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Axon Enterprise Is Under SEC Scrutiny. Should Investors Be Worried?

Rich Duprey, The Motley Fool

A spam filter plunged Taser maker Axon Enterprise (NASDAQ: AAXN) into an SEC inquiry, a falling stock, and numerous class action lawsuits. It could've been an otherwise humorous development, but for the ramification of what the regulatory probe is targeting.

Return to sender

Over the course of a month and a half beginning on Aug. 10, the SEC sent Axon a series of emails requesting explanations for several accounting practices, most prominently why its backlog surged in 2016. The SEC also wanted a fuller understanding of the company's revenue-recognition policies on its TASER 60 program that allows customers to pay for hardware purchases over five years.

Email spam folder

Image source: Getty Images.

Axon never responded until Oct. 19 because of "miscommunication issues" that it revealed to Fast Company was actually the result of an overly aggressive email spam filter. Because Axon's new CFO had never corresponded with the SEC before and the regulatory agency sent its requests by email instead of snail mail, as it typically does, the requests got sent to a junk folder. Doh!

It's not surprising that Axon Enterprise is suddenly in turmoil. Any hint of an SEC inquiry will typically send a stock lower, and the stun-gun maker's shares are down almost 9% since the revelation. Nor is it helping that trial lawyers are piling on, seeking to file class action lawsuits for losses sustained as a result of the snafu.

What investors should focus on is the substantive issues the SEC raised. For that, we'll have to wait until Axon responds to the agency to find out how serious the concerns may be.

Here's why Axon could have a problem.

Building up backlog

In Axon's annual report for 2016, the stun-gun maker said its backlog for products and services had grown from $183.9 million at the end of 2015 to $384.2 million at the end of last year, triple the amount. The backlog included $51 million and $85 million, respectively, of deferred revenue.

Police officers putting on Axon body cameras

Image source: Axon Enterprise.

Backlog is sales orders that need to be completed. On its fourth-quarter 2016 earnings conference call with analysts this past February, Axon President Luke Larson attributed the dramatic increase to the launch of and demand for its new Axon 2 camera, which he said at the time stood at around 9,000 units, but that he believed the company would work through the increased demand by the second quarter.

Little mention, however, was made of backlog in Axon's second-quarter call. In the first quarter it declined to 7,000 units.  Now the SEC wants Axon to disclose "the amount of backlog attributable to each reportable segment, and disclose the amount of total backlog expected to be realized in the next year."

Recognizing a revenue problem

The bigger issue may be the TASER 60 program, which a short-seller on Seeking Alpha named Aparecium Research recently identified as "aggressive" because it allowed Axon to recognize revenue when a contract was signed, rather than over the five-year life of the agreement.

A TASER conducted electrical weapon

Image source: Axon Enterprise.

TASER 60 is a plan whereby a customer enters into a five-year purchase agreement for its TASER weapons and also gets an extended warranty on the products. Axon says it recognizes revenue for the weapons at the time of the sale but recognizes the warranty revenue over the life of the contract. Further, it defers the sales commission costs of the sales over five years.

Using Freedom of Information Act requests from several police departments to view their billing records to Axon, Aparecium believes Axon has inflated its revenue by at least 10% and adjusted earnings before interest, taxes, depreciation, and amortization by at least 40%.

Whether or not the intricacies of these allegations pan out, Axon Enterprise is the one responsible for having them thrust into the public spotlight because, of all things, a spam filter. Typically, the SEC and a company hash these matters out behind the scenes, and only well after the fact are the matters publicly disclosed.

Because Axon had a spam filter as aggressive as its accounting practices are purported to be, investors have something of a real-time ringside seat to the unfolding drama. As a result, investors may want to use caution in buying its stock until the issue is resolved or else risk getting shocked by further disclosures.

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Rich Duprey has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Axon Enterprise. The Motley Fool has a disclosure policy.