EVOLV TECHNOLOGIES EVLV-NASD–JUST TELL IT TO US STRAIGHT!

The stock of Evolv Technologies (EVLV – NASDAQ) had a run from $3- $8 this year, and has come all way back–despite reporting improving financials and increasing guidance.

I can’t bring myself to buy the stock again. I did own it for a couple quarters, but sold it for a flat trade after I could not wrap my head around the way they reported their financials. How were they generating REAL positive cash?

With all the random violence in the western world, Evolve has a product that the world needs. And they say their business is trucking along. This story should be a big win.

But…I’m just not sure. Here’s why.

Evolv sells a next generation weapons detection system. It is a screener that prevents mass-casualty events at venues like schools, arenas/stadiums, workplaces, places of worship, nightclubs, movie-theatres, grocery stores, mall – sadly anywhere and everywhere these tragedies occur.

Source: Evolv Investor Presentation

We are terrified of random violence and where it might pop up next. Evolv believes they can solve that. Their AI-based scanning platform detects weapons faster than other technologies and it learns to be better at it over time.

Source: Evolv Technologies August Investor Presentation

Evolv’s product is already widely adopted. Their customers are sports teams, schools, hospitals, and offices. Evolv estimates their near-term addressable market is as much as $8 billion!

Source: Evolv Technologies August Investor Presentation

A growing customer base. A big market. A unique product. The business should be a no brainer! So why, oh why, does Evolv keep giving us reasons to not buy the stock?

HOW NOT TO DISCLOSE AN INFORMATION REQUEST

The latest misstep came on Thursday when Evolv issued their preliminary Q3 numbers – a big beat.

Source: Business Wire

The company beat their Q3 annual recurring revenue guidance, raised their gross margin guidance and they raised their full year guidance across the board.

Source: Evolv Technologies October 12th Press Release

So…what’s the problem?

Hidden in the 8-K, Evolv made another announcement. They disclosed that the FTC–the US Federal Trade Commission–had requested information about marketing practices. 

Source: Evolv Technologies 8-K

Look, I’ll be honest. I don’t know what “certain aspects of their marketing practices” means. No one does. It could be anything from using a word out of context to something far more misleading.

Unfortunately, the disclosure leaves the details EXTREMELY vague. It lets the imagination run wild. Which is not good for the stock.

Especially when this is not the first time Evolv has had their marketing practices in question.

Evolv has had a history of being questioned about marketing.

The physical security publication IPVM has written a number of articles on what they describe as “deceptive marketing” at Evolv.

Source: IPVM.com

Last year, IPVM examined an Evolv marketing video that showed people streaming through their scanning device, purportedly demonstrating the efficiency of the unit.

On closer inspection IPVM noted that the device was flashing red as many people passed, which means that more screening would be required.

In other words, the device was either detecting a lot of weapons or a lot of false positives.  Evolv responded that secondary screening is a part of their stations but not visible in the clip.

In another article IPVM estimated that Evolv’s false alert rate is 5-10%. Yet another article from IPVM said that Evolv paid for and manipulated research results.

I don’t know if IPVM just has a grudge to settle or what, but these stories certainly give context to the FTC inquiry.

Motherboard, a Vice publication, also wrote an expose on Evolv’s installation in high schools. The article reported how “the scanners have caused “chaos”—failing to detect common handguns at commonly-used sensitivity settings, mistaking everyday school items for deadly weapons, and failing to deliver on the company’s promise of frictionless school security”

There was also a BBC article last year that highlighted a National Center for Spectator Sports Safety and Security report that said the scanners “may fail to detect certain types of knives, as well as some bombs and components.”

Oh boy.

JUST GIVE US THE GOODS

We don’t know what the FTC is looking into or whether its something big or small. This could be a huge nothingburger.

What I do know is…that by disclosing the news in the same 8-K as their business update…and then giving investors very little details about the situation…Evolv accomplished exactly the opposite of what they intended to do.

I’m not sure what they were thinking. Investors don’t like a company whitewashing bad news. It almost never works.

Evolv would have been far better off to meet the story head-on, IMHO. They should have put out a press release explaining the details of the request and how they planned to deal with it.

It was far worse to bury the news (because we all found it anyway) and try to patch it over with raised guidance.

Predictably, the stock rose Thursday morning and then fell later in the day after everyone had their second coffee and made it to the 8-K.

THE BUSINESS MODEL

MAKES MY HEAD HURT

My subscriber portfolio owned Evolv last year. We bought the stock because the story was just so good. But we sold it last November after a few months.

Right from the start, my concern was cash generation.

In 2022 Evolv was growing, but they were also losing a lot of money. Evolv burned through close to $100 million for the full year.

Source: Evolv 2022 10-K

The problem was their gross margins. In 2022 Evolv had microscopic gross margins of only 3%.

This year Evolv has improved significantly on both counts. Their cash burn has markedly improved. In the first half of the year the cash outflow fell from $65 million in 2022 to $43 million in 2023.

Source: Evolv 2023 Q2 10-Q

Margins have improved even more. Evolv’s first half gross margins rose to 37%.

This should be great news. Closer to break-even, better margins, all while sustaining topline growth.  But exactly how Evolv has improved their cash burn is a bit murky to me.

Up until this year Evolv was selling two products: their Express unit (the physical walk-though detector), and the software/maintenance contracts that came with it.

The detector unit is, of course, the big upfront cost. The software and maintenance deals are recognized over up to 5 years while the unit is sold and recognized on Day 1. 

The problem was that Evolv sold the units at a negative gross margin. Northland Securities estimated that margin on hardware sales could be as much as negative 40%. 

Evolv sold the units at a loss to get their foot in the door – to gain a customer and generate the long tail of subscription and maintenance fees–SaaS (Software-as-a-Service). The Market LOVES recurring revenue. 

Consequently, Evolv’s income statement was a mess – often COGS (Cost Of Goods Sold) were higher than revenue (ie. negative gross margins) and the cash loss was significant.

Evolv realized that this was making their financials look horrible. Investor sentiment had shifted from valuing growth to valuing profits. They needed to change things up.

Beginning in 2022, Evolv shifted their go-to-market strategy by packaging units as a lease with the subscription, rather than selling them outright. This removed the low (or negative) gross margin unit sales.

It worked up to a point.  But many of their customers still wanted to own their own unit. Schools and hospitals have separate buckets for capex and opex budgets. Often it’s easier to approve a big project like a scanner on the capex side.

Through most of 2022 Evolv still sold a lot of units outright, which kept margins thin and cash flow weak.

HOW DO YOU SOLVE

A PROBLEM IN ACCOUNTING

Even as Evolv tried push a subscription focused model in H2 22, the number of outright unit sales still overwhelmed margins.

In response, in late 2022 Evolv went all-in on the lease model. They said that as of Jan 1st 2023 they would transition to a full subscription only model. No more sales; all units would be leased.

To facilitate this–while at the same time still giving customers the choice to own their unit–Evolv entered into an agreement with their contract manufacturer – Columbia Tech.

Columbia would sell the units to the customer and pay Evolv a licensing fee for doing so. Evolv described it on their Q2 23 call:

“Another important milestone for us in the second quarter was our expanded partnership with Columbia Technology. Columbia Technology, which has been our long-time contract manufacturer, is now an authorized distributor of Evolv Express. Simply put, customers that prefer to purchase the hardware component of Evolv Express can now do so by placing an order with one of the — one of our approved reseller partners, which in turn will place a hardware order for Evolve Xpress directly with Columbia Tech under a separate reseller agreement. So customers don’t have to turn to Evolv to purchase the hardware component of their Evolv Express system.”

The customer would still buy the detector. It would just not be sold by Evolv. Evolv had essentially created a middleman to take on the low-to-margin revenue.

A ZERO-SUM GAME?

Look, I get why Evolv created this relationship. It makes their income statement look A LOT better. Gross margins have gone from low-single digits to 40%+ and they are increasing. It is a win.

But I struggle with how the other end of this relationship works. What is Columbia Tech getting out of the deal?

Presumably, Columbia Tech is selling these units at a similar price to what Evolv sold them at. Plus, they are paying Evolv a $14,000 licensing fee for every unit they sell. Isn’t Columbia Tech selling these units at as big of a loss (or bigger?) than Evolv was?

To me, it doesn’t quite add up, and when I can’t figure something out, I’ve learned to stay away. Which is why I didn’t buy the stock back this year even after they put out strong YoY results and proved that their new go-to-market model was more profitable than the previous one.

Look, it pains me that I can’t buy this stock. In many ways the company is ideally positioned for success. Sports arenas, schools, hospitals, large offices, all are looking for ways to insure the safety of their staff, customers, patients and students.

It is a huge market. Evolv estimates their near-term opportunity at $6B-$8B!

Source: Evolv August Investor Presentation

But there are too many questions. The new one, what the FTC is asking about, adds to the list.

I wish that Evolv had just gave us the goods on what the FTC is after. If they had, maybe I would be writing up a new initiation piece instead of one that just asks a whole bunch of questions.

But they didn’t. So instead, I am writing up a piece with questions.  Until I get answers, I am forced to remain on the sidelines no matter how good the story could be.