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Friends,

If we were forced to pick our favorite business metric, it would be gross margin.

If you run a lemonade stand, your gross profit would be your total sales minus what it costs you to buy the lemons, sugar, cups, and water. Your gross margin would express gross profit as a percentage of sales.

A steady or expanding gross margin is a great sign for investors. It signals that a business has at least one of these three positive attributes working in its favor:

1. The company is resisting competitive pressure to lower prices
2. The company has pricing power with its customers
3. The company has bargaining power with its suppliers

As a general 'rule', a steady or rising gross margin is a positive signal. Conversely, a falling gross margin is a negative signal. The latter usually suggests that a business is facing trouble in the marketplace.

And yet -- as with all things in investing -- there are exceptions to every 'rule'.

Take the case of Axon Enterprise -- which makes both TASER stun guns and Axon body cameras for first responders. Back in 2018, the body camera division was starting to take off. Axon offered them to every police officer in the country for one year -- free of charge.

It was a brilliant move. Once police officers started using the body camera, they also had to use Axon's Evidence.com cloud-based software product. Evidence.com takes the video footage and stores, organizes, and analyzes it. Once departments start using the body cameras and Evidence.com, it becomes a huge pain to switch to a different provider.

But giving away the cameras for free came at a price: Axon's gross margins quickly fell 550 basis points to 55.1%. For context, outside of the pandemic, Axon hasn't had such low gross margins for over a decade.

The funny thing is that -- for the next year -- lower gross margins were a good thing. It meant more and more departments took Axon up on the free offer -- and locked themselves into Axon's ecosystem as long-term customers.

In essence, Axon was trading short-term profits for long-term market dominance.

This move has worked out brilliantly for Axon's investors. The stock is up 700% since management made that bold decision.

We bring this up to highlight that every investing "rule" has its exceptions. Normally, a falling gross margin signals a company is in trouble. In this case, it signaled that the company was going on the offensive.

If you invest, it's incredibly important to understand the "rules" of investing. Once you've mastered them, the next step is to learn when it's okay for businesses to break them.

Wishing you investing success,

- Brian Feroldi, Brian Stoffel, & Brian Withers

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