Good afternoon. My name is Cheryl, and I will be your conference operator today. At this time, I would like to welcome everyone to the Axon Reports Q4 and Full Year 2018 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Luke Larson, President, you may begin your conference.
Thanks, Cheryl. Good afternoon to everyone. I'm Luke Larson, the President of Axon. Welcome to Axon's fourth quarter 2018 earnings conference call. Joining today are CEO and Founder, Rick Smith, and our CFO, Jawad Ahsan. Before we get started, I want to give my mom a birthday shout-out. Now I'll turn it over to Andrea James, our VP of Investor Relations, to read our safe harbor statement.
Thanks, Luke. Good afternoon. This call is being broadcast online and is available on the investor relations section of the Axon Enterprise website. You can find our reported results and our quarterly shareholder letter, excuse me, which is available at investor.axon.com and on the SEC website. Today's call will include forward-looking statements, including statements regarding our future expectations, beliefs, intentions or strategies, and projections for future revenue growth and profitability. We intend that all forward-looking statements be subject to the safe harbor provided by the Private Securities Litigation Reform Act of 1995. Axon's forward-looking information is based on current information and expectations. Our 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 risks and uncertainties that could cause actual results to differ materially. These risks are discussed in greater detail in our annual reports on the Form 10-K and our quarterly reports on the Form 10-Q under the caption Risk Factors. You may find these filings as well as our other SEC filings at investor.axon.com or at sec.gov by searching for filings under the AAXN ticker. Okay, turning the call over to Rick.
Thanks, Andrea, and welcome everybody. 2018 was a record-breaking year. We drove top-line growth of 22%, and the bottom line grew more than twice as fast, with adjusted EBITDA up 53%. We raised $234 million in a follow-on offering, turning our balance sheet into a fortress. We acquired VIEVU and as a result, accelerated the largest police department in the U.S. onto the Axon network. We released a completely redesigned Axon Fleet in-car video system that is vying for market dominance. We released several groundbreaking software features, including Axon Citizen, and we have booked $389 million in business in the software and sensor segment, which is up 34% year-over-year. We also finished the year with a stellar Q4 for every product line.
We had a record quarter for TASER, record quarter for software and sensors, record quarter for international revenue, and a record quarter for total company bookings, including a record quarter for Axon Fleet. Of course, in the last month of the year, we began shipping the all-new TASER device, TASER 7, that connects to our software network. We are excited about the momentum and initial customer response on the features and offerings in the Officer Safety Plan 7 or OST 7, which bundles our next-generation body camera, AB3, with TASER 7, and with free Axon Records for five years. We announced that at the IACP conference, which is the International Association of Chiefs of Police, last October to time it for the 2019 procurement cycle, and we expect healthy attach rates in the back half, especially once AB3 starts shipping.
We are seeing great customer response to the TASER 7 Certification Plan. Our major city agency customers in particular view it as a significant upgrade over the TASER X2. Demonstrating this for the first time in the history of TASER, customers are demonstrating a willingness to upgrade earlier than five years, which is a statement to the utility and quality of the product and its value proposition. In order to facilitate customers who wish to upgrade with weapons less than five years old, we offered a prorated trade-in program. Credits for trade-ins of weapons less than five years old accounted for some of the margin compression in the quarter. In my opinion, it is a very strong indicator that customers really do want to take advantage of the new features in TASER 7, and they do not want to wait for their old weapon to hit end of life.
I personally want to thank the 76% of voting shareholders who approved our eXponential Stock Performance Plan earlier this month. It has brought new energy to the workforce, of course, we are excited that it drives total alignment between shareholders, the executive team, and every U.S. employee. We still have some work to do to roll it out internationally. We have lawyers and accountants that are working on that now. Our first operational milestone is either $710 million in revenue or $125 million in adjusted EBITDA. I can tell you, we are laser-focused on hitting those first goals and beyond. It is encouraging a CEO to have our employees thinking and making decisions just like long-term shareholders. That is all for me. Luke?
Thanks, Rick. The year is off to a strong start with several key wins. We look forward to welcoming the Swedish Police Authority onto the Axon network. That's the first European nationalized police force to deploy Axon Body cameras and go on the Axon network. We also received notice a few weeks ago that the Phoenix City Council approved a $5.7 million contract with Axon Enterprise to provide 2,000 body cameras for the department and evidence.com. We have a few more wins up our sleeve for both TASER 7 and body cameras that we look forward to announcing in the coming days and weeks. Some of you who have been with us for a while know that in late 2017, really led by our new CFO, Jawad, we pivoted our company culture to focus more on driving profitability.
It was important for us to demonstrate leverage on the body camera business after years of heavy investment. One year ago, I stood up in front of the company, and I declared that I'd shave my head if we hit our 2018 EBITDA goals. It's with mixed feelings that I share with the team, or share with everyone, that the team rallied, we did indeed hit those goals. In fact, we exceeded them. Even accounting for about a $10 million related loss with association of acquiring VIEVU in May. Several employees took turns shaving my head on stage during our annual company kickoff, which we privately broadcast to Axon offices all over the world. It was a pretty great moment for almost everyone except my wife.
I also got a heck of a sunburn at the Phoenix Open, I'm sharing this with all of our shareholders to let you know just how committed I was to driving this metric, the tone echoed throughout the organization, as evidenced by weekly reviews of our expense structure. Of course, I recognize that even as we demonstrate successful annual leverage, Axon remains in a period of underearning while we invest in major growth opportunities. We feel great about our 2018 performance, where the cost controls we began implementing in late 2017 cleared the way for us to acquire VIEVU and make the right decisions for our customers and for the long term, while still meeting our full-year profitability targets. Turning to 2019, I'm laser-focused on three primary execution items.
The first is ensuring that TASER 7 is the most successful TASER rollout ever, it's being very well received in the market. The second is launching our next-generation body camera, Axon Body 3, mid-year, which is our first LTE-connected camera. This is great timing. The launch of Axon Body 3 coincides with the rollout of the first dedicated first responder cellular networks by AT&T FirstNet and Verizon, both of which are Axon partners. Third, we're extremely focused on delivering the Axon Records software product to our launch partners. Double-clicking on this third one, let's talk about what a successful Axon Records rollout looks like. We need to nail the product, we have the right team in place to do that. We also need to really succeed in our early deployments. 2019, the key goal is to gain a foothold and delight our early launch customers.
We also want to sell Axon Records through our Officer Safety Plan 7 bundle with the TASER 7 and Axon Body 3, customers are set up for the full Axon experience. We're feeling really great about 2019. Now I'll turn over the call to our CFO, Jawad.
Thanks, Luke. I've never felt better about how the company is positioned for growth. We've proven we can execute. In 2018, we did what we said we were going to do, despite a pretty substantial headwind from VIEVU and one of their large domestic customers. We have terrific momentum on our top line, driven by investments in our products and teams, with international picking up and the fleet business vying for market leadership. I also feel great about having more than $800 million in total company backlog and the fact that annual recurring revenue for software has crossed $100 million in 2018. Axon Records and Dispatch are right around the corner, we feel good about Records coming online and contributing to bookings in 2019.
On the bottom line, this was the first year in our company's recent history that we hit our profitability goals, we expect that to continue going forward. I'm very proud of the team for embracing a new level of financial discipline. Turning to the balance sheet, our strong cash position gives us an incredible amount of resilience. In 2018, we generated $64 million in operating cash, up from $18 million a year ago. That, combined with the follow-on offering, gives us about $350 million in cash, which puts us in a strong position to flip the switch on selling TASER subscriptions. Equally important, we have the financial muscle to continue investing in our four strategic growth areas to drive ongoing innovation and market leadership. The guidance we're providing today reflects strength on both the top and bottom line.
As we look at 2019, we expect momentum to build throughout the year, Q1 sales reflecting a more modest growth rate relative to the back half. We will continue investing for growth with increases in R&D as a percentage of sales throughout the year. We plan to partially offset that by reducing SG&A as a percentage of sales. SG&A as a percentage of sales dropped from 40% in 2017 to 37% in 2018, we expect to further reduce that in 2019. Our teams are incredibly excited about our success in 2018, they're highly motivated to keep the top line growing and maintain the operating discipline needed to drive bottom-line results. With that, operator, let's turn to questions.
To ask a question, please press star one on your telephone keypad. The first question comes from the line of Mark Strouse of JPMorgan. Please go ahead. Your line is open.
Yeah. Thanks, everybody. Thanks for taking our questions. Jawad, I think you've done a pretty good job of laying out the one-time items that were weighing on margins in 4Q. Just a question for the guidance, how should we think about the, I guess, call it one-time items associated with VIEVU and their large contract that they have. Are there any more expenses that we should expect here in the first half of 2019? Kind of a quick follow-up to that is your guidance kind of points to EBITDA margin expansion a bit below your kind of long-term targets that you've talked about over the last year or so. I guess, how should we think about that longer term? Are you kind of stepping away from those targets, or can you reiterate those?
Yeah. Great question, Mark. I'll start with the VIEVU one. Look, VIEVU view was dilutive. We knew that when we acquired the business, and when we had the issue with that one large customer domestically, ended up being more of a headwind than we had counted on. We're still working very hard to get that business integrated and to rationalize some of the duplicative costs and to make sure that it's no longer a headwind going into 2019. We're certainly not going to see the level of dilutive cost that we saw last year or in 2018. We are expecting still in Q1, I would say, see some cost as we continue to just rationalize some of the cost base there. It's going to be an order of magnitude less than it was in 2018.
On your second question, it's also a good question. What we're looking to do very much is still to drive leverage. We're not stepping away from our guidance, we are just, again, facing this headwind from VIEVU view. Also, part of what you saw in our Q4 results was that the TASER 7 ramp costs ended up being higher than we were expecting, and we're expecting to see a little bit of that in Q1.
Okay, that's helpful. Thank you. You are mentioning, or I guess you are kind of adjacent markets more in the press release. Can you talk about the incremental expense associated with that is kind of baked into your 2019 OpEx? If there is anything high level that you can share to kind of help investors frame the addressable markets for those, that would be helpful. Thank you.
Yeah, Mark, I will handle the first part of that question. In terms of growing OpEx to support additional markets, we actually have several key members of our team that are working on new market expansion. One of the great motivations for them, we actually had quite a few senior individuals on our customer-facing teams opt into the XSU plan, they are working overtime to figure out how to open up these new markets. We do not see any great OpEx add there. I think we are going to continue to drive leverage in SG&A and still be able to open up some of these new markets. In terms of the focus of those markets, we really see an opportunity in what we would call very adjacent markets like EMS and fire, we have teams talking in those. They are not quite as big as the law enforcement market.
We also have had some interest from additional markets as well. I am actually going to kind of keep that pretty tight-lipped for now, just because we do not want to release any competitive intel.
Okay. Understood. Thank you very much.
Your next question comes from the line of William Power of Baird. Please go ahead. Your line is open.
Great. Yeah, thanks for taking the question. Maybe first, just coming back to the 2019 revenue guidance and the expected build through the year off of Q1. I guess, just be interested in the visibility into the second half, kind of the key drivers, I guess Axon Body 3 as part of that. Any reason why TASER 7 wouldn't continue to build off a Q4 level through the first half and then I guess, continue to build in the second half? Just trying to understand the visibility for that second half improvement in revenue.
Yeah. We're expecting TASER 7 production to be fully ramped by about the midpoint of the year. What we'll see is a pickup in revenue in the second half. What's going to happen is there'll be sort of a force multiplier effect with AB3. A lot of those upgrades are also coming up in the back half of the year. T7 being fully ramped as well as AB3 upgrades in the back half of the year, the profile will be heavier in the back half of the year.
Okay. Among the four key kind of strategic growth drivers, I think you talked about in the presentation or the release, you talked about Axon Records already, and pushing for bookings and key customers later this year. I guess I didn't hear much more on Axon Dispatch. I guess I'd be curious what you're thinking there and timing from here.
Yeah. Why don't we have Rick take that question?
Thanks, Luke. Yeah. Axon Dispatch, we are not releasing a lot for competitive reasons on that point. It's an area we're pretty excited about. Stay tuned for some calls later in the year. We'll provide some more details on it. For now, we're keeping that one fairly close to the vest.
Okay. Thank you.
Your next question comes from the line of Jonathan Ho of William Blair. Please go ahead. Your line is open.
Hi. Good afternoon. Can you hear me okay?
Yep.
Yes.
Perfect. Just wanted to start out, in terms of your bookings expectations around RMS. I know you talked about the second half being the opportunity timeframe, but what magnitude of bookings should we be thinking about? Can you give us some color in terms of the types of customers you'd be targeting initially?
Yeah, I can take that one. This is Rick. Most of the early bookings actually we expect to be as part of the OSP bundles.
The Officer Safety Plan bundle. We've included Records in that because we think the real target market for us are agencies that are already using the majority of our ecosystem with TASER weapons, the body cameras, and cloud software. The real play we see is the opportunity there. There is some revenue allocation that is allocated towards Records. I'm actually in a different area of the country from Jawad and Luke. Jawad, I assume we're not giving any more details in terms of how that revenue allocation is being handled at this time?
No, not at this time.
We really view this as part of the overall enterprise sale. The reason to include Records as a free add-on in that sale is we see the real value long haul is in the data, not in the software itself. Fundamentally, Records software is form-filling software. It's the forms and reports officers fill out. We think that, no matter how good your form-filling software is, it will largely be a commodity. As such, when we see things that are commodity, our general strategy is to have a more aggressive go-to-market plan. In this case, we decided to make it free in that bundle.
The rationale really is that the real value add will be in the automation that's possible by connecting the audio/video stream from the camera to the record management software so that we can begin pre-populating and ultimately over a 5 to 7-year time horizon, we believe we can dramatically cut the amount of time that officers spend filling out forms. Fundamentally, a law enforcement interaction is what my AI team sort of points to as a really great target for machine transcription because they're very structured conversations. You know, "Hello, sir. What's your name? Where do you live? What's your date of birth?" With that sort of structured conversation, to be able to extract that information from the audio/video record and pre-populate it into the printed record is something that'll be hugely valuable.
To just give you an idea, I talked to one major customer in the U.S., and they had spent recently something like a $40 million contract on a multi-year record management system time period. That same agency spends about $1.6 billion a year on payroll, and their officers are spending about half their time doing administrative tasks. The value creation opportunity is for us to automate that $800 million payroll cost that's going to non-value-added bureaucratic tasks. That's where you'll begin to see. You will see revenue associated with Records. It'll largely be a function of allocation against the bundle in the early years. Where it'll really kick in is when we add the high-value analytics and AI automation that connects the body cameras to Records over the next 3 to 5 years.
Excellent. Thank you for the color. Just as a follow-up, when we look at sort of the strengths around TASER 7 and the excitement that you're seeing in the customer base, can you talk about how maybe that impacts OSP? Are you seeing other customers that have historically been sort of hardware-only, now want to refresh TASER 7 and look at the broader bundle, or how does that potentially maybe change that mix?
Absolutely.
Go ahead, Rick.
Yeah. We see a great opportunity every time we get in front of our customers to talk about the total Axon solution. The strength of our portfolio is when all those products are used together, the agencies see additional benefits. Every time we're in, talking with a customer about any one of our products, we're kind of highlighting the benefit of the total solution. Over to you, Rick.
Yeah, I would say the TASER 7 definitely has a much stronger data integration element to it. Actually, just yesterday, I was going over with some of our design team what they did on things like device assignment, which doesn't sound particularly sexy, or even the returns process. When you're an agency that's deploying thousands of TASER weapons, having to write down serial numbers and type them into a spreadsheet later versus now we do it with a mobile app where you tap it on the device and assign it to an officer, we're doing thousands of these. It just dramatically improves the experience, and that's all part of that integrated software ecosystem.
With AB3, that will pair with your TASER 7 and start to allow things like real-time alerting, so that if an officer arms or fires their TASER 7 in the field, that alert can be routed to other officers within the agency, or administrators in a service we're calling Axon Aware, which really is to help the agency be better aware of what's actually happening out in the field. I'd wrap by saying, to me, the most exciting thing coming this year will be Axon Body 3, because I think fundamentally, we're poised for an iPhone moment. Meaning, when the iPod went to the iPhone, the initial perception is, well, my music player now has a phone in it. Now as we look back at it, pretty rarely people even use the thing as a phone anymore. It became such a transformatively connected device.
We see similar opportunities in effectively today, we make sort of a nuanced GoPro type of camera. We make a great camera that the officers wear, and they download the information and use it later. Once LTE kicks in, we'll be able to offer all kinds of real-time services that will sit on top of that hardware platform, so the camera becomes something more like an Alexa on your chest as opposed to just a camera you wear to record. We think that will open up a whole host of really interesting services, some of which we're already planning for and some of which we think we'll discover once that connectivity comes online, and we're out in the field.
By the way, the significant majority of our customers in the U.S. are on a hardware upgrade program, so they will get Axon Body 3. Sort of like clockwork as part of their subscription, which is a really big part of both the customer benefit that we carry them into the future with both hardware and software upgrade features. It's great for us because we can plan our roadmap. We don't have to plan to indefinitely support the last three generations of cameras. We can move our installed base along with us, and that gives us flexibility to move and innovate faster than any of the competitors in this space.
Great. Thank you for the color.
Your next question comes from the line of Jeremy Hamblin of Dougherty & Company. Please go ahead. Your line is open.
Thanks for taking the questions. I wanted to ask about that. You mentioned the time to rebuild the TASER gross margin. Can you give us a better sense, maybe a more specific timeframe in which you think you'll get that business back into that 69%, 70% range on the gross margin?
At this point, Jeremy, that's something we're going to see throughout 2019. It'll successively build. There's a lot of factors. Obviously, we have the ramp costs that we're dealing with in Q4, and we're going to see that in the first half of the year until we're fully ramped. We're also still very much at the point where we've got trade-in credits that are in the mix, and there's the discounting. Although we have changed the incentive structure with the sales team to minimize discounting, there's still some early leader pricing going on. There's some trade-in credits. What we're going to expect to see is throughout the year, those margins will build and hopefully exiting 2019, they'll be more at a normalized basis.
Got you. That's very helpful. Just in terms of, you've talked about investment, and as we think about our R&D outlook this year. You had a little bit lower number here in Q4. As we think about 2019, and your R&D investments, how is that going to reflect, I guess, the new product launches, Axon Records coming along? How should we be thinking about that particular line item?
Good question, Jeremy. We've continued to increase our investment in R&D. We're very excited about the opportunities that are ahead of us, certainly in the markets that we're addressing today, but there are some new opportunities in adjacent markets, and we're very excited about Axon Records and Axon Dispatch as well. What we don't want to do is under-invest and miss out on those opportunities. For 2019, you can expect that our R&D as a percentage of revenue will be slightly above 20%. That's up from about 18% in 2018. It's up from 16% in 2017. What we're doing to help offset that, if you look at our SG&A as a percentage of revenue, that's coming down. It was 40% at the end of 2017, about 37% at the end of 2018.
We're going to expect to drive that down even further in 2019, closer to about 35%. What we're very consciously doing is driving leverage in our support function costs and reinvesting those dollars into R&D.
Okay, great. Just a follow-up related to that question, which is, in thinking about Axon Records specifically, in terms of the timeframe in which that's going to be a revenue-generating product, can you give us a sense? In 2020, is that something in early 2020, in terms of revenue generation or more the second half of the year?
Yeah. As Rick was saying earlier, we're actually selling Axon Records today bundled in with our TASER 7 Officer Safety Plan offering. We would see that being a contributor in the first part of 2020.
Okay. Thanks, guys. Good luck.
Just to add a little color there. We don't expect that we're going to be selling many standalone deals of Axon Records because where our solution will be particularly strong is an integrated piece of the Axon ecosystem, which it just so happens the vast majority of major agencies are already on. You'll see it showing up in these bundled sales, and we'll start recognizing revenue as soon as the product is in general availability with features that meet the rev rec guidelines that our customers can start to gain utility from those features. We expect that to happen late this year.
Right. That was really the question of when that product is going to be recognized as revenue. I think we got the answer. Thanks, guys.
Your next question comes from the line of Michael Latimore of Northland Capital Markets. Please go ahead. Your line is open.
Hi, guys. Thanks for taking my question. This is Pawan Aun for Michael Latimore. I have two questions. My first one is what percentage of your TASER sales were sold on a recurring plan and as upgrades?
We're just going to track that down. We got that in our shareholder letter.
35% of all weapons sold in Q4 were on a recurring payment plan. In the U.S. specifically, it was 48% of new TASER contracts. I believe it was almost all T7 was on a recurring.
Yeah. My second question is could you give us a sense of your backlog of evidence.com seats not yet activated?
Yeah, we do have that. It's generally about 20%. Hold on.
Yeah. It's about 15%-20% of our book seats
Yeah. Thanks for answering my questions. Bye.
Your next question comes from the line of Saliq Khan of Imperial Capital. Please go ahead, your line is open.
Great, thank you. Hey, guys. How are you?
Doing great.
Great.
Perfect, guys. Quick questions for you on my end. First one is, could you give me a bit more granularity on the Axon Fleet 2, either regarding your expected revenue or the margin contribution? Even more importantly is, are you seeing any competitive pressures from the likes of WatchGuard?
Yeah. Why don't I start with the back half of your question. We have really seen demand for Fleet 2, and are just really proud of the kind of market's response, and the demand for Fleet. We sell the majority of our fleet products just like we do our cameras, where we sell them on a bookings, where they'll buy on a five-year contract, and then we recognize that over a five-year period.
Hey, Luke, if I could contribute as well. I would say, a couple of years ago, WatchGuard was the clear market leader in in-car video. By the way, they're a company we hold in high regard. I'd say we've been quite competitive. Our competitive intel tells us there have been quarters where we've been the market leader on a dollar booking basis. We continue to feel that the momentum is heading our direction. We feel really good about within a year or two of launch, we've been able to become a contender for the number one spot, and we think we only get stronger with time.
Perfect.
Yeah.
Go ahead, please.
I just want to provide some extra color. We shipped about 4,000 units in the quarter. We're expecting in 2019 a quarterly run rate to be at or above that level.
That's very helpful. Thank you for that. Guys, two more questions on my end as well. You may have touched upon the first one. The Axon Flex unit sales, I noticed that they had declined roughly 3% year-over-year. Is that because you're seeing some of the sales be cannibalized by your other offerings? Or is there something else going on that I may be missing?
At IACP, we announced our Axon Body 3 camera, and so we've been working with a lot of our customers on how we would transition them over to the new technology that's going to be shipping this year.
Yeah. This is Rick. I would add in that, in general, I think we've seen the market shifting in favor of the integrated one-piece body camera versus the two-piece. The original concept of Flex was that it would be a head-mounted camera that would track the perspective of the officer. What we've found is just in practice, officers really do not enjoy wearing the camera on their heads, so they tend to wear it on their shoulders, et cetera, and that ends up really giving you a sub-optimal experience because then you have the narrower field of view, and it's not ultimately tracking the officer's head. I'm continuing to see a trend where officers and agencies are just moving towards the more simplified body camera design that both AB 2 and now AB 3.
Yeah, I would envision that as well. I think the form factor and just the ease of use altogether for the AB 3, just seems a lot better than what I saw with the Axon Flex. Nonetheless, it's a great product. Last question on my end, guys. I know, Rick, you had done a ton of work with this in the past, and I believe you continue to do a lot more of this. If you take a look at the international business, that tends to be a bit different due to the slower agencies that are out there. What have you done over the past year or two to be able to improve the predictability of your international business?
The main thing we've done is really hiring dedicated salespeople in-market. I think we've got a pretty good model of what it takes to open a market. I don't want to get into detail here because we may have competitors on the call about how we resource markets. I think we've got it down to where we're able to replicate that as we go into new markets in a pretty efficient way. We did just come off a record period in international sales. We do expect the year ahead, we could really start to see international continue to blossom, really across the world, but I think mainland Europe are areas we've got our eye on. I was there in 2015, 2016. It's been two, three years, and we're now starting to see some of those national police forces like we saw in Sweden.
We've got some others that are in field trials of both TASER weapons and cameras.
Great. Thank you, guys.
Thank you, guys.
Yep, thank you.
Your next question comes from the line of Scott Berg of Needham. Please go ahead, your line is open.
Hi, everyone. Thanks for taking my questions. I have one and a follow-up. I guess, first of all, I don't know if Rick or Luke want to answer the question, can you give us a sense of what you saw from customers in the quarter that were evaluating the new TASER 7 in terms of their willingness to purchase subscription? I heard Andrea give the metric that the vast majority of the sales in the quarter on the TASER 7 were subscription, how about maybe a broader comment on the conversations you had?
Rick, why don't you take that? Oh, well, yeah, sure. Historically, when we were approaching customers, a lot of the early TASER purchases for M26 and X26 were out of.
They were out of their discretionary funds, usually kind of chunks of cash that they could spend on whatever they wanted. We've effectively positioned the TASER as mission-critical gear. The majority of the agencies, especially in the U.S. States, have actually come to us with a pull to put that into their operating budget, which really aligns with our subscription plans. I would see over the next three to five years, we would expect the vast majority of our U.S. customers to buy on a recurring service plan. We do want to keep in mind that they still have some of these discretionary funds, and if that's the way they like to purchase, we're never going to turn away a PO. I would see the majority of the customers looking to buy on the subscription plans.
Yeah, I would add that as well. TASER selling is a little interesting in that virtually every sale, it has a subscription element. Even if they buy the weapon, there's a subscription element for the docks, rechargeable batteries, and software services, that they would really need to effectively run the program, even if they bought the weapons outright. To my awareness, I think every significant order in the quarter had some subscription element.
In fact, I can't think of one offhand where the customer came in and basically said, "No, no, we want to buy the weapons and only do the subscription for the smaller parts." There may have been some of that, the tone of the market is quite different, whereas three, four years ago, when we started offering payment plans for weapons, I would say the majority of customers would come back and say, "No, no, I want to buy this the way I've always bought it and pay you one time and own it." Now I would say the majority, at least of the larger customers where I'm having personal exposure, they're all that I'm aware of, that I was involved with, going on to one of these Officer Safety or certification-type plans, where it's a subscription model.
Got it. Helpful. My follow-up would be on, in your press release, you mentioned some incremental investments outside of law enforcement, like fire departments, emergency medical, or emergency services, et cetera. Can you maybe quantify what those additional investments or those incremental investments look like here in 2019? How about any other success stories in your endeavors outside of law enforcement, outside of the, I think it was the Charlotte Fire Department that was a big win during the year. Thank you.
I'll start with the level of investment. You can expect that we'll make those investments within the guidance that we've given for R&D. We've guided to north of 20% for R&D as a percentage of revenue, and that's inclusive of the investments we're making for adjacent markets. At this point, as part of the overall bucket, it's still relatively minimal.
I would just add there that what we're mostly focused on is how do we take the same product and feature set we've created for law enforcement and find other enterprise users that would want similar capabilities. In fact, this is one where having law enforcement as reference customers is pretty powerful because that's seen by enterprises as a fairly elite, very data secure-oriented market where we're the clear leader. Now we're looking at how we can parlay that leadership into revenue in other markets, where we do it in a pretty scrappy way. Just building on what Jawad said, it's not something you will see broken out. These are nowhere near the level of investment that we're making into major initiatives like records, dispatch.
This is really taking the major investments we've made in building these connected body cameras and now taking those into new markets. From an SG&A perspective, our expectation is that new markets should pay for themselves relatively quickly. There's not going to be some huge upfront marketing and launch expense. We're moving to these markets in a pretty cost-effective way.
Actually, I want to add to that. I want to give Rick and Luke a lot of kudos here. Previously, when we thought about getting into new markets, new products, we made pretty heavy investments. What we've done recently is really shift to this smaller, scrappier mindset, Rick and Luke have pioneered these delta teams that you've heard us talk about, where we'll take very small teams of one to three people and basically have them bootstrap their way into growth. We've done that with our drones business. There are some other new product categories we're getting into where we're doing this. We are very excited about the early returns we're seeing from these new products.
There are certainly markets for existing products, like body cameras and TASERs, that we're looking for markets outside of law enforcement, there are also new product categories that we're approaching in a small, scrappy mindset.
Great. Congrats on the quarter. Thanks for taking my questions.
Thanks.
Your next question comes from the line of Steve Dyer of Craig-Hallum. Please go ahead. Your line is open.
Great. Thanks. A question on the TASER business, another question on software and sensors. On the TASER business, I think you touched on a little bit of the gross margin degradation. Operating margin of 18.5%. Jawad, when you add back, I know there were some one-time add-backs, when you add those back, what do you feel like a good sort of normalized operating margin in the quarter was?
For TASER, we were looking at. Hang on a second. Got it here. On a pro forma basis. Part of the issue we have, Steve, is that we're no longer breaking out SG&A by segment because a lot of our SG&A costs were actually most of our SG&A costs were allocated to TASER, and it wasn't very meaningful to look at that by segment. We look at our gross margins by segment, we look at our R&D by segment, but SG&A, we really look at on a consolidated basis. I would really point you to focus to the TASER gross margins, and that's something where, like we had said, in the short term, 61%-63%, and we expect that to normalize by the end of the year.
Got it. I guess where my question's going is, not that long ago, a couple of years ago, as recently as that, the TASER business was a mid-to-high 30s operating margin business, and it's sort of been gradually declining over the last couple of years. Again, I calculate 18.5% this quarter on an operating basis, but I realize there was a couple of one-time things weighing on that. I guess I'm just trying to figure out, is the TASER business structurally different in any way than it was a couple of years ago? Or is its pricing different? I would think, if anything, more people on a subscription plan would actually be more profitable. Anything-
Yeah
going on there that I can make heads or tails with?
Yeah. Steve, that's very perceptive, and what you're seeing is that the company overall is much different than it was a couple of years ago. A lot of the infrastructure that we've added, from an SG&A standpoint, is servicing the entire company, but all those costs have been burdened in TASER. When you look at the TASER operating margins over that period, for sure, it's going to have degraded, but that's not really reflective of what's going on in the TASER business, because again, we haven't been allocating those costs to software and sensors, which is why we're really looking at gross margins by segment and SG&A, we look at on a consolidated basis. Again, I've already given you the guidance for the gross margins on TASER.
It's taking a bit of a step back as we're ramping up TASER 7, but we expect that's going to normalize throughout 2019. We also feel really good about the body camera business. If you take out the costs for VIEVU, those one-time headwinds, we actually were very close to break-even.
Got it. That's helpful. Thanks. I guess one more question on weapons while I have you. TASER 7, is your expectation that the buyers of that product will typically be people who already have TASER devices, or do you anticipate any new conquest sales from people on that, I guess, going forward? Where do you expect to get that growth from?
I'd like to start with this before I turn it over. One of the things that I'm very excited about with TASER 7, so a key part of our strategy has been to shift towards a recurring pricing model with the TASER weapons. First, we've always talked about the five-year useful life and how that should be a driver of new sales. Then we talked about shifting from CapEx to OpEx and really being a line item in the budget. For the first time, what we're seeing is demand for the new TASER weapon on the merits of the weapon being very good. Historically, for TASER X2, for TASER X26P, it's been the five-year useful life, it's been the shift to OpEx. Now what we're seeing is people actually want the TASER 7 because it's so good.
Yeah. We think every frontline officer should carry a TASER. It wasn't that long ago that Chicago PD had a high-profile incident where they called for a TASER seven times, and they didn't have one, then in the wake of that incident, they really made a push to get them on all frontline officers. We're working on filling out every major city, every white space. We believe frontline officers should have TASERs. Internationally, we're also seeing a big opportunity where historically we've seen smaller percentage of forces, just a percentage deploy, and we're now making strides in positioning, hey, this should be carried by every officer.
Last one from me, just as it relates to body cams. They've been out there now for a few years, I'm sure to the point that you're starting to see some opportunities for renewal. What are you seeing as people come up for their first renewal, some of the early adopters on body cams? Is there any attrition to speak of or any color there would be great. Thanks.
Yeah. One of our margin, or one of our metrics for last year was actually on churn and retention. We're laser-focused on every deal, ensuring that when they come up for renewal, they stay on the Axon network. We've not rested on our laurels. We're investing in making these products even better and offer more capabilities like the AB3. Both Rick and I are taking an active role in meeting with major cities. This week, we're both going to be out at different major cities along with our chief revenue officer, not only talking about the body cameras, but talking about the entire OSP7 offering with TASER 7 and Records. We feel very confident that we've got a sticky solution with the entire Axon offering.
With all that said, are there any stats that you're able to share just around any attrition or any renewal percentages, et cetera?
I'm sorry, could you repeat that? Your line is really staticky. I couldn't make that out.
Yeah, I guess what I'm looking for is some of the early adopters come up for renewal on the body cams. Is just any anecdotal or quantitative attrition or renewal or anything like that to suggest that it's a long-term sticky product?
Yeah. For the first time last year, we changed our bonus metrics. They were previously all commercially focused, and for the first time last year, we introduced some profitability metrics. We also introduced some usage and we had churn as one of the metrics, and it was less than, I want to say, a third of a percent. It was practically zero. We had, I want to say, about 20 different accounts up for renewal. It's been a very sticky product. Actually, a lot of what we're seeing is that the customers don't even go the full five years. They end up renewing early and adding scope, adding users, and scope of work to their contracts.
Yeah. I would also offer, when they adopt Axon Body cameras, we're not only offering them cameras, we're going into their operating workflow where the officer gets to learn the product. They also, a day in the life, they're docking that in a dock that's infrastructure that we actually install on site. Then all of that evidence uploads to evidence.com, which is now, we have over 40 petabytes of data on evidence.com. We want to continually provide new value to the agencies, but we also have really cemented ourselves in that workflow with the infrastructure that we've put in place as well as just the amount of data that they're uploading to the SaaS system.
Yeah. This is Rick. Just to put a finer point on it, of all the agencies large enough for me on my radar screen last year, there was only one that did not renew. It was a customer that had a small T&E, meaning a small test number of units that they were not actively using. That's the sort of customer you'd expect wouldn't renew if they got a small number and for whatever reason didn't deploy them. Every significant customer with any decent number of cameras on the network renewed last year. I should knock on wood when I say that. We're very happy that customers are finding utility.
We saw a lot of customers last year upgrade early because they wanted to add, whether it's a TASER 7, whether it's adding Fleet, or any of the other new features. We're seeing that that is a very common phenomenon, and once agencies do go through adding something onto their contract, it's pretty universal. I'm looking at my team here to make sure I'm accurate on this, that most of the time, if they're going to go through a procurement, they want to co-terminate and extend to another 5 years, so they don't have to keep going through another procurement process, unless they want to, because we've created another value prop for them to come in and increase it. The punchline is it's working, I'd say, better than I could have anticipated when we got into this business.
Your next question comes from the line of George Godfrey of CLK. Please go ahead. Your line is open.
Thank you. Thank you for taking my question. Question one for you, Jawad. Adjusted EBITDA is $82.5 million at the midpoint. I'm just thinking that in 2018, adjusted EBITDA came in at $61 million. Free cash flow was $47 million, a 77% conversion rate. Would you expect a similar conversion rate on your adjusted EBITDA in 2019?
Directionally, yes. I think it'll probably What we were generally expecting to see a bit of an impact on cash with TASER 7, because most of those sales are obviously on subscription versus the upfront, like book and ship model for the previous weapons. We haven't seen as much of an impact because we also now have had customers on these recurring deals for some period of time. With that base building, it's less of an impact. I'd say directionally, it's going to be about the same.
Okay.
It may be slightly lower, but about the same.
Second question is more high level. I read through the announcement again just now for the Swedish Police Authority and taking the Axon Body camera. Your sales pitch is probably very similar across countries, but I'm just curious, what did Sweden latch on to, or what pushed them over the goal line versus other countries that you're still having to work through, to get them to sign a contract?
Yeah. In international, we have a slightly different sales dynamic. In the U.S., we've got these municipal agencies, they're much faster sales cycle. There's also a lot of now earned comfort with going all in on the cloud. In Europe, in continental Europe in particular, we're still working with some countries on issues around data sovereignty. In some kind of mid-tier markets, they actually have infrastructure gaps. They might not have access to constant connectivity for a cloud-based solution. In Sweden, we have a great kind of reference customer. They're close to greater Metropolitan Police Service and other big agencies in the U.K. I think all those factors made it very compelling for them to go onto the Axon network.
Sweden is more comfortable with their infrastructure data connectivity versus, say, in Italy or in Germany?
In Germany in particular, there is a lot of sensitivity around working with German providers for technology and infrastructure. We've hired a on-the-ground German customer-facing rep. We're still in the process of developing the right technology and implementation partners in Germany, those kind of slow down the adoption cycle.
Got it. Thank you for taking my questions.
Operator, before we go to the next question, we can go a few minutes over, I just wanted a quick point of clarification of something that's been said in the last couple minutes, it's pretty clear in the shareholder letter that the gross margin guidance for Q1 and the rest of the year is 61%-63% for the whole company, not the TASER segment. Just wanted to make sure that was clear. Okay, next question, please.
The next question comes from the line of Keith Housum of Northcoast Research. Please go ahead. Your line is open.
Good afternoon. Thanks for the question. Guys, as we're looking at the TASER 7 acceptance, I noticed about 11% acceptance rate in the quarter. I noticed you guys are saying it's going to ramp up throughout the year. Can you provide a little bit of color on, I guess, how fast you expect it to ramp up, and do you expect to perhaps exit FY 2019 with 100% TASER 7 sales from going forward?
We wouldn't expect 100% TASER 7 sales. Roughly 20% of our business is going to come from international. That's going to be a slower market to adopt TASER 7 as we clear all of their regulatory things that we need to have in place. In the U.S., we think the majority of the deals will end the year with TASER 7 being our number one seller. We will have some agencies that may be laggards or have price sensitivity, in which case we've got a great offering in the X26P still.
Got it. Jawad, if I look at the profitability of the T7 under the subscription plan, I noticed in the release you guys talked about 45% of the revenue being recognized at the time of sale. What would be the profitability at that point in time? It would be the same percentage as the sale or no?
There are two models that we sell the TASER under. One is a $40 a month plan, one is a $60 a month plan. The 45% is for the $60 a month plan. The $40 plan actually has more revenue up front. It has about 75% of revenue up front. That's because in the $60 plan, more of the revenue gets allocated to the software components. The profitability will depend on the mix of the two plans. Overall, what we expect for the entire company is that what we'll see is that the margins will then start to tick up on the software side.
Maybe if I ask the question a little bit differently. If, let's say the 60-month plan, $60 a month, 45% of the revenue is recognized at that point in time. Does that mean that 45% of the cost is also recognized at that point in time?
No. The cost for the weapon will be recognized upfront.
Okay.
It will see less revenue than it would see under the $40 a month plan. The margins would actually be less if we have a higher mix of the $60 a month plan.
All right. I'll take that offline as well. Thanks. Appreciate it.
Your next question comes from the line of Glen Madsen of Ladenburg. Please go ahead. Your line is open.
Hi. I know it's really a recent event, but I'm just curious to see if you guys are hearing anything in the field out there. The recent Supreme Court ruling that prohibits excessive confiscation in the terms of asset forfeitures and what that would mean for police budgets going forward, and especially in light of the fact that it's kind of a major price increase for the current Officer Safety Plan. If you're going to continue to see success with that program, I guess you'd be taking share from a shrinking budget, potentially. Just generally your thoughts on if you're hearing anything yet or what you think you might hear down the road from that kind of a ruling.
Yeah. This is Rick. We've seen no real impact from it to date. I would say this is one advantage of getting into the annual budgets. The things that get hardest hit by those asset forfeiture would be the one-time purchases, where agencies, they have an event that leads to some confiscated assets, that leads to some money that they can buy things with. That's overall a relatively small portion of their overall budget. That's more, again, just the things that they buy one-off. As our business has become ever more integrated into the budget line items, we've become less susceptible to those sort of whims of fate based on what they may or may not have had in terms of confiscations recently.
We haven't seen much of an effect, and I don't anticipate there to be much of an effect, especially given the shift heavier to subscription.
Okay. That's it for me. Thanks for the call.
Great. Thanks.
There are no further questions at this time. I would like to turn the call over to Rick Smith for closing remarks.
Great. Hey, everybody, thanks for coming on the call today. Come out and see us at Accelerate, our annual user conference. It's coming up the end of April and the 1st of May. We will have segments targeted for investors, so you can come out and see hundreds to thousands of our customers and some of the new stuff we'll be showcasing as we move into the back half of the year. Thanks, everybody, and have a great day.
This concludes today's conference call. You may now disconnect.