1 Worrisome Number From TASER International's Earnings

TASER International (NASDAQ: TASR) reported its fourth-quarter and full-year earnings on Feb. 28 -- to generally poor reviews. Although TASER's numbers looked good at first glance, with quarterly sales growing 46% and earnings per share not far behind at 33% growth, investors reacted with revulsion -- and TASER stock is down about 14% in the week since earnings came out. But why were investors upset?

Opinions vary.

Why did TASER stock crash after earnings? Let us break it down for you. Image source: Getty Images.

Over at Benzinga.com, for example, the working theory is that TASER is a "margin story," and with gross profit margin plunging 540 basis points year over year in Q4, that spooked investors. In contrast, Barron's focused farther down the income statement, arguing that investors were mainly concerned over a 42% increase in operating expenses, as the company invested $40.4 million to develop new technologies in artificial intelligence and automation.

If you ask me, though, there's just one number that should frighten investors above all else: $12.9 million.

"12.9 million" what?

Thatwas the amount of free cash flow (i.e., cash profits) that TASER generated over the course of all of 2016. While the number was positive, it was also down a stunning 68% from the $40.4 million in cash profit TASER had generated in 2015.

TASER arrived at this disconcerting news by a curious route. Barron's notes that TASER has been making a lot of investment in new technologies, for example, but capital expenditures in 2016 actually declined from $6 million in 2015 to just $5 million. As detailed in its 10-K filing with the SEC, the real cash drain at TASER last year came from just two things: an $18.7 million increase in inventories, and $29.1 million spent on "prepaid expenses and other assets."

Inventories mount

On the former, CEO Rick Smith noted on the post-earningsconference call,"We strategically made the decision ... to ramp up some of our finished-goods inventory to make sure that we were able to fulfill demand in a really timely fashion." And indeed, the 10-K shows TASER's finished goods inventory of completed TASER stun guns, Axon body cameras, and other equipment jumped 143% year over year -- four times the rate of revenue growth. Further evidence of a big buildup in TASER's production capacity is found in the company's 105% increase in raw-materials inventory. Averaged out, that made for a 120% increase in overall inventories over the course of the year.

This all suggests that 2017 could be a very big sales year for TASER -- or it could leave TASER with a mountain of obsolete merchandise, if sales disappoint.

Prepayments increase

Big as the inventory build was in 2016, TASER laid out even more cash for prepayments of expenses. It takes some digging to figure out to what these relate, but notes buried within the 10-K suggest that these payments included everything from "prepaid commissions" to TASER's sales agents, to life insurance premiums on company executives, "contingent consideration in connection with a business combination," and even a "performance guarantee related to an international customer sales contract."

Whatever the purpose of all these payments, though, they were an enormous drain on TASER's cash last year. It's therefore essential to investors to determine whether this was an unpleasant one-off event or something we can expect to be ongoing.

Finance director Arvind Bobra seemed to suggest the latter. In comments on the conference call, he told stock analysts that he "would expect free cash flow to be relatively stable [in 2017]." Whether that means stable at the level of the $40.4 million generated in 2015, though, or stable at the much-reduced level seen in 2016 remains to be seen -- and is crucial.

The upshot for investors

It's crucial because if TASER generates "stable" free cash flow of only $12.9 million, then at its current $1.2 billion market capitalization, TASER stock is selling for an insanely high valuation of 90 times free cash flow -- even higher than the stock's 77.5 P/E ratio. On the other hand, if TASER can generate stable cash profits closer to $40.4 million, then the stock actually might be a whole lot more attractive than its P/E ratio makes it look, and is selling for a P/FCF ratio of only 29. With analysts cited on S&P Global Market Intelligence currently calling for long-term profits growth of 30% annually over the next five years, 29 times FCF might not be too much to pay for TASER stock.

But 90 times FCF surely would be too much to pay.

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Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Taser International. The Motley Fool has a disclosure policy.