Axon: Stunning The Competition - [Business Breakdowns, EP.175]

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1:05This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. And we are here to bring them to you. To find more episodes of Breakdowns, check out JoinColossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. hosts, podcast guests, their employers, or affiliates may maintain positions in the securities discussed in this podcast.

1:48This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Welcome back to Business Breakdowns. This is Matt Russell, and today we are breaking down Axon Enterprise. Now, you may know Axon as the pioneer of the taser, but the business has truly evolved over the years and now has expanded into body camps and other supporting tools for law enforcement and the defense industries. Our guest is Danielle Menichella, Portfolio Manager at SANS Capital. Danielle details not just how Axon expanded its product offering, but how it's shifted that business model from pure hardware to a mix of hardware software.

2:33Given the customer base, I think this is a really interesting episode to pair with Motorola, which we recorded and released about one month ago. It's very interesting when you get into unique customer dynamics, what's driving the growth in certain industries, and we get into a lot of that and more on this episode. So please enjoy the episode on Axon. All right, Danielle, excited to talk about Axon today. This is a name that someone close to me brought up many years ago. I looked at it at the time, somewhat forgot about it. We had a conversation, discussed the podcast, brought it back up. But I certainly don't think it's a household name.

3:13Maybe we could just start out the conversation with some high level description of Axon the business to get listeners familiar. Axon sells a public safety technology ecosystem that includes three main product groups, tasers, body worn cameras, and other sensors. and evidence software, amongst a host of other software services, including virtual reality training. The ecosystem supports Axon's mission, which is to protect life, to capture truth, and to accelerate justice. Axon Solutions really seeks to solve three of the biggest problems facing public safety. Too many officers and too many suspects are dying from gunshots, and the way Axon solves for this is as the monopoly provider of tasers globally.

4:00A taser can be used as an alternative to firearms to temporarily incapacitate a suspect so that they may be restrained with a much, much lower chance of doing physical harm. Then we need more accountability for both our police officers, but also the public with whom they interact. And Axon does this with body -worn cameras as the market leader in the space. The body camera collects data and then sends it to the Axon cloud where it can be shared but not manipulated. And then the third problem, it just takes too long to go through evidence and write reports and then get that information to all the necessary parties.

4:36And this is made worse by too few human resources. Axon software helps get this done more efficiently. And like the first two product categories, Axon is the market leader in evidence management software. So I would say what makes Axon special is it has this existing pretty resilient customer base through Taser customers where there really isn't an alternative. Since 2015, we've seen increasing body cameras, mandates for those, and Axon is winning share there There's the overwhelming market leader with market share multiples higher than their competitors. And the body camera basically creates the evidence, which makes those customers very likely to use Axon software and cloud services.

5:22So it's virtual flywheel. And the result is we had a business that has shifted from a predominantly hardware sales model to an increasingly software -driven subscription model with 95 % subscription sales, 122 % net revenue retention, increasing margins as a result of more software, and the ability to generate higher cash flows in the future. I think you hit on it at the end there, just in terms of some of the numbers, which are eye -popping in terms of where they are today. Going back to the beginning of the business, it's my understanding that they invented the Taser or were early players in that Taser market.

6:03Can you just talk a bit about the start and some of the evolution of the business, which you touched on a bit there, but just getting some sense of the origin story would be helpful? They basically commercialized it. So before Axon, the company was called Taser. Taser was founded in 1993 by brothers Rick and Tom Smith in Scottsdale, Arizona, and Rick's still the CEO today. The genesis for the idea behind Axon was to find a real solution for guns with bullets, something that could stop an imminent threat quickly and effectively without ending a life. And Rick was inspired to do this after he learned that two of his friends from his high school years were driving home one night, got involved in an incident of road rage, and ended up shot dead on the side of the road.

6:48So after finishing business school, Rick decided to get to work to develop a product someone could use for self -defense without really risking killing someone else. And then Axon was launched in 1993 as Taser with the help of Jack Coover. So Jack Kover was a leading scientist from the 1960s who had worked on the Impala moon landing. He grew up wanting to be an inventor, reading science fiction of the times, and that included a famous series about a boy hero named Tom Swift. I'm telling you that for a reason. In 1967, Jack embarked on a quest to help the government find non -lethal weapons alternatives.

7:28And he worked on such technology, amassing patents along the way, but no real commercial products until Rick sought him out. Ultimately, the two helped create the Taser. It was named that in honor of Jack Covert's childhood hero. Taser stands for Thomas A. Swift's electric rifle. Jack passed away in 2009. So the first Taser was introduced in 94. It was for the civilian market. Four years later, we started to see some law enforcement use it and really use it as an option like you would use a baton or pepper spray. But each subsequent model aimed to make the taser better and more likely to be able to ultimately replace a gun with bullets in terms of reliability.

8:11We're still not there yet. We're close, though, after seven models. And we now have the taser 10, which was introduced in 2023. This one, to me at least, seemed like a real game changer when it was introduced. When studies were done regarding why previous versions of the taser didn't work at de -escalation or stopping the threat, there were two key issues that emerged. One, range. The officer shot the taser from too far away and it failed to reach the target. And two, lack of follow -up ability. The taser was shot. The target was missed. Previously, tasers only had two shots to get it right. So the latest taser, the 10, helps solve those problems and more.

8:54It has increased range up to 45 feet. It has 10 shots to get it right. Additionally, it has all weather functioning, a loud and bright effective warning alert, and comes with multiple forms of training, including in -person, online, and virtual reality. Virtual reality is proving to be the most effective, especially when considering cost savings associated with being able to do it from anywhere and to do it repeatedly. Then Axon first launched cameras in 2009. That was with an ear attachment, introduced fleet cameras in 2012, and its first body camera was launched in 2013. Since then, we've seen lots of mandates calling for more body cameras.

9:36And there have been several versions of all of those cameras. And then in 2017, Taser officially changed its name to Axon as part of the purposeful strategic shift to be more than just a Taser company and create a public safety technology platform with a focus on the accountability through the body cameras, data storage and software. Very interesting timing that we're having this discussion just several weeks ago. We recorded on Motorola, which sells... I listened to it last night. It sells into a very similar customer base. Very interesting to hear how that has evolved and some of the things that they work on.

10:14With Axon and maybe the Taser product to start, obviously, body cams certainly being in that camp as well. It sounds like the founder's initial thesis very much relied around a less lethal form of defense. And it sounded like the experience that he had was maybe more in the civilian world. What Axon seems to be controlling is more in law enforcement and that segment. Do you have some sense just of the customer segment breakdown or the market as you would think about it and frame it for Axon in terms of how big it actually is, whether that law enforcement category is that customer that's going to make up the most eyes, any context there?

10:54If you look at their customer breakdown right now, for sure, state and local police agencies are the largest single group, but their TAM is quite large and larger than that would suggest. So Axon has been publishing its TAM for a while. And as of May this year, that TAM was estimated at $77 billion. So to break that down, $7 billion for Taser, $10 billion for camera hardware, $18 billion for software and cloud, and then $16 billion for real -time operations, which would include things like dispatch and respond and their recent FUSIS acquisition. $19 billion for Exxon Air, and that's the nascent category of drones as first responders, so that's pretty new.

11:39And $5 billion in consumer tasers and personal protection. What I would say, what my analysis supports is all of that except for that personal protection category. I have more questions there. So I think of the TAM as about $70 billion versus last year's revenue of only $1 .6 billion. And then we can give some more context to that. So if I exclude civilian, $17 billion is for U .S. state and local agencies. Right now in tasers, Axon is in 92 % or estimated 92 % of those agencies in the U .S. 13 billion to U .S. federal, 17 billion to enterprise, and 26 billion for international. I think the key point with this TAM discussion, though, is how underpenetrated Axon's market actually is.

12:26Even in the U .S., we probably tend to think of taser penetration as pretty high, and it is in local and state police departments. Like I said, over 90 % penetration. But overall, in the US when you think of all the other end customers, whether it be federal, corrections, private security, or enterprise. US taser penetration is only about 35%. And body cameras for all the mandates and cries for more accountability from over the past five years or so, penetration rates are only 14 % in the US. And then the big one there is the 4 % penetration in software and cloud. And that, in my opinion, is like the key value added driver.

13:06Yeah, it's interesting, particularly on the body cam point. I have someone who's in law enforcement in my family. And I was before this episode asking a lot about Axon, and particularly the body cams. And I asked a bit about whether it was really a bad thing, or they didn't like it when they originally got body cams. And he said his department was the first to get it. And they could not live without it. Because not only does it provide accountability on him, which his point was, we're not doing anything wrong, but it provides accountability on the other side and any accusations made against them that are easy to defend.

13:42And now they don't have to take up all these hours now defending cases without merit. How did that evolution come to be in the body cam market? Because going from tasers and owning that market, doing something that's very, very specific to going into the body cam market, was this a major leap? Just talk a little bit about the DNA of the business that allowed them to go into that. And was it an early success? Did they immediately come out and hit the ground running? I would love to hear more about not necessarily pivoting, but expanding the idea and eventually changing the name of the business, which I think tells the story well.

14:19Yeah, yeah. The company started thinking about body cameras in the late 2000, right before 2010, I would say. And they started to sort of dip their toes into that market first with the cameras that were worn on your ear, then they went to fleet cameras. And Brick had a very strong view that body cameras would be something that their customers was going to need. And if you think about how Axon interacts with their customer base, they're very close to them. They are the monopoly provider of tasers. The product people at Exxon, the salespeople, and the R &D team really relies on feedback from their customers to figure out what next features are needed in tasers and what the concerns are from the officers who were using it enough.

15:15And the idea of the body camera had come up. They started to look into that, And then they really went into it in a meaningful way in 2013. At that time, there were some calls for mandates and some desires to get more accountability, but it wasn't anything like we saw in 2020 after George Floyd. But they continued to work towards that. And you're right. In the beginning, the customer base was kind of on the fence. It seemed like your privacy was being compromised. It seemed like people didn't trust you. Why did you have to wear this video surveillance basically all of the time? And like you said, they started to roll out slowly with certain customers.

15:58And what police officers ultimately found was they felt safer wearing the body camera. They felt as though if they weren't doing anything wrong, if they were good police, they needed to protect the name of the good police. They wanted to make sure that they couldn't be accused of saying or doing something that wasn't right. They wanted to have that accountability and that protection. And so I think that it kind of expanded over the years as there's been more pushback against the police. There's been more concerns from the public issue that some police aren't acting in the right way. And so by 2020, a lot of police were very eager to be wearing those body cameras.

16:41Yeah, it was very interesting for me to have this conversation and just hear some of the feedback in terms of how many accusations were made and how much time that took up. And to your earlier point about talking to the customers, this is another thing where it came up records management and their ambitions to get into that world, I think, certainly echoes what I've heard from this particular contact where they said it is just brutal now in terms of the weakness of record management, all the different systems, and not having a simple solution, which ends up taking significant time to log things.

17:18Just with that all in mind, I think you touched a little bit on the market opportunity. But when you go back in time and look at the overall TAM for the business, something that they're publishing, and then you think into the future, what is the growth of the market today? Is it just more penetration of some of the things that we've been talking about? Are there other drivers that you think are material to the growth of that overall TAM? When I think about growth for the company, I think it predominantly comes from four key categories. I would say new versions of existing products with more and better value -added features, including more automation.

17:55So Axon can upsell and cross -sell these new models to existing customers. And that might occur during a typical replacement cycle. It might happen faster. We talked about the introduction of the Taser 10. I would expect at least two more meaningfully improved versions of the Taser to be introduced over the next decade or so. That should drive adoption. Also, software that's capable of doing more and doing more with less time, less resources from the teams themselves. Then new products that can be sold to new and old customers. So we've seen this with virtual reality training and some new software like Axon Respond.

18:36Eventually, we expect Axon Air, which is the drone program to fit in here. And they could sell existing products to new verticals. We talked about how Axon's pretty well penetrated in U .S. local and state police departments. But an opportunity also exists with federal customers, justice and legal departments, fire and EMS corrections, military and enterprise. And then finally, I would say expansion outside the US. About 20 % of revenue today comes from international. So there have been successes there. And we've seen this with the expansion of body cameras into Brazil, or tasers into the Commonwealth nations, or Exxon evidence software into Scotland.

19:17Exxon's only beginning to ramp up sales efforts internationally. You mentioned before the recording a bit about how they're leveraging AI. You mentioned a few times the virtual reality training. Is that where it's mostly showing up? Are there other ways that they're leveraging this new technology? I think the most exciting thing happened earlier this year. So in April of this year, at the Axon User Conference, it introduced an AI product that has the potential to meaningfully change things in public safety. The product is called DraftOne. It's a software program that leverages generative AI and takes body -worn camera audio to produce high -quality draft report narratives in seconds.

20:00The output's a report that is standard, more clear, more concise, more consistent. And the big thing is that this is saving police officers between one and two hours worth of desk work a day. A day. So that's multiple hours more that they can spend policing and interacting with communities. At this point, draft one, officers will still have to fill in some things manually. They'll have to sign off on these reports. They're only being used for misdemeanors, but ultimately we think that the time savings could be two to four hours a day. Right now an officer sits behind their desk up to four hours of their eight hour shift.

20:39So that is meaningful time that they can get back on the street, they can interact with their communities, they can stop crime. And while the proof points are limited so far, The data we've seen has suggested that the AI -generated reports are more accurate and more complete than manually written ones. But this is Axon in 2024, after the chat GPT moment from a few years ago. What I think is special about Axon is that they have a vision of the future, and they share it. And that's been the case historically. So in 2018, Axon shared a video of what it thought policing could look like with the help of AI.

21:16and the video looked a lot like draft one. There's some more things that could happen, but a lot of it was there. And even before generative AI, Axon was adding AI tools to their software. So just one example is the redaction tool in evidence .com. This feature was able to automatically black out faces, license plates, other personal information from video evidence. Axon also offered transcription, which automatically transcribes video into text. Another example is it used AI training for its ALPR or automated license plate reading products, trained them how to read ones from different states.

21:56So previously, these were all things that were being done by humans manually. Exxon made existing software by including them. So it just kind of shows that Exxon's had this history of thinking about how to make things more automated and more efficient and easier for their customer base. And now I think with the product draft one, you see that really coming to light in a good way. Can you talk about with those customers, there was a shift from pure hardware model towards software model. There's still some hardware involved there, somewhat of a razor razor blade model, it sounds like. But can you talk about what a contract looks like or any general structure that you think is the right way to frame how a customer is buying from Axon?

22:39I think the first thing is the taser really got Axon into the customer base, then expanded to the body cameras, now going to software and other areas. Like I said before, 95 % of revenues are from subscription, and they can range from pure software to pure hardware or a combination of both. And what we really like to see is the combination of both, obviously. The lowest subscription starts at about $15 a month per user, and that's for single software seat per month. Right now, the highest bundle is about $325 per seat per month, and that's for what Axon calls the Officer Safety Plan 10 Plus Premium.

23:20That's the gold standard, and that includes the Taser 10 and cartridges, the latest body camera, training, software, cloud, and there are many other bundles in between, between the beginning officer safety plan and the 10 plus premium. As new generation products get introduced with more features, the high end of those bundle prices go up. So that $325 bundle just a few years ago was only $99. But during that time, many features have had to be added that would justify the additional cost. Most contracts are on a five -year term, but there are some shorter, some that are 10 years or more. But let's talk about the five -year contract for the officer safety plan.

24:03I think that probably is the best example. In year one, the officer will get a body camera and a taser, including cartridges and training. And that includes virtual reality hardware and cloud software. The cartridges, training, software, and cloud are continuous, meaning they get access to it over each of the five years. Then in year three, the officer will get a new body camera. So the expectation is that at the start of the next contract, the officer will get the new taser and another new body camera. One taser for five years, two body cameras for five years. And contracts generally include a low single digit price up annually.

24:42So Axon has a pretty stable 122 % net revenue retention, meaning Axon isn't losing customers and customers renew contracts at higher value. That's justified given the additional features constantly being introduced, whether it's the latest version of the taser that becomes more and more effective, or the software that is more AI enabled. And as for customer stickiness, what I really think makes the customer so sticky are these three things. The value Axon provides, its ecosystem solves real problems for a relatively low price of one to 3 % of a police department's budget, to the ease of integration, taser with cameras, with software, and increasingly with fleets and dispatch systems as well.

25:26And then it's very difficult to deploy a scaled body camera program due to the thousands and thousands of hours of video footage that are piling up rapidly. And they have to be kept depending on the state. It could be a couple of years. It could be indefinitely depending on the crime. And so Axon's winning that market by building tools that help customers best and most efficiently manage the high and growing number of digital evidence hours that they're generating. and customers would have significant difficulty in moving that stored data from the Exxon cloud elsewhere. I mean, Exxon says you can.

26:02Exxon says it will help you do it. But in reality, there's a massive amount of data that would need to be moved and it would be very difficult for customers to move that data in a timely or cost -effective way. With these bundles, I don't know if they really break out the margin profile of the hardware versus the software, but whatever numbers they do provide, I'd be curious what that margin profile looks like, whether you want to talk about the overall business, segments, hardware versus software, whatever you have would be useful. Yeah, they do break out by division. They break it into basically tasers, cameras, and then the software separately.

26:40And surprisingly, the taser has some pretty nice margins. Their gross margins are about 60%. The sensor division, which is predominantly the camera, is much lower, 40%. And then the cloud and software has margins in the high 70s. And we think that it probably can be much higher over time. So if you think about the overall margins of the business, as you sell more software than more hardware, as you have more of those higher end bundles, we think it's a safe assumption to say margins go up over time. And that's ignoring any sort of efficiencies that can be gained in the production processes. With the body cam segment and that Delta versus Tasers, 60 % versus 40%, would you attribute that to more competition in the body cam market versus the market share that they have in Tasers today?