Axon Enterprise - Earnings Call - Q3 2011

Transcript

Speaker 2

Good day, ladies and gentlemen, and welcome to the third quarter 2011 Axon Enterprise Earnings Conference call. My name is Jennifer, and I'll be your operator for today. At this time, all participants are in listen-only mode, and later we will conduct a question and answer session. If at any time you require operator assistance, please press star followed by zero, and an operator will be happy to assist you. As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Rick Smith, CEO of Axon Enterprise. Please proceed.

Speaker 4

Thank you, and good morning. Before we get started, I'm going to have our CFO, Dan Behrendt, read the safe harbor statement.

Speaker 1

Yeah, good morning. Safe harbor statement. Certain statements contained in this presentation may be deemed to be forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995, and Axon Enterprise intends that such forward-looking statements be subject to the safe harbor created thereby. Such forward-looking statements relate to expected revenue and earnings growth, estimations regarding the size of our target markets, successful penetration of law enforcement markets, expansion of product sales to private security, military, and consumer self-defense markets, growth expectations for new and existing accounts, expansion of production capabilities, new product introductions, product safety, and our business model. We caution that these statements are qualified by important factors that could cause actual results to differ materially from those reflected by the forward-looking statement herein.

Such factors include, but are not limited to, market acceptance of our products, establishment and expansion of our client and indirect distribution channels, attracting and retaining the endorsement of key opinion leaders in the law enforcement community, the level of product technology and price competition for our products, the degree and rate of growth of the markets in which we compete, and the accompanying demand for our products, potential delays in international and domestic orders, implementation risk with manufacturing automation, risks associated with rapid technological change, execution and implementation risk of new technology, new product introduction risk, ramping manufacturing production to meet demand, litigation resulting from alleged product-related injuries and deaths, media publicity concerning product uses and allegations of injury and deaths, and the negative impact this could have on sales, product quality risks, potential fluctuations in quarterly operating results, competition, negative reports concerning Axon device uses, financial and budgetary constraints to prospects and customers, dependence upon sole and limited source suppliers, fluctuations in component pricing, risk of government investigations and regulations, Axon product tests and reports, dependence on key employees, employee retention rates, and other factors detailed in the company's filings with the Securities and Exchange Commission.

With that, I'll turn it back over to Rick Smith.

Speaker 4

Thanks, Dan. Okay, so I'm sure everyone has seen the release this morning. Pretty happy with the results, up 16% over the same quarter last year, with $24.4 million in revenue, and the business generating $5.3 million in cash from operations. That's 22% of revenue and cash generation. One of the key drivers there was the introduction of the Taser X2 from the second quarter. This was the first full quarter that the Taser X2 was available to our customers. It accounted for about 15% of revenue, but close to 20% of bookings. The disparity there is, we had a very high attachment rate of extended warranties and training services that are deferred and recognized over time. As we look into next year, we see around a $300 million upgrade opportunity if we're successful in helping our customers to upgrade X26 units that are more than five years old.

One other point about the Taser X2 is in our surveys with instructors who teach electronic control devices, we've seen 96% of them select the Taser X2 as their preferred full-time carry weapon, even over the X26, which was a huge number, a huge achievement actually, because the X26 was such a hit in law enforcement. The rigorous voice of the customer development process, where we put hundreds and hundreds of officers through surveys and focus groups to identify the right feature matrix for the Taser X2, really seems to be paying off. It looks like we do have the generation ECD that should be able to drive growth into the future. This quarter, we also saw international sales continue to grow.

It was up over the prior year by $4.4 million year to date, up $2.3 million in the third quarter, with a large portion of that coming from strong cartridge sales to our installed base overseas. Finally, before I turn over to Dan to go through the numbers in detail, we've continued to return cash to shareholders. As of the end of the quarter, we had executed a total of $12.4 million out of our $20 million buyback. Let me give you more current numbers. Through last Friday, we had completed $17.77 million of the buyback, leaving $2.3 million left to go. Those are in dollar terms. If we add that up, this year to date, we've returned $30.27 million to shareholders. Just to put that in perspective, the company we took public in 2001 had a pre-money market capitalization of right around $10 million.

We've returned multiples of the value we took public a decade ago, just this year in cash to our shareholders, something we're pretty proud of. With that, I'm going to point out one last item. Our basis on the shares we purchased is around a little under $4.30 a share. We're pretty excited to have reduced our share count by so far about 11.3% this year. We started the year with 62.6 million shares, and at the current time, we're at about 55.6 million shares, a little under 55.6 million. We should be able to complete the rest of this buyback by the end of the year. With that, let me turn over to Dan to go through some more details on the financial performance.

Speaker 1

Okay, thank you, Rick. As Rick said, revenues for Q3 were $24.4 million. This is up approximately $3.3 million, or 16% from the prior year. The increase is driven mostly by the introduction of the new Taser X2 two-shot Taser device, which generated approximately $3.7 million of sales during Q3. As a result, the North American law enforcement sales for the third quarter are up about 11% over the prior year. International sales are also up significantly over the prior year due to some sizable follow-on orders during the quarter. Our international sales for the quarter are 19% of sales, and we're running about 22% of our total sales year to date are international. This is up over the prior year. That's excellent news to see further penetration. Gross margins of $13.1 million, or 53.7% of revenues, are up 4.3%.

That's a percentage of sales from the 49.4% of the prior year. The improvement was driven by a combination of factors, including the cost of our SaaS data center operations and software maintenance for Evidence.com were reduced over the prior year. We had a lot of dedicated effort in the third quarter of 2010 around just sort of final bug fixes and maintenance for Evidence.com, which ended up in operations. That is behind us, so we're kind of more at a normalized level for the SaaS data center costs, the cost to support Evidence.com. We also experienced a more favorable sales mix with higher margin international sales representing a greater percentage of our total. We saw improved leverage over fixed operating and overhead expenses.

Those were offset by, you know, we didn't have a generous trade-in credit for the Taser X2 this quarter, which had about a $1 million impact, about 180 basis points. Overall, we're pleased with the direction we're heading in gross margin. The SG&A expenses of $9.5 million for the third quarter are up just slightly over the $9.4 million in the prior year. SG&A as a percentage of sales was 38.9% of sales in Q3 of 2011 compared to 44.7% of Q3 in 2010. Again, the total cost for the quarter, we had reductions in sales and marketing, consulting, travel, and other SG&A expenses. Those were partially offset by an increase in legal fees just due to the timing of cases and some other factors. Research and development expenses of $2.4 million for the third quarter, this is down $0.7 million compared to 2010.

Again, it's driven really by the reduction of the allocation of development costs that were made its way up into cost of sales last year, which is down back, down in R&D this year. We're kind of more of a normalized level. If you look at sort of the trend during the year of R&D, we're back to kind of that normalized level. The adjusted operating income, which excludes the impact of stock-based compensation, depreciation, amortization, and losses regarding the write-downs and disposals of property, was about $4 million for the third quarter of 2011. This is a $1.7 million increase, or 72% higher than the adjusted operating income of $2.3 million we had in the third quarter of 2010. The GAAP income from operations was $1.2 million for the quarter compared to a loss from operations of $0.7 million in the third quarter of 2010.

These improvements demonstrate that we're seeing really great operating leverage on the incremental costs or incremental sales we see. You know, once we cross break-even, we see a really a very healthy fallthrough in the business, and you can see that reflected this quarter with the dramatic fallthrough to operating income from the higher sales value. Net income for the third quarter of 2011 was $1.02 a share on a basic and diluted basis compared to a loss of $2.3 million or $0.04 a share on a basic and diluted basis in the prior year. You may notice that the effective tax rate for the quarter is unusually low.

This is because we had R&D tax credits included in the 2010 tax returns, which are filed in September of 2011, were much higher than we'd forecast in the tax provision we had last year, due to a higher percentage of research and development activities qualifying for tax credits. This is good news. It ran through the third quarter results. We booked about a $500,000 benefit for those higher R&D tax credits in this quarter's tax provision. Our effective tax rate on a normal basis remains right around 40%, I'm sorry, about 50% for 2011, but we did see a benefit from that normal rate in this quarter, which certainly benefited the net income as well. Moving on to the balance sheet, we finished the quarter with $30.8 million of cash, cash equivalents, and short-term investments.

The decrease of $11.9 million from the prior year end is due to the $24.9 million of cash used in the stock buyback during the first nine months of 2011, partially offset by $14.6 million of cash provided by operating activities. Accounts receivable, $12.5 million, is down $1 million from the prior year end balance just due to the timing of collections and sales. Inventory of $15.5 million is down $2.3 million from the year-end balance due to larger quarter-end orders in the third quarter and also just a concentrated effort to reduce those inventory balances. The investment of property equipment of $29.8 million is down $6 million. The net decrease is comprised mostly of $5.6 million in depreciation expense. We've had a fairly low CapEx requirement this year, so our depreciation is running significantly higher than the capital expenditures, which is bringing down that net PP&E balance.

We also saw a reduction in the property equipment balance due to the write-down of Protector and some surplus MSI Comp data center assets during the year. The total assets at September 30, 2011, were $117.2 million. Moving on to the liability and the stockholders' equity section of the balance sheet, accounts payable of $5.1 million is up almost $600,000 from the year-end balance due to some timing of AP check runs and just normal changes in activity. Accrued liabilities of $7.7 million is an increase of $3.9 million due from the 12/31 balance due to the litigation judgment expense reserve of $3.3 million recorded on the Turner case that's recorded in the second quarter. We had a total deferred revenue of $7.4 million.

This is a decrease of $284,000 from the 12/31 balances due to extended warranty revenue recognized in the third quarter, outpacing the addition of new warranties, although we are seeing a good attachment rate of warranties on the Taser X2, so we may see that reverse itself over time. Our total liabilities are $23.1 million, and the company finished the quarter with $94.1 million of stockholders' equity, which has decreased $23.5 million, primarily due to the stock repurchase programs we've executed so far in 2011. We still have no long-term debt and continue to have funding liquidity to fund our R&D efforts and operations as we move into the future here. Moving on to just the selected statements from the cash flow statements, the company did have cash provided from operations of $5.3 million during the third quarter and $14.6 million for the nine months ended September 30, 2011.

This compares to cash used from operations of $2.4 million for the nine months ended September 30, 2010. The cash generation for the nine months ended September 30, 2011, is really driven by our adjusted operating income of $10.4 million, a decrease of inventory, and also some other changes in working capital. We are very pleased with the cash generation ability and the cash from operations. That is really a big driver of the company's confidence in order to return cash to shareholders through the buyback. We did have net cash used in investing activities for the nine months ended September 30, 2011, at $7.8 million. This compares to $3.4 million in the same period of 2010. The use of cash is mainly driven by the purchasing of some short-term investments in order to improve our yield on our cash and investments.

We also had cash used in financing activities of $24.8 million, again, driven by the two buyback programs, the one approved in March and also the one that we announced in July. Through the end of the third quarter, we purchased 5.9 million shares for a cost of $24.9 million. As Rick indicated earlier on the call, we've continued to buy in October here, so those balances are slightly higher now. The company ended the quarter with $24.6 million in cash and $6.2 million in short-term investments for a total of $30.8 million of cash and investments. We feel very good about the liquidity position we're in and feel like we're really positioned for a strong end of the year and a strong 2012. With that, I'd like to turn the call back over to Rick Smith, our CEO.

Speaker 4

Thanks, Dan. I want to touch on a couple of significant events for the quarter. First, New Jersey, the last remaining holdout state that had prohibited law enforcement from using ECDs, has now changed. They have now specifically approved only the X26 and X2 models for use by law enforcement officers in New Jersey. There was a rather rigorous process of evaluation by the AG's office, and we're delighted to finally cross that important milestone. I just got back from the International Chiefs of Police Conference in Chicago last week, and I can tell you there was a lot of excitement from the chiefs in New Jersey to now have this tool available. During the quarter, we had a number of significant orders for the X2.

San Bernardino County became the first major county sheriff upgrading all of their 1,500 officers to the new X2 and also deploying 20 of the Axon on-officer camera systems. Also critically important was Charlotte-Mecklenburg. For those of you who haven't put the two pieces of information together, the Turner case, where we had the adverse verdict earlier this year, which still has not been entered, by the way. We're still in post-trial rulings. Charlotte, as part of their risk mitigation plan, took their X26 units off the street to do an evaluation, look at their policy, etc.

They actually made a determination that part of their response was to upgrade their systems to the new X2s to take advantage of some of the new safety features, particularly the audible alarm and shutdown features to help avoid extended durations, and the charge metering, and the new Trilogy logs that record more data about how the devices are used and ensure that we're delivering in a very narrow band of an electrical output to maximize effectiveness and safety. We also saw other agencies moving, the University of Texas at Houston, Plymouth Police Department, putting 85 X2s on the street. We continue to see a lot of momentum.

We have a trade-in program that will run through the end of the year, where we give agencies a $300 trade-in credit for their X26s toward an upgrade package that includes the X2, extended warranties, cartridges, holsters, sort of a full conversion kit. We're finding that that's really fitting a critical need for these larger agencies to be able to justify making the upgrade. We also saw some significant orders internationally. We have 377 X26s with Taser cams. The new TASER Cam HD, which is our high-definition unit, we introduced that at the IACP. We expect that should be shipping around the end of this quarter. It will really help in states like New Jersey, where they're requiring TASER Cams, as well as Australia, New Zealand, and some other international markets, where they, I believe, they're generally required the use of TASER Cams.

We saw a large 60,000 cartridge order, so some continuing business from our installed base. We also saw continued traction with our Axon on-officer camera system. We had a number of smaller agencies deploy. I would tell you this. You're standing at the IACP, I've met probably with 40 chiefs, many of them from the largest agencies, and we're seeing a real shift in the tone, which is very encouraging. Two years ago, when we really started talking about on-officer cameras and Evidence.com as a cloud storage solution, the typical reaction was, "You want to do what?" This idea of putting a camera on an officer, there was a fair amount of, you know, "Hey, it sounds like a great idea. It's pretty futuristic. Not sure when it's going to happen." The idea of using the cloud was pretty foreign a few years ago. Last year, it was getting better.

I think last year, I'd characterize the tone was, "Yeah, we see cameras coming someday, but you know it's probably, you know, off in the distant future." This year, the tone was much more, "Yep, this stuff's coming. We got to get on board. We need to start really looking hard at on-officer camera systems." With the cloud-first policy announced at the federal government level, that is a key endorsement of a cloud strategy, excuse me, as well as, frankly, Apple's iCloud, bringing the whole cloud concept mainstream. Again, of the chiefs I talked to, I would say the majority of them have now gone from being cloud skeptics to very interested in how can we use the cloud to be able to better our IT performance.

As Vivek Kundra, the former CIO of the federal government, says, "The advantage of the cloud is that customers get value day one when they start using a service that's up and running." As one example, I talked to two former chiefs of major police departments. Each of them told me that they had spent over $10 million in their department on a project that had been going for more than a decade to do a digital record management system. Neither of those systems were live after 10 years and more than $10 million in both cases.

They both related to me the level of frustration that at least one of them had had an independent firm sort of audit their system and told them, "The day it goes live, it will be more than a decade out of date." It's basically the technology equivalent of what the private sector was giving away and scrapping five years ago. The message about the cloud being a way to hold service providers accountable, get more, more, more value starting day one really resonated with those chiefs. The other thing that we've done is we have separated our Axon camera systems from Evidence.com. Evidence.com is now optional. Previously, the Axon only worked with Evidence.com. We're now enabling agencies to use the Axon in a standalone mode and download it. If they want to build out their own data servers and data centers, they can, or they can use Evidence.com.

We've actually found that just removing the mandate has had a huge impact psychologically in that agencies now don't feel—it's simplifying a bit the purchase process, where previously they had to make a long-term commitment to Evidence.com to really buy the cameras. Now they can buy the cameras, use Evidence.com, or use it locally. We're finding that that's reducing some of the purchasing decision friction. At this point, I would say we're continuing to focus on streamlining implementation, preparing for scaling. We just released—we're on about a 90-day release cycle. We just released our version 1.11, which had a bunch of new enterprise data management features that allowed agencies to track, by user, usage statistics across the agency, how much data storage they're using, etc. We're really refining the user experience down to make it simpler and simpler to the individual officer.

Just a lot of refinement going on, and I believe 2012 will be a very interesting year for Axon and Evidence.com. The net effect of the quarter, it looks like with X2 that we have a—I guess I'd call it a hit. We've got a great product that the market's reacting well to. Given the slowdown of the last few years, most of our customers know that their equipment's getting out of date. Hopefully, as we come out of what was a pretty nasty recession, these agencies know that they're going to have to be investing in their technology and capital equipment. We believe we're well-positioned, both with the X2 and now with the Axon on-officer camera systems. With that, thanks for joining us on the call today, and we'll go to a few questions.

Speaker 2

Ladies and gentlemen, if you wish to ask a question, please press star followed by one on your phone. If your question has been answered or you'd like to withdraw your question, please press star followed by two. Please press star one to begin. Your first question comes from the line of Steve Dyer from Craig-Hallum. Please proceed.

Speaker 4

Thank you. Good morning.

Speaker 0

Morning.

Speaker 4

Dan, as you have customarily, could you go through product by product and give us the quantities there?

Speaker 1

Yeah, sure thing, Steve. X26 for the quarter were 10,600 units. X2, we had 4,987 units. M26, 1,647 units. We sold 16 X3s, 1,962 C2 ECD devices, 1,751 Taser cams, and cartridge total was 389,676.

Speaker 4

Okay, great. Am I correct in assuming that we'll have another quarter of the gross margin impact just on the trade-in credit?

Speaker 1

Yes. We'll see that in the fourth quarter as well. In the second quarter, the X2 sales were kind of a positive impact because most of those were sold at full price because they were just sales into our distribution channel. This quarter, a lot of them are trade-ins, but the margin of that, even with that trade-in, is good. Part of what impacts us is we defer some of that revenue because it relates to warranties and training.

Speaker 4

Okay. Makes sense. I'm wondering, as it relates to the buyback, you guys have obviously done a good job of buying back stock. I'm wondering why it looks like you bought about 3 million shares in the quarter and the diluted share count didn't move down much. Can you give me a little color there?

Speaker 1

Yeah, it's based on the weighted average, so it just kind of tends to move a little bit slower, but you'll see more of that impact as we go into the fourth quarter.

Speaker 4

Okay. Do you know the number that you ended the third quarter with offhand on a diluted basis?

Speaker 1

We were about $56.7 million on a basic, you know, with before the options.

Speaker 4

Okay, I will hop back in the queue. Thanks.

Speaker 1

Great. Thanks, Steve.

Speaker 2

Your next question comes from the line of Craig-Hallum from Baird. Please proceed.

Speaker 3

Good morning. I wonder if you could talk a little bit about, from both Evidence.com and Axon, how many agencies are now using the product, how many units have been installed, and maybe set that number in context of what you think the broader market opportunity is.

Speaker 4

Gotcha. This is Rick. We're going to give a lot more detail in our year-end call that'll be coming up in February. At this point, I would say we're still in the early, early phase. We do have several hundred agencies using Evidence.com. That's a combination of the free introductory version that we do that comes with the Taser devices, so they can store their Taser logs and their Taser cam files on there. We actually expect that number to continue to grow because with the new Taser X2, there's a whole bunch of advanced data features that are making it much more compelling for agencies to use Evidence.com, what we call LIFE, which is the free version. By the way, the reason that that's important is that helps get agencies over the initial sort of trepidation of using the cloud.

Having them start using the LIFE version gets them over the line. There are some colorful adjectives we could use about that, but you could probably imagine them. It gets past the initial resistance. In terms of the number of Axon units in the field, I don't have the number of agencies here. It's in the dozens of agencies, not in the hundreds of agencies, that have purchased. We have a couple dozen more agencies that are in the testing phase. I would say, on what we call the Evidence.com Pro side, which is the paid version and the hardware, we've identified a number of things that we're refining in the experience with the product based on the last 18 months or so out in the marketplace. We're seeing continued traction, but we've not yet hit the knee of the curve in terms of adoption.

We expect next year we'll be talking about those numbers in more detail.

Speaker 3

Thank you. On the X2, can you just walk through the history there a little bit again? When did that product officially begin shipping, and maybe compare and contrast, you know, you did almost 5,000 units there here in the quarter. Compare and contrast how September was versus the June quarter.

Speaker 1

Yeah. This is Dan. We sold about 600 units or so in Q2. We introduced it in Q2, so we didn't start shipping it until late Q2. In fact, we finished Q2 with a little bit of a backlog. We had about a 500-unit backlog at the end of Q2. We really just started shipping it in June. This was the first full quarter, and we sold close to 5,000 units this quarter, including, as Rick indicated, a couple big upgrades in San Bernardino and Charlotte. I think it's encouraging. As you know, that upgrade opportunity is really the compelling thing with X2 to go back and resell into that installed base. We've seen a couple of our bigger customers embrace that right out of the gate, which is encouraging.

Speaker 3

Thank you. The accounting for that rebate, that $300 rebate, can you remind us how that flows through the P&L?

Speaker 1

Yeah. What we do is we basically take that as a sales allowance. We're basically reducing the sale. The trade-in comes in a package of a Taser device, the holster, six cartridges, some training, and an extended warranty. The total is about $1,550. We actually just record in revenue about $1,250 of that. Part of that $1,250 is even deferred because it's the warranty, so we'll recognize that ratably over the five years. Out of the total sale, it starts at $1,550. We recognize about $1,000 in the quarter, and then about $250 we'll recognize over time.

Speaker 3

Thank you.

Speaker 1

Sure thing.

Speaker 2

There are no further questions at this time. I will now turn the call over back to the presenters for closing remarks.

Speaker 4

Great. I'd like to wish everybody out there a happy Halloween. I'll be out trick-or-treating with my kids tonight. Wish you all the best. Great holiday season. The momentum here internally, for those of you who get a chance to come and visit the company, I think the operations are really hitting their stride. Our product development processes have really matured over the last couple of years. I think the fiscal discipline, we're seeing it in the cash generation and the improved profitability. I couldn't be more excited for the future. Thanks for joining us today, and we'll be back for our next conference call in February of next year to report on the full year.

Speaker 1

Thanks, and bye-bye.

Speaker 2

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect.