Welcome to the Axon Enterprise, Inc. Q1 2017 Earnings Conference Call. [Operator Instructions]. I would now like to introduce your host for today's conference, Mr. Luke Larson, President of Axon. Sir, you may begin.

Thank you and good afternoon to everyone. Welcome to Axon's First Quarter 2017 Earnings Conference Call. Before we get started, I'm going to turn the call over to Arvind Bobra, our Director of Finance, to read the safe harbor statement.

This call is being broadcast on the Internet and is available on the Investor Relations section of the Axon Enterprise website. Please note that the earnings press release as well as supplemental materials, including our key operating metrics, are available on our website. Today, we will open the call with prepared remarks. We will follow the prepared remarks with our standard live question-and-answer session. Statements made on today's call will include forward-looking statements, including statements regarding our expectations, beliefs, intentions or strategies regarding future and including statements around projected spending. We intend that such forward-looking statements be subject to the safe harbor provided by the Private Securities Litigation Reform Act of 1995. The forward-looking information is based upon current information and expectations regarding Axon Enterprise. These estimates and statements speak only as of the date on which they are made, are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. All forward-looking statements that are made on today's call are subject to the risks and uncertainties that could cause our actual results to materially -- to differ materially. These risks are discussed in our press release we issued today and in greater detail in our annual reports on Form 10-K and quarterly reports on Form 10-Q under the caption, Risk Factors. You may find these filings as well as our other SEC filings on our website, www.axon.com. With that, I will now hand the call over to Rick Smith, our CEO and Founder.

Thank you, Arvind and good afternoon, everyone. Welcome to our first earnings call as Axon. As we announced on April 5, we rebranded the company as Axon Enterprise. Over the last several quarters, we've outlined our growing vision for the company as the platform technology provider to law enforcement, from TASER Weapons to Axon cameras to evidence management, records management and artificial intelligence, we've been expanding well beyond any single solution. Axon is a connected network of people, devices and applications. We're excited that our new corporate name now reflects the end-to-end integrated nature of our business. This is a change that was a long time coming and we're really excited to move forward as Axon. We also announced a program to equip every police offer in America with a body camera and software for a free 1 year trial. No other provider in the market today can offer the same capabilities as Axon. With this program, we're removing any barriers to field testing. This gives us the opportunity to compete head-to-head in the field where it matters. The response to this offering has been tremendous. Since we announced the program in April, we've had over 1,000 inquiries, resulting in hundreds of qualified leads at this point. In addition to the Mecklenburg County sheriffs who had publicly announce will be participating in this field trial, we have several major cities, multiple major sheriffs, several state patrols and hundreds of smaller agencies in active discussions regarding this program. I have personally participated in several meetings with key prospective customers where this program was a clear game changer. One major agency had previously told us they have no interest in body cameras, but once we began to discuss the national field trial offer, they've thought of 2 areas where they would like…

Thanks, Rick. We had a strong first quarter of 2017 and I'm proud to share the highlights of our accomplishments. Revenues came in at $79.2 million with international sales contributing $14.5 million to the total. Bookings on our Axon platform were $60.1 million in the first quarter, an increase of 15% compared to the first quarter of 2016. We're coming off a record $72.5 million in bookings quarter as we were successful in closing several deals before year-end. Annual recurring revenue in the first quarter was $46.2 million, an increase of 15% sequentially and 155% increase over the prior year as we converted over 10,000 seats to paid seats. We ended the quarter with 7,000 Flex 2 camera backlog which will be recognized in future quarters. In the fourth quarter, we booked approximately 16,400 incremental new seats on our Axon platform. That brings our cumulative total booked seats to 148,000 since inception and represents 12% growth sequentially. Operating income for the TASER Weapons segment was $20.2 million at a 35.1% margin in the first quarter of 2017, up from $15.4 million at 33.5% margin in the prior year quarter. The increase was driven by an 18% increase in weapon units and a 28% increase in cartridge units. The ratio of the lifetime value of a customer to the customer acquisition cost in the first quarter was 4.3x, down from 6x in the prior quarter on lower bookings. As a reminder, this ratio is calculated only on including current product at current price levels. We strongly believe the true value of each customer will be significantly higher as we're able to add premium service tiers and new product such as our RMS offering, Fleet in-car system and AI-based offerings. Together, we see these offerings more than doubling the potential value of…

Great, thanks, Luke. This is my first earnings call since joining in April and I'm excited to be onboard as part of the Axon team. I look forward to bringing my expertise to Axon, including my experience working with cloud-based software models as well as international operations. I see a tremendous opportunity for Axon to continue to lead with innovation. Rick and the team have evolved the business into the robust platform provider that it is today. I look forward to working with the team to drive continued growth while maintaining our focus on financial discipline and sustainable long term profitability. I also plan to build upon our relationships with investors and analysts, to increase awareness and understanding of the Axon vision. I'll now the move on to the discussion of financial results. Just a housekeeping note here that we -- since we've rebranded the entire company as Axon, going forward, we'll refer to the business segment we used to call Axon now as Software and Sensors. Revenue in the first quarter, as Luke mentioned, was $79.2 million, a 43% increase from the prior year and another strong quarter of year-over-year growth. This quarter's increase was driven by more than doubling in Software and Sensors segment revenue and a 26% increase in Weapons segment revenue. The $11.9 million year-over-year increase in Software and Sensors segment revenue was driven by 105% increase in hardware revenue as we shipped over 23,000 cameras in the quarter and 140% increase in our Axon service revenue. Our hardware and service revenue growth in the first quarter did not include the future anticipated contribution from the outstanding backlog on our new Axon Flex 2 camera. The first quarter also included $1 million in catch-up service revenue previously held due to the delay in meeting contractual terms…

[Operator Instructions]. And our first question comes from the line of Jeremy Hamblin from Dougherty and Company.

Congratulations on the strong results. I wanted to just get in real quick to the operating expenses. I believe, Jawad, that you said you're looking for a sequential increase of 4% to 6% versus what we just saw in Q1. Is that -- do I have that right?

That's correct.

And as we look forward a little bit in terms of just thinking about your base and where operating expenses are likely to grow, do you see kind of a commensurate growth rate in the R&D side versus SG&A? Or are you going to continue to see the R&D side grow at a much faster rate given the number of staff that you brought on earlier this year?

Yes. I'm a month in and I'm still really getting the lay of the land in understanding the cost structure. What I can tell you is that for Q2, we're expecting the 4% to 6% increase sequentially over Q1 which again is going to be primarily driven by our investments in RMS, AI, also in international and in Fleet. And for the rest of the year, we're still calibrating where we expect our cost structure to be relative to our revenue and bookings growth.

Okay. And then for Rick and Luke, if you could just provide a little bit more color. You mentioned that you had 1,000 inquiries since the free camera offer was initiated. You mentioned that you've got kind of concrete leads potentially on hundreds of agencies. Could you provide a little more color in terms of where you're seeing the best traction? Are you seeing at those mid-level tier agencies? Or are you seeing a lot of the growth here on much smaller agencies that maybe you thought that body cameras were years and years off, but because of this software, we're seeing a pull forward on that? Or is it much larger tier cities?

Well, I would say we're seeing pretty even interest across the board and I mean that quantitatively, most of the inquiries are coming from small agencies, right, because there's, what I'd say about 17,000 small agencies in the U.S. and a thousand big ones. We're seeing really good interest. If I were to characterize the one pleasant surprise has been the sheriffs have really -- seem to be coming on strong, where a few years ago, I think we talked about that sheriff's offices tended to be less interested in body cameras than the major cities in the early phases. I think we're now seeing that really a spike in interest from the sheriffs. And hard to say if that was just happening on its own organically or if we -- if spurred that with the trial offer.

Okay. And then in terms of the trial offer itself, are you looking at all towards extending that deadline because I think when you initially discussed it, you were looking at really 1 year providing that? Or is this going to be something that's kind of an ongoing marketing effort for the company?

I think our plan at this point is that we're going to offer this for a 1 year period, meaning that agencies would have up to a year to sign up and from the point that they sign-up, we would give them a year-long trial, but I don't envision at this point that we would continue it beyond that in that it's a pretty sort of breakout program that we're doing. I don't know if we'd leave it indefinite that we would do free trials for every agency for every officer indefinitely. I think will always have free trial programs. But this is really something that's on a pretty large scale and I think part of the philosophy here is that we saw this is a unique moment in time, where now is the time for us to do something out of the ordinary to help accelerate the market forward. But again, we're learning. We pride ourselves on being a business that experiments and learns. So I don't know. I could draw a line in the sand and absolutely, we would not extend it. But at this point in time, that's not our intention.

Okay. Last one for me. On the gross margins, it came in a little bit lighter, I think, than most expected. I think a lot of that obviously is being driven by mix. And I think you noted kind of the onetime nonrecurring payment that I think you said adjusted gross margins were 62.7%. As we look forward, is there kind of a natural time line at which you see those gross margins bottoming out and then starting to lift as we move forward and as most of the U.S. market has been divvied up on the body camera and video side of the business?

Yes. So in the Axon or the Software and Sensors segment specifically, the margins there were driven by the customer mix which really includes the strategic decision we made, the pricing decisions around some of our international beachhead accounts to open up those markets. And we would actually expect -- part of our model is that we would expect those margins to improve over time. As you're aware, there's a discount on the hardware upfront and we expected in the near term margin to improve to 25% and over the longer term on those contracts to get to 50%.

On the hardware?

On the hardware upgrades, yes.

And our next question comes from the line of Steve Dyer from Craig-Hallum.

As it relates, I guess, initially, Jawad, to your commentary around Q2, that implies an 8% or 9% sort of sequential downtick in revenue which as far back as I can remember, has never happened. So I guess I'm just trying to figure out if that's just conservatism on your part or if maybe you pulled something into Q1 that you had anticipated in Q2? Or how we should think about that?

So actually, Steve, do you mind maybe adding a little color on where you're getting that number?

Well, I think, I guess what I heard was Q2 revenue up 25%, year-over-year. Maybe I heard that wrong, but that would imply like a 73-ish million dollar revenue quarter which would be obviously down from the 70, 90, just...

We did see some revenue coming in earlier and -- obviously, Q1, we had really strong quarter particularly coming out the heels of the U.K. approval, with weapon sales starting in the U.K. So there was some -- revenue became -- we had a really strong quarter. And I think some of it too, we're being a bit conservative in our outlook.

Yes, okay, got it. On the weapons side, you know, growth there just continues to be really, really good. You have -- it certainly helped penetrated things are in North America. Maybe a little bit of color as to where you're seeing that. If you sense is there's a lot of upgrades, I know that the 2 outsold the X26P for I think the first time that I've seen, had a really strong quarter. Any color around sort of what's driving that at the moment?

Yes, I think -- well, part of it, again, is the U.K. approval, of the X2. We think that's really got a nicely -- it just opened up a key market for us. And we see actual opportunity for expansion in the U.K. We've obviously seen some pretty terrible events happening there recently where the national police union has been pushing for every officer that wants to carry Taser, to have the ability to carry one. We believe that there's actually some traction there and we'll see some expansion. So not just a replacement of the -- the X26Es that have been out of production for a few years, the only weapons that were in the U.K. up until this approval. So it will see continued growth in the U.K. and the TASER 60 and the Officer Safety Plan, these payment programs are continuing to drive some of that growth and we think there's still some fuel in that tank.

And I think looking forward long term, I mean, is that 20%, 25% of weapon sales being toward the TASER 60 program? I'm mean is that kind of what you think is a reasonable number going forward? Or do you sense it will be more than or less?

Yes, great question, Steve. So approximately 35% of our customers purchased on a payment plan either TASER 60 or OSP. Now our goal would actually be to get as much of our revenue as possible on these payment programs. A lot of the law enforcement still has discretionary funding that they get from asset forfeiture or other seized assets and will never turn down those deals, but our goal would be to push as much of our business possible on these subscription plans. So I think it can be much, much greater than 35%.

Okay. And then real quickly on the, I guess, the old video side sensors, the sensors business now. The bookings rate seems to have kind of found a level maybe between this 60 million and 80 million. Is that your sense of sort of the new normal, just because you gobbled up so much of the market already and so forth? Or does that still have room to grow in your view?

Yes, so I think that's a good insight, Steve. Q1 is seasonally slower a quarter with less overall activity than Q4. Our pipeline still remains strong and I think we're looking at future growth opportunities with product expansion, specifically Axon Fleet and then our next RMS product.

Okay. Lastly for me and then I'll hop back in the queue. We're probably, I'm guessing, coming up at sort of towards the end of the initial video contracts that were being signed. I'm just wondering anecdotally if you have any commentary about what you're seeing in terms of renewal rates. In other words, has it proven to be sort of a sticky as you had thought kind of initially? Or any color there would be great.

Yes. So I would tell you what we see is if agencies are using this system at any scale, I think they almost all renew. The only agencies I'm aware of it didn't renew were people who potentially flock the products and then weren't using it, smaller agencies. Those are literally the only agencies that I'm aware of, where when it came up time to renewal, hey, is anybody using this? And they weren't using it and they didn't renew. But if they're using it, they renew. Probably the best example there is Albuquerque. With the approval we just got from the city council. Those of you who have been watching over the years, Albuquerque had no shortage of controversy. They're one of our early adopters many years ago. And the Chief in Albuquerque used to come and speak in a lot of our conferences because we absolutely turned their program around. They've started with the standard off-the-shelf camera and when they transitioned onto our platform, it was a real game changer. There was again some controversy around the Chief speaking at our convention et cetera, to where it was sort of a politically challenging environment in Albuquerque and I think when they actually -- and so there was a lot of scrutiny on the program and they tested multiple vendors. And what they found was our solution just really stood out. And not only did they renew, but they expanded the program in Albuquerque with thousands of additional cameras. So we really do stand by the customers that use our product find tremendous value in it. And just like we saw in Alameda County, getting an agency to change is really hard. They got to retrain their officers, et cetera. And -- but if we get that opening to go on and tested, all the investments we've made, building out a great hardware and software team and all the support functions, you know it really pays off because when customers actually try the solution, we're in a really great position.

And our next question comes from the line of Andrew Uerkwitz from Oppenheimer & Co.

Luke, I think in your prepared remarks, you mentioned that you expect gross margins to increase over time. One, is that based on what's already been booked in the contracts you have there and just a matter of time until those hit? Or two, does that require further upsell on some of the new software features you guys are developing?

Andrew, great question. So Q1 margins are primarily driven by 2 factors. The customer mix which includes strategic pricing decisions on the international beachhead accounts to open up additional markets. And also discounts on upfront camera purchases on multiyear contracts. We're really confident as we continue to add more high value-add features and expanding the product, that those margins -- we'll see margin expansion in that Sensor and Software segment.

Great. And then my second question is around bookings. If you could share with us, was -- dash camera or auto-related cameras, was that material in the quarter as far as bookings go? And how do you see that shaping bookings in the back half of the year?

In this quarter, it was roughly 10%. We're still -- just to clarify, we're still not in full production in shipping that. We did -- we had some very high-profile betas and at the end of Q2, we expect to be shipping product. And so in the first quarter of shipping, I would suspect that it's not going to be meaningful. By the end of the year, we suspect that will be a meaningful bookings contribution with the Fleet program.

And then my last question. You guys have continued to have kind of a backlog on the camera side. You're ramping dash cameras. Should we expect to see some larger than expected CapEx going forward on manufacturing expansion or plant moves or anything along those lines?

No. No, we -- at this point, we're not anticipating any unusual CapEx related to that.

And our next question comes from the line of George Godfrey from CL King.

Two questions. Based on the revenue guidance and the OpEx guidance for Q4. It looks like the operating margin for the company is going to be probably around 4% give or take or maybe 3%. Do you view that as the low-water mark given that you expect the margins to ramp up in Q3 and Q4 as we move out into '18 and '19?

Yes, I think our general expectation is would be the low-water mark at this point.

Okay. And then secondly, you mentioned some cost related to the Microsoft transition from Amazon. And I was just wondering, have you seen any sales benefit from being with Microsoft versus Amazon on helping opening accounts or customer education or anything like that?

Yes, absolutely. In the U.K., the CEO of Microsoft U.K. went with me to the London Met and they were absolutely critical, up until that point in time, the London Met was on track to build and run their own data center and that would have been really disruptive for us. You have to sort of run EVIDENCE.com in a customer's data center that's not going to have all the sort of standardization you'd get in a major cloud data center. And Microsoft was absolutely critical there. They've been very helpful in other international markets as well and here in the U.S. with federal agencies, we've co-presented in several places. So yes, they had really -- Microsoft sales channel is really effective and they've been a good partner.

They don't carry a quota, but they're very helpful in generating conversations would that be fair?

Yes, they don't carry a quota specific to our solution, but since the new CEO took over at Microsoft a few years ago, it's been palpable. I mean they've made -- they've really -- it's been impressive how they pivoted their organizational focus and they just been on fire about cloud and they see us as a very strategic account because of all the progress we've made and really being the first mover in public safety and they courted us, frankly, really hard and they made a compelling case that together, we did really sell effectively and they've delivered on that.

And my last question, I don't have a full cash flow statement in front of me, but it looks like working capital due to the inventory build, a pretty significant use of cash. How do you see working capital this year versus '16 on impacts on cash flow?

Yes, so in first quarter, that was really primarily driven by the build in inventory which we had discussed. We don't expect that operating activities are going to be a significant use of cash for the remainder of the year. We're expecting towards the back half that the inventory levels will normalize and that trend will continue.

And our next question comes from the line of Glenn Mattson from Ladenburg Thalmann.

Just a couple of things. On the SG&A, being a bit lighter than you had anticipated coming in, was that a result of not being able to hire fast enough or perhaps the bookings being a little softer than expected? What was the root cause of that?

Yes, so actually, while we were transitioning to Jawad coming on board, we did slow our hiring a bit just to make sure when he was coming in, we had a good base for him to understand the cost structure.

Okay. Sounds good. And then the other question I had was on the -- I mean, I guess you could try and back into it through the percent of people on the TASER 60 plan, but the growth rates in Weapons have been abnormally high for a relatively mature product, the last 3 quarters which coincides with the time when you introduce that plan. I think 34%, 25% and then again, 25% this quarter. So after Q2, I guess, then Q3 of this year, you'll start to lap that, anniversary that plan. So what would be a more normal growth rate for the weapons once that surge kind of has run its course?

Yes, I would probably not give a specific gross percentage. I think the 2 key items that we're focused on is international growth will continue to be a contributor. And we're also looking to get -- we want full penetration in the U.S., every officer to carry a weapon and that weapon to be on a payment program. And so for the next few quarters at least, we continue to see growth.

And our final question comes from the line of Allen Klee from Sidoti.

My apologies, I jumped on late. Maybe you touched on this, but have you -- did you -- have you said anything about the impact of the free trial on the quarter? Your thoughts on kind of how that impacts your kind of analysis of lifetime profit to cost acquiring a customer? And any impacts from customer responses to this program?

Yes, I'll take that one. So in general, we have not seen that it derails deals because for the most part, if you're in a law enforcement agency and they're moving through a procurement, procurements are frankly somewhat painful process to go through and most people don't want to hit the restart button. And so what we found is what -- we just need to reassure our customers is sit down and take them through the economics that yes, you could take the year free, but -- or what you're effectively doing when you sign up with us is we'll have discounts and other incentives that gets you to as good a deal or better, as if you've taken the free year. And we're finding in most agencies, as long as they feel we're being transparent, they're being fairly treated and the deal is sensible, most of them say, let's just take this through to completion. We don't want to like pause, take a free year and then start a procurement over. But again, I think it's one of the reasons why we're really are focused on these payment plans for agencies to be able to just get on a program where they pay a known fee and we're upgrading their hardware regularly. That's really great for us. It accelerates our upgrade cycle and makes our business more predictable. But our customers I think love it even more than we do because for them to go back and have to do onetime purchases, it's just bureaucratically painful for them to do. So if we can streamline that process, it's great for both sides.

Thank you. This concludes today's Q&A session. I would now like to turn the call back over to Rick Smith, CEO, for closing remarks.

Great. Well, everybody, appreciate you joining us today. I'm really proud of the team and the work they did across the board. Josh and the sales team really delivered this quarter. You have Darren and the communications team, I think just did a great job with the name change and the national field trial offer. And we're really excited to add Jawad on board, bring a fresh perspective here and really look forward to seeing how the rest of the year plays out, feeling great about the momentum across the board. We just had our international sales meeting and we're really feeling great about the team that we have on the field globally now and tons of opportunity there for growth. So appreciate you all being shareholders and being part of the company and we look forward to hopefully seeing you here at our Shareholder Meeting here in Scottsdale later this month. And if you can't make that, then hopefully we'll have you on the next earnings call. So thank you, everybody. Have a great day.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone, have a great day.