opinion, the stock price is undervalued, I expect that Axon will emerge from the pandemic in terrific shape and continue to perform well thereafter. The stock price is pushing to new all-time highs, suggesting more bullishness to come. For these reasons, I am giving Axon a very bullish rating.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.