What happened

Shares of Axon Enterprise (AXON -0.13%) tumbled in early trading Friday after the company on Thursday evening reported a sales beat but an earnings miss for the second quarter. Analysts had expected the maker of Taser stun guns and body cameras for police to report non-GAAP (i.e. pro forma) earnings of $0.16 per share on sales of $133.4 million. What Axon actually earned was only $0.01 per share, despite its sales for the quarter topping $141 million.  

Axon stock was trading 8.7% lower as of 11:35 a.m. EDT.

Glowing red stock chart arrow trending down

Image source: Getty Images.

So what

It gets worse.

Sales were the highlight of Axon's quarter, with revenues up 26% year over year, annual recurring revenue (including subscriptions to the Axon Evidence platform) up 42%, and gross profit margins on that revenue 62.4% -- "the highest it has been since Q3 2018," said Axon). The problem was, costs rose, too.  

Research and development spending paced sales growth, up 26% (which isn't necessarily a bad thing), but sales, general, and administrative expenses surged by more than 66% (which is a bad thing -- at least for profit margins). As a result, The $0.01 per share GAAP profit that Axon booked in the year-ago quarter turned into a $0.51 per share GAAP loss in Q2 2020 -- a result that likely muted whatever limited investor enthusiasm might have been generated by the company's $0.01 pro forma profit.

Axon blamed non-cash "stock-based compensation expense, including nearly $11 million in 'catch up' expense" for the surge in SG&A spending. But in fact, operating cash flow also turned negative in the quarter, and Axon ended up with negative free cash flow of $25.7 million.

Now what

Looking ahead, Axon noted that "total company quarterly bookings in Q2 2020 on contracts of five years or fewer," indicative of future revenue growth, were flat year over year. Management still expects to achieve 15% sales growth in Q3, slightly below analysts' previous consensus prediction. But the company noted that one of the reasons gross margins were so strong in Q2 was because of "improved yields on TASER 7 and our highest-ever mix of high-margin cloud software revenue, which was 30% of the total in the quarter."

In Q3, in contrast, "we expect gross margin in Q3 2020 to be approximately 700 basis points lower on a sequential basis, as we fulfill several large shipments of lower-margin body camera hardware to large major city customers."

Long story short, weaker profit margins look likely to sap the strength from Axon's sales growth in the current quarter -- and I expect that's the reason Axon stock fell Friday morning.