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June 10, 2021Print | PDF
In the Winter term of 2021, Shane Obata (MFin ’17) joined the Lazaridis Master of Finance students to explain his process of doing deep-dive equity research into a company. Obata works as a portfolio manager at Middlefield Capital Corporation and his responsibilities include finding companies in which to invest. Middlefield has more than $4 billion in assets under management, and Obata personally manages five funds worth about $180 million.
The purpose of this presentation was for instruction only and should not be perceived as investment advice in any way.
The following is an overview of Obata’s presentation and has been edited for length and clarity.
The purpose of this presentation is to show the process I use to do deep-dive research into a company our firm is considering investing in. There are many ways to go about this process, but the following 16 steps represent my preferred method.
I always start with the reverse onion method, which is simply beginning my analysis from the inside out.
One of the key challenges for this kind of research is finding the most unbiased information available about a company. Fundamental analysis begins with finding the least biased materials you can get a hold of, such as 10-K, proxies or other regulatory files produced by the company.
The next layer is the company’s presentations and conference calls. There is always going to be a little more bias because the company is going to frame itself in the most positive way it can.
The last layer is sell-side research reports. These are the most biased because they are incentivized to bank with companies and therefore are generally more bullish based on those recommendations.
For the purposes of this exercise, we will look at Axon Enterprise Inc. (NASD: AXON), a company in the aerospace and defense sub industry in the U.S. Once we have reviewed the fundamental data about our company, it is time to begin the deep-dive research we need to do to determine if this stock is a worthwhile investment.
The first part of your pitch deck will be your business analysis, which answers the very basic question: What does this company do?
For Axon, they are the manufacturers of TASERs, but we are more interested in the body cameras and the cloud-based technology they use to support that in the law enforcement, security, and corrections fields.
This is a timely analysis because there are calls for reduced violence and higher accountability in these professions. Axon helps with delivering those things and therefore is a relevant company for this analysis.
It is important to analyze the business segments a company may have. For Axon, TASER sales account for 53 per cent of their 2019 revenue and their software and sensors accounted for 47 per cent of revenue. There are around 700,000 TASERS in use today and new models are always getting released, with the bulk of the revenue coming from the cartridges you need to buy to replace spent ones that conduct electricity.
Another important thing to look at is competition. Axon in particular has long-standing and deep relationships with U.S. police departments – 17,000 out of 18,000 U.S. police departments have purchased a product from Axon, with 70 per cent of U.S. patrol officers carrying a TASER device.
In the policing industry, other non-lethal weapons are employed (rubber bullets, pepper spray, etc.) but not to the extent of TASERS.
On the software and sensor side, they are also a market leader.
It is great to see when a company has a competitive advantage, but investors are always curious about the extent to which that competitive advantage is sustainable. Axon is a key beneficiary of large societal trends that are not going away. They are in a strong competitive position for the foreseeable future.
Axon has also built an integrated ecosystem of technology and services that work together. For example, if you are already using a TASER, the body camera and their recording services, then it is easier to introduce a new product. Axon has a customer retention of 99.5 per cent and therefore we can assume they have a very high level of customer satisfaction with a very strong brand within their target markets.
The first thing I look at is historical performance, specifically revenue growth in recent years. Then I look at how much value the company has created for shareholders – what is their return on invested capital? In Axon’s case, it has been around 10 per cent for the last few years, with weighted average cost of capital declining, so it generates a lot of value for shareholders.
This is where we infer to what extent past performance indicates future performance. For Axon, the packages they sell such as Officer Safety 7+, include not only TASERs and camera hardware, but also recurring cloud software revenue. Therefore, the more packages they sell, the more revenue they can project because of the built-in recurring costs.
Research and development is also something that drives margin and should get analyzed as well for a more accurate projection of future growth. With this analysis, you should answer the question, ‘is the company keeping their investment up in R&D?’ If the answer is yes, then it is clear they want to keep their products ahead of the competition. For Axon, the newest TASER will generally yield improvements from the last generation. Growth R&D can lead to new products and that often leads to new markets and therefore more revenue streams.
It is important to look at free cash flow trends and dividends paid to shareholders. We also look at whether a company is issuing equity, or doing a stock buy-back. If they are buying back stock, how are they paying for it, with cash or debt? Axon is attractive because it has effectively no debt after two equity issuances in 2020 and therefore they are in a very good cash position if they want to borrow money or pursue an acquisition. We look at Bloomberg to show us the credit quality and see their probability of default is extremely low.
Understanding a company’s supply chain is key to assessing risk. For Axon, they produce, manufacture, and test their equipment in Scottsdale, Arizona. This is considered low risk because they do this onsite near their management headquarters. They own their equipment for manufacturing (ie. low risk), source components from a small number of concentrated providers (ie. generally considered high risk), but the company says they could find components elsewhere if needed, without much disruption. All these things should be balanced in your analysis.
This aspect of your analysis is much more art than science. There are many different providers for this kind of assessment such as S&P, Sustainalytics and Bloomberg. This is important to factor into your analysis because you want to assess the longevity of the company and its products and services.
Axon fits the profile for a high ESG rating and should score increasingly well over time as they are aiming to make society better by encouraging and facilitating the de-escalation of lethal interactions between police and the public. They are also planning the release of virtual-reality empathy training to help officers practice dealing with emotionally or psychologically distressed individuals so they are not nervous in the field and do not escalate situations unnecessarily.
This is important to consider to ensure management is aligned with the company, more from an organizational standpoint than from a stock perspective. One question to consider in this part of your analysis is whether performance compensation is tied to operational goals or the company’s market cap. I would always rather have management focus on operational goals rather than the market cap, but it is okay to have both. Who are the leaders in the organization, how did they get to where they are now? Doing this kind of due diligence is a great way to get a sense of how the company got to where is it today.
Similar to the research you should do into the company’s management, looking into the board’s membership is also important. From this analysis you should be able to answer questions about the mix of the board, where is their experience from and what insights can they bring from other industries and sectors?
This is where you will take a wider look at the performance of the stock by analyzing past performance and the history of valuation. This is not the perfect tool because it cannot tell you where the company is in its life cycle, but it does give you some added perspective about stock performance and that is important to have. This is also an opportunity to see how a company is trading against its peers.
For this step, you will build a bull case, a bear case and a base case to find out what drivers are going to take this to the bull case and what negatives are on the horizon that would send it into a bear scenario. This is important because it prompts you to think in terms of probabilities and to consider different pathways leading to different outcomes. This is good training to get into the habit of doing so you can learn to avoid getting fixated on just one potential outcome.
Momentum and sentiment are also important for comparison when gauging a company’s performance against the market. Sentiment is checked against street consensus and this is determined by tallying the buy, hold and sell ratings. For a growth company you would want to see performance leading the target price. Getting an accurate picture of where the company is can help you to beat expectations, which is a large part of the game in growth investing.
At this stage, it is time to understand the risk of investing in the company. Axon for example showed a Beta positive (B+) of more than plus one, meaning that when the market was up, their price was up more than the average. It has a Beta negative (B-) of less than one, meaning that when the market was down, Axon’s price was down less. Something like that is rare, and is a great risk profile. Added to this are positive sales surprises which work to undermine risk in your position.
This is where you scan for non-financial risks that could impact the company. For Axon, these include the fact that most of their customers are government agencies and are therefore susceptible to political budget cuts. They could also face a challenge by regulators wishing to re-classify TASERs as firearms as they are not currently classified as such.
This is where you want to examine the environment beyond the business and locate any potential threats to the business that could dramatically impact sales, especially in the private market. Lawsuits and claims of liability, intellectual property, data security, and key-person risk are all risk factors for this company in particular.
Finally, it is always a good practice to look at large stake owners in the company. Knowing who else is investing in the company, and how much they own, is a good way to understand its perception to other companies. For example, Ballie Gifford is a very successful high-growth investment firm and they have taken a nearly 7 per cent position in Axon. It does not hurt to see other asset managers who are in the investment with you and the size of their equity ownership.
The Lazaridis Master of Finance program thanks Shane Obata for taking the time to share his research process with our students. For a full list of our guest speakers, visit our events website.
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