ShotSpotter: Paying Too Much For A Good Business – ShotSpotter, Inc. (NASDAQ:SSTI)

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ShotSpotter (SSTI) is a good business. Their solution SpotFlex helps police enforcement to respond in matter of minutes to gunshots captured by acoustic sensors surrounding a neighborhood. Growth has been impressive and reflected in the stock price since the company went public, but now every outcome needs to be perfect for the company to deliver on those growth expectations, which as we will see is not going to be the case in future quarters.

Numbers are showing some weakness in the business. Margins are going to be challenged during the near future and growth might be slowing. Valuation is exorbitant. The market is pricing ShotSpotter with an EV/sales of 10.72. More things can go wrong than right at this point. Paying such a high price doesn’t leave enough margin of safety to make this an appropriate investment for now. Better wait for the market to give us a favorable entry point.

What is Shotspotter?

Shortspotter is a company that owns a technology that helps the police force detect gunshots around a community. The product aims to reduce gun violence by detecting gun shots and have police enforcement arrive at the scene without needing to wait for a call. The company estimates that around 90% of gunshots are not reported to the police or 911 by residents.

How does it work?

The company installs acoustic sensors in places like buildings and light posts throughout a neighborhood. For every square mile, around 20 to 25 sensors are placed. If a gunshot is fired, the sensors would detect and timestamp the sound. The exact location of the gunshot would be spotted by the time it takes each sensor to detect the sound, basically triangulating the data points and match it with a location. The alert is sent to dispatch centers or to police mobile computers or smartphones.

Image source

On Jan. 24, 2018, they announced a partnership with Verizon (VZ) which would bring the ShotSpotter solution to cities willing to contract with them by using Verizon’s IoT platform (Verizon Intelligent Lighting Solutions) deployed on street lights. By using a city’s street lights, it becomes easier to install ShotSpotter gunshot detection in key locations and expanded coverage area. In Aug. 28 of 2018, the partnership was extended to included reselling rights for SpotFlex as a standalone offer to Verizon business customers. The details of pricing arrangements were not disclosed. This provides the company with a huge opportunity by leveraging Verizon’s relations with entities to introduce its products to new customers and expand market.

Here are some comments from the 1Q 2019 conference call about the Verizon partnership:

Ralph Clark CEO:

“Yes, so we’re still in conversations with Verizon. They’ve actually been very constructive in terms of getting us introduced to a couple of potential opportunities that we’re hoping we’re going to be able to talk to more about in the next earnings call, so still onward and upward with Verizon.”

Management is very positive about the partnership. This type of deal takes some time to pay out but is positive for the future of the company. However, I see some headwinds in the future that would make investing ShotSpotter risky at the moment.

Worrisome trends

The business model of the company makes for the analysis of the financial statements a bit tricky. For example since the company gets its revenues from contracts, deferred revenue becomes a key metric to always have in check. In this case I have revenue on the income statement play a second role as it mostly symbolizes the recognition of deferred revenue on the income statement once the contracts become live.

Other important key metrics are Line Miles, sales and marketing expenses and most recently accounts receivable. All these metrics helps us understand the health of the business.

ShotSpotter business model operates with negative working capital. The lifeblood of the business is its deferred revenue. The growth in this account is what gives the company its cash to operate and possibly fund its growth. Keep in mind that deferred revenue is in-flowing cash. As the company starts executing, the amount gets charged on the income statement over the length of the contract. Unfortunately, deferred revenue as a percent of sales is going down and accounts receivable as a percent of sales is going up.

ShotSpotter: Paying Too Much For A Good Business - ShotSpotter, Inc. (NASDAQ:SSTI)

Source: Table created by author from company filings

At fiscal year-end 2016, before ShotSpotter became a publicly-traded stock, deferred revenue as a percent of sales stood at 90.12%. This percentage number has been going down steadily for the following years, reaching 65.47% for the TTM. Accounts receivables on the other hand has seen more choppy action, reaching as high as 43.93% in 2018 and now settling at 19.70%, but increasing, albeit slowly, as a percentage of sales. If the trend keeps going, more cash would be tied up to working capital, reducing the liquidity provided by deferred revenue.

Shrinking order book

The revenue recognition disclosure found on the annual report and 10Qs provides important numbers not seen in the financial statements (that’s the income statement, balance sheet and cash flow statement). Those are the estimated contractually committed revenue. I see these numbers as the order book for the company. Contracts that are in place but cannot be put on the statements because they don’t complete the guidelines for revenue recognition under GAAP accounting. Only when these guidelines are checked is that those numbers can be transferred to the balance sheet as deferred revenue and subsequently recognize on the income statement as revenue.

Estimated contractually Committed Revenue:

ShotSpotter: Paying Too Much For A Good Business - ShotSpotter, Inc. (NASDAQ:SSTI)Source: Table created by author from company filings

To understand what these numbers means it’s important to read the disclosures found on the company’s annual and quarterly reports:

“We recognize subscription revenues over the term of a subscription agreement. Once we enter into a contract with a customer, there is a delay until we begin recognizing revenues while we survey the coverage areas, obtain any required consents for installation, and install our sensors, which together can take up to several months or more. We begin recognizing revenues from a sale only when all of these steps are complete and the solution is live.”

“Because we generally recognize our subscription revenues ratably over the term of our contract with a customer, fluctuations in sales will not be fully reflected in our operating results until future periods

“As a result, much of the revenues that we report in each quarter are attributable to agreements entered into during previous quarters. Consequently, a decline in sales, customer renewals or market acceptance of our solutions in any one quarter would not necessarily be fully reflected in the revenues in that quarter, and would negatively affect our revenues and profitability in future quarters”

Source: p.34 10K 2018

If we focus on the growth of the order book, numbers show a decline starting in Q4 2018 of 8.3%, with a following decline of 32.5% in Q12019. Due to the long nature of the sales cycle we might see revenue getting hit in the future. It could be a reason for lower revenue guidance from management in 2019.

“For the full year of 2019, the company adjusted its revenue outlook to a range of $44.5 million to $45.5 million (previously $45 million to $47 million), due to delays in the contract negotiation and approval process with two new potential customers and the loss of one customer that had a contract of seven miles.” – Q1 2019 press release.

The drop in the order book is the consequence of some customers canceling their contract or not renewing. The disclosures above are key. It’s a reason why revenue is not the best indicator of the company’s health in this situation. Management needs to be quick enough to start signing new customers to keep the revenue growth trend from not falling. Revenue growth is a lagging indicator.

Near-Term Margin Compression

Reading through the latest annual and quarterly report, management made the following disclosures:

“Approximately half of our installed ShotSpotter sensors use fourth-generation (“4G”) Long-Term Evolution (“LTE”) wireless technology and half use third-generation (“3G”), cellular communications. Our US wireless carriers have advised us that they will discontinue their 3G services in the future and our ShotSpotter sensors will not be able to transmit on these networks. As a result, we will have to upgrade the sensors that use 3G cellular communications at no additional cost to our customers prior to the discontinuation of 3G services, before the end of 2022. These sensor replacements will require significant capital expenditures” – p.31 of 10K 2018

Starting mid-2020 through 2022, we will have to upgrade our sensors that use third-generation cellular communications to the fourth-generation Long-Term Evolution wireless technology, which will increase our cost of revenues.” – p.18 of 1Q 2019

It’s hard to know how much in dollar terms does “significant capital expenditures” account for. Last year total capital expenditures came at $8.4 million. On average total capex has been increasing $2 millioneach year. The replacement of the sensors using 3G technology is going to take the company a year and a half to get completed with the upgrade expected to start in the second half of 2020. Management expects the investment in capex to increase cost of revenues since 96% of the total depreciation number reported is attributed to the costs of sales. The company breaks those numbers below:

ShotSpotter: Paying Too Much For A Good Business - ShotSpotter, Inc. (NASDAQ:SSTI)

Source: 2018 10K p.47

“Stickiness” of the Business still not proven

What will happen if a recession hits? That’s’s the question that makes me wonder about the need for a product as SpotFlex.

ShotSpotter’s main customers for now, are police departments. They account for most revenues. Police departments are governed by budgets driven by taxpayers. If a recession hits, budgets are going to be reviewed and a service such as SpotFlex can be the first one to go. The probability of the police force being shrunk to give space to a add on service is very low.

Recently the Sheriff’s Office from Sacramento County cut the program from their budget. The news article mentions other priorities such as jail staffing, emergency response times and a bigger task force to focus on homelessness on top of the list. They won’t renew their contract which runs until 2020 because “it simply doesn’t fit in their budget.”

Here’s a comment from Sgt. Tess Deterding from the Sheriff’s Office:

“It boils down to money,” “Because at the end of the day, the cuts have to come from somewhere.”

This shines a different point of view. The business model, while having SaaS characteristics, would have a difficult time expanding if at the end of the day, their customers become their competitors by fighting over the same budget money.

Conclusion

The market is pricing ShotSpotter on an EV/sales of 10.72. Established and mature SaaS companies can trade for those types of multiples, or even emerging growth companies can. But at this point, ShotSpotter would have to show impressive numbers to keep that multiple as a fair price to pay. However as shown in this article, there are some headwinds coming their way. Their shrinking order book follows management comments of a required investment in capex over the next year and a half, can make this ride very bumpy. My recommendation would be to stay on the sidelines on this one until the dust settles and the market gives us a better price for the business.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.