Good day, ladies and gentlemen, and welcome to the Third Quarter Axon Enterprise Earnings Conference Call. At this time, all participants are in a listen only mode. Later, we will conduct a question and answer session and instructions will be given at that time. I would now like to turn the call over to Luke Larson, President at Axon Enterprises.
Thank you, and good afternoon to everyone. Welcome to Axon's Q3 2017 earnings conference call. Joining on today's call from management are Rick Smith, CEO and Founder and Jawad Hassan, our CFO. Before we get started, I'm gonna turn the call over to Andrea James, our VP of Investor Relations to read the Safe Harbor statement.
Thanks, Luke. Our earnings are available on the SEC website and our Investor Relations site. This call is being broadcast on the Internet and is available on the Investor Relations section of Axon Enterprise website. Please note that the earnings shareholder letter as well as supplemental materials, including our key operating metrics are available on our website. Today, we will open the call with prepared remarks and 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 the future, 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, Inc. 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 risks and uncertainties that could cause our actual results to differ materially.
These risks are discussed in greater detail in our annual reports on Form 10 ks 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 at www.axon.com. With that, I will now hand the call over to Rick Smith, our CEO and Founder.
Thank you, Andrea, and good afternoon, everyone. Thanks for joining our call and thank you for your interest in Axon. In Q3, we executed against our long term plan of creating the end to end technology platform for policing and public safety. We're proud of our revenue and product milestone achievements in the quarter. While we incurred some additional costs that were necessary for the long term success of our business, we are also taking a harder look at our operating margin performance and improving rigor around operating expenses.
Specifically, our domestic body camera business is now transitioning from the early market formation phase, where growth is the dominant focus, to our scaling phase, where we are now placing significant emphasis on operating leverage and building the foundations of long term profitability. Our strong quarterly revenue is indicative of our product leadership across all categories. There is no doubt about our market leadership and our strong customer relationships. Our record revenue in the quarter was driven by strength across our product segments, including strong international weapons revenue growth. Our weapons revenue growth is quality growth.
Giving on a budget line item where grows the long term revenue stream from the customer by giving them a clear mechanism to be able to consistently upgrade every 5 years. Without these budget line items in place, we estimate our historic upgrade cycle was closer to the 8 to 10 year range. We believe we can shorten that cycle to 5 years for agencies with a budget line item in place. We also believe that service plans for the weapons will pave the way for us to add software, training and other service plans as upgrades to create additional customer value and revenue opportunities starting in 2018. Our operating loss in the quarter was caused by 3 key factors, which we addressed in our shareholder letter in detail and which Jawad will cover in more detail.
At a high level though, let me offer a quick review. First, when we enter a new market, we usually do so with disruptive upfront discounting, which compresses initial ASPs and gross margins. We did this with the TASER weapon 20 years ago, with the domestic body worn cameras and eminence.com starting 5 years ago. This is the case today as we penetrate international greenfield markets with body worn cameras as well as the introduction of our new fleet product domestically, which began to scale in the Q3. We are displacing several competitors with our fleet offering and we've shipped 1600 fleet units in Q3 at higher discounted pricing and higher implementation costs as we iron out the new deployment processes required with this new product segment.
We're gaining an important foothold with our in car video system. As many of you know, we've already converted several fleets onto our platform because fleet was coming. But the costs and discounts did impact the profitability of both our weapons and software and sensors segment due to how the accounting works, which Jawad will cover in more detail. Under the generally accepted accounting principles, a discount on one element of these multi element deals must be proportionately applied across all the elements regardless of the appearance on the customer invoice. So this not only caused compressed margins in the Software and Sensors segment in the quarter, but also compressed weapons margins because of those fleet contracts where we also sold a bundled weapon.
This effect can be a bit exacerbated with deferred contingent hardware under the Kernan accounting guidelines. While there are many challenging aspects with the new 606 guidelines coming next year, these new guidelines will much better match the economics of our signed deals to the accounting. And as a result, we expect to see significant improvement in body camera hardware economics starting in the Q1 of 2018. The second factor, gross margins were also compressed by $1,400,000 in data migration costs in the quarter as we performed the largest cloud data migration ever with about 16 petabytes of data migrating from AWS to Microsoft Azure. After this data migration is complete, we will have a strong sales partner in Microsoft and can leverage their relationships with customers around the globe as we grow our own product offerings.
And the third factor, we made the decision in Q3 to bring closer scrutiny to our financial control functions. Jawad will go over this in a few minutes, but I just wanted to point out that the investment in restructuring our international entities should yield a significant ROI going forward. We expect to see a reduction in our effective tax rate by over 10 percentage points as a result of these efforts. Although we plan to continue investing in R and D for future growth areas such as records management, artificial intelligence and fleet, we have identified other areas that would benefit from greater cost control in our company and we're taking a magnifying glass to our discounting practices to identify areas for improvement. Up until now, we've been focused almost entirely on growth.
Our key metrics, including all the compensation metrics, were focused primarily on growth and that's exactly what the organization has delivered. As part of our pivot toward profitability in the body camera segment, we're adding profitability metrics to our compensation and long term performance equity plans for 2018 and beyond. While we believe the strategic investments we made in Q3 were the right decisions to make for the long term management of the business, we also wanted to highlight to investors that we have internal plans in place regarding cost control and slowing many areas of spend growth. We're committed to executing in this next phase of growth with a more rigorous focus on profitability. I'd like to conclude by reiterating that our focus today has been on building the network of devices, apps and people so that we can create new highly valuable services that are only possible because of that network.
And we made tremendous progress today. We have over 6,000 agencies on the Axon network utilizing evidence.com. We've added over 200 prosecutors offices and are adding the Crown prosecution offices across the entire United Kingdom to enable highly valuable and secure information sharing services. We have 245,000 camera sensors in the field today and have ingested over 16,000,000 gigabytes of data or 16 petabytes, one of the largest data sets in the world. And we've added the industry's leading artificial intelligence research and engineering team to develop advanced AI services that will unlock the value in this data for our customers, enabling the automation of cumbersome business processes and creating high value services.
In 2018, we expect to begin launching some of these premium services that are made possible by the network that we have built. These new services will create significant and unique value for our customers and will create high margin services that will accelerate long term profitability. And with that, I'd like to turn the call over to Luke.
Thanks, Rick. We had exceptional bookings in Q3 of $78,000,000 as we continue to lead the market. Bookings grew 36% or by $20,000,000 from the prior year quarter. Similar to the 2017 Q2, this quarter's strong bookings were not reliant on any one large order. Fleet bookings made a more meaningful contribution representing over 10% of this quarter's bookings.
Our customers see and appreciate the value in our end to end solutions, which improve the workflow of everyone in the chain from officers to prosecutors to defenders. This was evidenced by 12 wins in Q3 where our body worn camera or our fleet offering displays competitors. This is on top of 12 win backs we announced in Q2. It's not easy for an agency to switch body camera providers, but the fact that they do and migrate to our platform speaks to the quality and value proposition of the solutions we are providing. We also saw 4 large customer expansions in Q3 where agencies including the Las Vegas Metropolitan Police Department chose to upsize their contracts and their reliance on the Axon network.
Las Vegas was one of our earliest body worn camera customers and in Q3 they decided to renew their contract early and sign on to our officer safety plan. We are pleased with the pace of our product development, which is accelerating and our software and sensors segment is seeing a rise in operational discipline in 2017 as we've seen improvement in hitting product development milestones compared with past years.
I want to
touch on 4 product development milestones or accomplishments in this quarter. Artificial Intelligence, Evidence.com, SignalSidom and Axon Citizen. First, artificial intelligence. We are investing in AI and machine learning that will deploy across our products for enhanced functionality. We see AI as a productivity multiplier and not an end product in itself, which differentiates us from competitors and offers us a clear path to monetization.
While our AI research investments are still pre revenue, we received a major validation of our approach in the quarter. We had a really big win with the Los Angeles Police Department choosing Axon over several competitors to be the AI technology supplier for a special video analytics project. A panel of reviewers evaluated each of the competitors' work via scientifically rigorous test. We were evaluated against benchmarks such as categorizing the video, accuracy and workflow improvement speed up. LAPD received a federal grant to pay for the project and though it is not material to results, we believe the win points to our strategic advantage of specifically focusing on solutions for law enforcement.
2nd, our software development teams rolled out 3 new evidence.com updates in Q3 as we mentioned in our shareholder letter. Not only does evidence.com eliminate pain points for officers in the field, but it also solves problems in the back office at agencies helping departments to make the best use of their body camera investment. For example, our update in the quarter to the device search feature now allows agencies to filter video by which camera recorded it. One of our customers said, I used the device search feature and the first day it was available, it saved me hours of work. These are really meaningful features for our customers.
We also received encouraging feedback regarding a feature update that gives customers more granular control over who has access to evidence from an update that allows users to run a device summary report that brings together all the various device related details into a single place. One of the customers wrote, thank you, thank you, thank you, thank you for the device summary. Again, we are really connected to our customers and making VOC driven feature decisions. We take customer feedback very seriously. Evidence.com is continuously improving as we roll out monthly updates to agency customers.
3rd, signal sidearm. We continue to see strong interest from customers and our internal development is tracking to plan. We finished beta testing in October and the product is now available to ship for all Acton customers. Signal Sidearm is a smart sensor that attaches to most law enforcement firearm holsters. When a firearm is removed from its holster, a wireless alert is sent to all Axon cameras within range to begin recording and capture buffered video from before the firearm was drawn.
And 4th, we recently released Axon Citizen, a public safety portal that allows community members to submit evidence directly to law enforcement agencies only for crimes under investigation. This is a specific product that was requested by our customers and has generated a lot of user interest. Finally, I'd like to update you on RMS, which is still pre revenue and represents a large future opportunity. RMS remains on track to ship in 2018 to select agencies that are our early access partners. In Q3, we signed up 1 major agency and a number of smaller agencies as early access partners.
We were really encouraged by the level of customer interest shown for our Axon developed RMS at the International Association of Chiefs of Police Conference in October. And now I'll turn it over to Jawad, who will discuss our financial results.
Great. Thanks, Luke. Before I begin my prepared remarks, we wanted to briefly address the SEC's comment letter. We've been working to address the SEC's questions. And earlier today, we received a letter from the SEC stating that they've completed their review of our Form 10 ks filings.
Turning back to the quarter. We had record revenue of $90,300,000 in Q3, which represents 26% annual growth. On the weapon side, we continue to execute in domestic weapons, penetrating deeper into agencies who are upgrading at a healthy pace. International weapons was also pretty exciting as we drove a lot of growth there. In software and sensors, we continue to add users to the Axon network and to ship hardware to new customers.
That's what drove the 63% revenue growth of that segment in the quarter. Within software and sensors, Axon service grew 88% and hardware grew 42% as we shipped nearly 37,000 cameras in Q3. This quarter's record camera unit volume was driven by continued strength in the domestic market, shipments to international customers and contractual upgrades on customers with a 2.5 year mark in their 5 year contracts. The Q3 also included $2,000,000 in catch up service revenue previously held pending fulfillment of contractual terms or milestones. The 12% year over year increase in weapon segment revenue to $59,400,000 was driven primarily by an increase in both international revenue and domestic revenue.
International revenue growth was driven by strong X2 smart weapon sales in the UK and some large orders outside our Tier 1 markets. For the first time this quarter, we offer our TASER 60 payment plan in the UK. This helped drive our total weapons orders on our payment plan to 43%. Total international revenues in the 2nd quarter increased $5,700,000 or 51% from the prior year to $17,100,000 The growth was driven primarily by an increase in weapons and cartridge revenue and a more than doubling of software and sensors service revenue. In the U.
K. This quarter, we received continued benefit from the approval of sales of the weapon in the UK in the 2017 Q1. Annual recurring revenue, which captures the growth of our subscription based business at the end of the Q3 was $63,700,000 doubling our Q3 2016 number and representing 16% or $9,000,000 growth sequentially as we've converted approximately 17,000 domestic booked seats to paid seats. Gross margins in the 2nd quarter were 55.1% on a consolidated basis. Weapons segment gross margin was 67.6% and was unfavorably impacted by a greater mix of X2 weapons and the pricing impact of bundling with initial Axon fleet customers.
In the Software and Sensors segment, we were impacted by several items leading to a 31.1% gross margin in the quarter, which is down slightly 2.7% in the 2nd quarter. Software and Sensors hardware margin was lower due to 3 items. First, we were impacted by our early fleet deals, some of which were booked more than a year ago, where we offered both aggressive leader pricing in concessions on accessories such as the routers needed for data flows. Our recently signed fleet deals do not have the same level of discounting and in fact we now charge $99 a month for our fleet unlimited package plus the cost of upfront hardware. Axon fleet bookings are accelerating even at our full pricing, which is highly disruptive in the industry.
2nd, we did not receive the full benefit we expected from standardizing the terms and conditions across our contracts, which would have allowed us to recognize all of the revenue allocated to the upfront camera at the time of shipment. We expect to see some uplift in margins in Q4 if we are able to ship on a larger percentage of contracts with a standardized language. As a reminder, this contract change is expected to partially accelerate the hardware gross margin improvement we expected in Q1 2018 under the new 606 accounting guidelines. Lastly, we were unfavorably impacted by the pricing on certain large international beachhead accounts at levels that we do not expect in 2018. Software and Sensors service gross margin was 64% and was unfavorably impacted by $1,400,000 of costs related to the previously disclosed migration from Amazon Web Services to Microsoft Azure's Government Cloud.
As a reminder, this is the largest cloud data migration in history. We completed the first phase of the migration in October and are on track to be entirely on Azure by the end of Q4. However, we still expect up to $1,000,000 of costs related to the migration in the Q4. Additionally, cost of services includes $520,000 of amortization related to the Misfit acquisition, which was previously recorded in research and development expense, but will now be classified as cost of goods sold as it is revenue producing. Total operating expense in the quarter was 50.6 $1,000,000 Selling, general and administrative expenses were $36,400,000 up from $31,800,000 in the prior quarter.
In the quarter, we had about $1,500,000 of professional fees and contractor expenses related to material weakness remediation and international tax restructuring, which we decided to prioritize in this quarter. After our last earnings call, when we forecast Q2 as a low point in margins, we had to make a call to bring in outside help relative to 3 subsequent events. We weren't satisfied with the pace at which we were remediating our material weaknesses, getting ready for the new ASC 606 accounting guidelines or addressing lingering issues in our back office support capabilities. These are independent issues with different yet critical deadlines that are important to hit. We were making progress against these goals, but I felt it best to bring in outside consultants to help us ensure that we put these issues behind us definitively.
We could have solved for these items with internal resources, but it wouldn't have happened at the pace we needed it to. We're very excited about 2018 and made the call to deal with these items now, so we can exit the year with a strong foundation on which we can execute with confidence and continue our great momentum. Overall, we've been working to bring our finance organization to world class levels by bringing in new leadership and thought partners in key areas. This includes our new VP of Accounting, Jim Zito, critical hires in other important finance roles and a team at Ernst and Young led by Todd Stein that I previously worked with. A key focus of this team going forward will be to improve our expense and operating rigor to steadily drive up profitability.
Additionally, flowing through SG and A, we had a sequential $1,400,000 increase in expenses from increased commissions and selling expenses, both tied to revenue that beat our internal forecasts. Research and development expenses were $14,200,000 in Q3, up from $13,000,000 in Q2. The increase was driven by a $2,400,000 increase in headcount related spend as we accelerated our investment in new lines of business including fleet and RMS. The increase in headcount was partially offset by lower professional and consulting spend and the shift of misfit amortization expense to cost of goods sold. Below the operating line, other income of $1,400,000 consisted of $1,100,000 of gain related to foreign currency transaction adjustment and interest income, which includes interest on the TASER 60 program where GAAP rules require that we allocate a small portion of customer payments on the TASER 60 to interest income as we are essentially financing the hardware for our customers.
We are executing on our inventory management plan. Total inventory in the quarter decreased by $8,100,000 to $52,700,000 putting us on track to meet or exceed our target of $50,000,000 by year end. Turning to our outlook for the rest of the year. As you have in our shareholder letter in front of you, we now expect full year revenue growth to exceed 25%, which surpasses our original guidance of 15% to 20% growth in 2017. We expect modest sequential gross margin improvement and a sequential increase in operating expenses of 5% to 8% in Q4.
We are actively working to adjust the trajectory of our operating expense growth rate to drive leverage as Rick stated at the beginning of this call. We look forward to providing an overview of our long term vision at our Investor and Analyst Day next week in New York. And with that, we can now move to the question and answer portion of the call.
Our first question comes from Mark Strouse of JPMorgan. Your line is open.
Hi, guys. Thanks for taking our questions. So I just want to clarify something if I could. The one time items that weighed down on gross margin this quarter, it sounds like there's still some impact in 4Q, but by the time we get to 1Q of 2018, it will be a much cleaner margin number. Is that accurate?
Yes, that's exactly right. We have, as we mentioned, the data migration, we had some of the leader pricing on the international beachhead accounts and we're expecting by Q1 that's going to be behind us.
Okay. Okay. And then, so you mentioned transitioning into profitability phase here now for the market. In 2018, you're going to have a pretty easy year over year comp for operating margin. So I guess can you just kind of and maybe I'm stealing your thunder for next week, but is there any kind of more specific target you can give for operating margins next year?
So that is absolutely something that we're going to discuss next week. I can tell you though that what I as Rick mentioned, we are making this shift to profitability and we are going to be also, as Rick mentioned, incentivizing our executive team and frankly all our employees to be driving towards profitability.
Got it. And if I can just sneak in one more if I can. Rick, just your high level thoughts coming out of IACP on the competitive landscape, people getting more aggressive, any competitors exiting? And then is your latest thoughts on where you see Axon's market share in the domestic body cam space? Thanks.
Yes. I mean, we're feeling really good about it coming out of the show. We're continuing to see lots of win backs. We're having discussions with some significant customers that had gone on different platforms and are really struggling and they're hearing really positive things from the people that are on our platform. I was particularly delighted at the feedback on Axon Fleet.
That product took us a little longer to get to market than we initially expected. I think we've talked about on previous calls, the complexity of integrating into wireless networks and all the hardware in the patrol cars turned out to be a bigger little lift than we thought when we first launched that product. But I was just delighted at the positive feedback. Every chief I talked to who had Axon Fleet was telling me that they were just sort of blown away by the experience, how the sort of connected nature of the cloud in their car was really compelling. The lightweight hardware approach that we've taken that makes it easy to maintain as well as getting really great feedback on the overall experience with our customer service staff.
We've had to build a sort of new function of people to be handling the customer installs and professional services related to that. So that I think felt really good. We feel well positioned in the in car space. Had a great meeting with a lot of state police colonels that are very interested in that product. And then I think the we're continuing to see a lot of customer excitement around our AI strategy.
A year ago, we sort of announced going into records management with the idea that really video records and text records should end up in one system. And ultimately, the text records should be metadata that's extracted from the video records. And we've made a lot of progress toward that with the build out of our AI capabilities in our team. So I think that was really resonating at a number of customers coming back and frankly telling us they selected us for their body camera vendor because they believe that that vision is the right one, that it's much bigger than cameras, that this is about a whole new way to collect and analyze information. So I think it was a really solid show for us and we're feeling, I think, better than ever about the overall competitive positioning.
Okay. That's helpful. Thank you.
Our next question comes from Steve Dyer of Craig Hallum Capital. Your line is open.
Thanks for taking my question. On the software and services side, even if I exclude the one time hits in the quarter for service revenue, gross margin was still down year over year, which sort of seems counterintuitive given the bigger installed base now. Any other color you can add as to why that would be?
Yes, I think there's 2 items in there. 1, we had a big shipment on one of these older contracts from last year internationally that had just really not high margins, particularly the way the contingent hardware is handled. So those cameras were at, it's going to be negative margin actually the way they were accounted for. And then there was fleet. The fleet hardware was sold off some of our initial pricing, which is more aggressive.
And then as Jawad pointed out, early on there was some confusion with some of our customers about supporting hardware that they might need such as in car routers, etcetera. And we made the call that in some cases we provided at our cost some accommodations to those customers and that we think that's the right thing. The most important thing when we're entering a new market space is to make sure your first customers have a great experience. And so in that case, we determined the right thing to do was to eat the extra cost and get off on a great launch. I think that was the right call, but it did impact the quarter adversely.
We think we've got a pretty good handle on that and we should see continued improvement in fleet, although fleet relative to body cameras is going to that we're still in sort of the market introduction phase there. So the margins in fleet will be less favorable than they are in body cameras. I think especially starting in Q1, we expect to see overall net improvements that are significant, particularly in the body camera segment. And then fleet will improve relative to its performance last quarter, but we'll provide more detail on that in the future.
Great. And then that sort of dovetails into my next question. Just you talked about 2018 being a transition year, more focused on profitability in the body camera market. Is that should I take that to mean the same thing as software and services? Or is that a sort of a deliberate distinction where there might not be as much profitability on that overall segment of the business?
You're good. Yes, I mean, we're being very specific that body cameras are entering the profitability phase. We do see that the overall Software and Sensors segment, at least what we've traditionally had for Software and segment, will be improving not only due to margin on hardware, but also we will be launching some premium software services that are only possible now that we've built the network that are going to help raise ARPU and those should be high margin services. The effect of Fleet because that is a newer product with lower gross margins will sort of counteract that a bit. The question comes out as to how successful fleet is relative to body cameras.
And that remains to be seen. Ultimately, we've run the long term models on fleet. It is going to be a very profitable segment for us, but we did want to call it out that specifically, as we think about these different segments, each of them are going to show their own S curves and their own life cycles. And we're just calling it out now that very deliberately, we think we've hit a point now where body cameras, it's time for that shift towards profitability. And
Steve, I want to clarify that this is also we're talking about profitability in the body camera segment, and we're going to be making investments in other areas. But at an enterprise level, we're absolutely looking to drive leverage.
Right. I guess maybe relative to Mark's earlier question, I mean is it fair to expect improved operating margins next year at least directionally?
Yes.
Okay. A quick housekeeping one, Jawad, and then I'll jump back in queue. The new effective tax rate is obviously a plus. When is that effective? And I don't even know what that will be.
Your tax rate has jumped around so much. I mean, how are you thinking about that in terms of modeling?
Yes. So it has jumped around a bit and we've had a little bit of noise with that accounting change relative to equity this year. But the headlining point for us was that we've simplified our tax structure that took effect in October. And so we would expect that in Q4, you should start to see it come down.
And Josh, I'd like to
At this point, so it's hard to estimate what the impact is going to be from any of the new equity tax changes, but we're anticipating it'll be south of 40%.
Okay, got it. I'll hop back in queue. Thank you.
Yes. One thing I'd like to jump in and add is just Jawad has only been here for a few months and the impact on the organization has been pretty significant. Right out of the gate, you identified our international tax strategy was not optimal and moved aggressively to rectify it. And to have that completed a few months into the job, I think was a pretty big accomplishment. I mean that took a lot of work with both accounting and legal to both figure the strategy, implement and execute.
And then frankly bringing Jim Zito in over in accounting, Jawad moved aggressively there as well. So look, we know we have not been great at forecasting our expenses and that we really need more rigor in our financial systems. Also the material weaknesses are not something that are acceptable going forward. And I was I've been very pleased to see Jawad brought in known people he's worked with and the team at E and Y has been, I think, pretty awesome as well to make sure that we move aggressively to get all these things dialed in. So they're behind us as we move into 2018.
Our next question comes from Jeremy Hamlin of Dougherty and Company. Your line is open.
Hi, guys. I want to come back to the hardware margins and think about you mentioned that fleet was about 10% of bookings in this quarter and I'm guessing that it's probably going to be an even larger portion moving forward. But you note that you expect hardware margins to return to the 25% level as we enter 2018, but you also note that's excluding fleet. So from the perspective of what given the difficulties that you've had with gross margins this year and the underperformance on that, should we what type of level should we be assuming that the Axon fleet gross margins are going to look like? I mean, is this going to be selling at kind of a negative 5%, negative 10% gross margin?
Or how much of an impact could that have on next year's gross margins overall?
I think that'd be a question probably better answered at our Investor Day, where we're going to go through a little more detail both the 2018 the long term.
Also, I wanted to clarify, Jeremy, that we said excluding fleet pass through hardware, not excluding fleet in its entirety. So there are components of the deal, which are 3rd party pass through and that's what we were excluding.
Okay.
Yes, let's put a little more color there. With that, discussions, there's elements like routers and servers that are frankly sort of commodity items where we've gone through the debate, do we have our customers go buy those independently rather than having a significant portion that we're passing through at very low margins. And ultimately, we've made the decision that we need to make it easy for on our on our income statement. So we think that's the right call. We also, I think, understand it better.
A lot of the deals that flew through this quarter were early deals where we didn't have a great handle on that. And so there were a lot more accommodations than we expect to make in the future.
Yes. No, that's helpful. I think what I'm the heart of my question is, there's that this that they've had really, really difficult time forecasting gross margins this year, including in this last quarter when you expected them to sequentially be up from Q2 and yet they were down significantly from Q2. So what I'm really trying to get at is thinking ahead to next year and forecasting next year, it sounds like there will be some improvement, but maybe not that much of an improvement.
Yes. This is Luke here. I mean with these new products, it's difficult to know exactly what the forecast is going to be. We own that. We're trying to communicate that in such a way where we can give more confidence in the products that have more maturity.
With Fleet, we're very confident in the long term. With the storage, we just had the largest data migration in history. And it was hard for all of the parties involved to understand what all the components of that transfer would be. And we did not have accurate visibility on that. And therefore, we couldn't forecast it.
That's something that's now behind us. At the Investor Day, we're going to sign up for bottom line growth over the next 3 years and we feel really confident about it. We're putting both annual as well as long term performance packages in place for key leaders to hit those targets.
No, I understand that, Luke. And just to be fair, even if I add back the 3 items that were called out in your summary release, you'd still have gross margins that would have been just under 60%. So I'm just trying to wrap my head around thinking is maybe kind of low 60s a better baseline to be thinking about rather than historically the company has been in the 63%, 64%, 65% range. And I just want expectations to be set appropriately.
So with something like Fleet, as we talked about, it's tough to know what that pricing is going to do in the early stages. And as we ship that hardware, there's going to be given the accounting rules, there's going to be some compression in the upfront margins. But we're confident that over time, these deals are going to be accretive to our margins. And you may not see that effect immediately. But again, over time, we do we're confident that that's going to be accretive.
And I guess the silver lining on this is fleet will be largely incremental to the existing business. So it will be adding gross margin dollars even if the percentage rate may not be as high as in the other segments. So the more fleet we're adding, the more gross margin dollars we'll have in the business. They just may not be at the same margin percentage.
Let me move on to operating expenses, which also came in higher than forecast. In terms of I just want to clarify, the guidance for the Q4 is $53,000,000 to $54,500,000 Is that or do we need to back out the recurring amortization expense for the Australian distributor. I mean, since it's recurring, I'm assuming that's inclusive of your guidance, but I want to just pin down the range.
That's correct. The math
would be 53 to 54.5?
That's correct. It includes.
And does that include any costs related to the free camera trial?
Yes.
It does. Okay.
Okay, great. Let me transition to something that was a very strong positive. On your evidence.comrevenues, it looked like they were up about $3,500,000 sequentially to about 16,000,000 dollars In terms of what drove that growth, how much did your active pain licenses increase in Q3?
I'm not sure I understand the question. Are you
Your evidence.comservicerevenues, right, that grew to roughly $16,000,000 in the quarter. My question is, how many active paying licenses what was the increase in active paying licenses in the quarter? Paying license, not the bookings.
Yes, 17,000 domestic.
Okay, great. And then thinking into Q4, do you is there going to be a similar type of growth in terms of the number of licenses turned on or how should we be thinking about that?
Yes, we would expect it to be roughly in line with that same growth rate.
Okay, great. Thanks guys for taking
One thing I want to add there is just to punctuate this, 2018, I think will be the 1st year that you start to see us adding additional upsell services that would tend to go back and be uplifting some of those existing seats through some of the additional services we're launching. So historically, our primary focus has been on growing the size of the network. We're certainly going to be continuing to do that. But some of the things we're doing with AI, etcetera, gives us an opportunity to go back and increase revenue per existing customer.
Yes. Well, you're already growing pretty nicely on the service revenue side. So we look forward to continued growth and thanks for taking the questions.
Our next question comes from George Godfrey of CL King. Your line is open.
Thank you and thank you for taking my question. Just to be clear on the Q4, so given the revenue growth for the full year, 25% and the OpEx, so operating income should be a loss of about $2,500,000 is what I'm getting, maybe a little bit more.
So I think we're not going to give specific guidance on operating margins for next quarter. What I can tell you is that, first of all, we acknowledge that we've got an opportunity to do better at our forecasting. And so we're and I own that, right? That's part of what we're doing with building out the team and ensuring up our capabilities. And so we're trying to we wanted to give guidance that we felt we could hit for Q4 as far as operating expenses.
The other thing which shouldn't be lost in the comments we've given you is that we're bringing additional expense rigor. And it is absolutely our intention to claw back as much of the increase as we can. And we're not going to give any specific guidance relative to that. But it is our intention to get Q4 as close to Q3 as we can.
Yes. And I would just highlight, I think Jawad has shown a lot of leadership here. This is a tough call for a new CFO to come in and say, I want to add expense structure to get ready for the 606 change as well as remediate the material weakness. And we could choose not to make those investments, but we feel strongly and it's important that we enter into 2018 prepared for 606 as well as have this restructuring with our international entities, in addition to really having a handle on these material weaknesses. And so Jawadz made a strong push to come in and say, let's bring in the right consultants E and Y to get this done.
And there is a cost to that. And so I'm supportive of that. And I think we really believe this is the right investment for the company.
And I appreciate all that. And I'm just trying to understand what the impact of these financial implications are in Q4 and where they're going to go over the next 3 years. What I was getting at is, if we started a margin of minus 3% and we go back to the Investor Day of a target margin of 30% and we take a 3 year timeframe and I realized it probably won't work on a linear basis, but that's 12 quarters of adding 300 basis points of operating margin per quarter. And so my question is, are we resetting base expectations relative to where we were a year and a half ago? Or does the 350,000 seats we're looking at just Axon get you to that steady state 20% margin?
Or are these are those figures a number that we talked about a year ago, do they need to be reset?
Yes. So we're obviously going to be resetting the forward looking models in just a few days here. So rather than getting into some of the details here, I will tell you just in general, we're really we're not optimizing for EPS in the Q4. We're optimizing to have a very solid 2018 and a predictable trajectory towards a highly profitable business over the next 3 years. And we know that our it's not a surprise, it won't shock anybody on this call, our ability to accurately forecast expenses to the Street has not been a bright spot for us.
And Jawad is committed that those days will be behind us as we roll into next year. So he's got a team that's really focused on it and we're going to improve our performance there.
Okay. Thank you for taking my question.
Yes. Thank you.
Our next question comes from Glenn Mattson of Ladenburg Thalmann. Your line is open.
Yes. Thanks for taking the question. Just on the weapons, a little better than I expected. Can you talk about what drove that? Was there one large deal that you called out?
I might have missed that. And I'm just looking at the units. It doesn't look like there was any unit growth between the X26 and X2. The decline in 1 offset the gain in the other. So what drove the year over year revenue growth?
And
maybe a lot of it
is attributed to cartridges. And if there's no growth in weapons, can you give us an idea why cartridges is growing so fast?
Yes. So a couple of things. There were some big federal orders. The approval of TASERs in the UK, in the United Kingdom, Josh, how many cartridges do they typically use in training per TASER? It's significantly higher than the U.
S.
15 to 20 per officer per year.
So right there, the expansion of TASERs in the UK, that's significantly more cartridges they consume in training than our typical U. S. Customer. That and also launching TASER 60 in the U. K.
Has also been helpful in helping them to sort of drive growth in bundled cartridges into service plans.
Sorry, Rick, what was that number on the cartridge usage?
Josh? 15 to 20 cartridges per officer per year between training and field duty.
Versus from what I remember in the U. S, it was like 3 to 5 or something, wasn't it?
Yes. That's accurate, yes.
Okay.
And that's sustainable? I mean, if they train everyone after a while, do they stop using them at that rate? Or is that I mean, it seems like a Yes.
It's completely sustainable, so much so that most of our U. K. Customers are committing to TASER 60 Premium, which builds in that number of cartridges every year. And so that's it's going to trend that way from here on out in the UK specifically.
Okay.
It's something I'm particularly proud of, I'll tell you in the UK. If you talk to UK policing that they believe that they're making the proper investment in weapon handling and weapon training. And it's we don't see that going away. They look at other countries that may have had more misuse issues and they believe part of the reason they've had less of that in the UK is the extensive training they do.
Next question on, you said, international large beachhead accounts hurt margins also. Was that in video? And could you give us more color on what you're talking about? Are they new countries that we haven't heard about before or just a little color there, Rick?
No. Yes. Again, we don't like to give too much specific details, but this is one very large customer that we signed last year. It was important flagship customer that opened an international market for us and we shipped a lot of cameras on that order.
Okay, great. And then one last point, Someone asked a couple of questions ago about the video service sales growing sequentially, but there was a one time catch up in that, right? There's a $2,500,000 catch up or something, dollars 2,000,000 catch up?
That's right. Dollars 2,000,000 catch up.
Okay. All right, great. That's it for me. Thanks.
Our next question comes from Allen Klee of Sidoti. Your line is open.
Yes. Hi. Two questions, just clarifying some stuff you mentioned. For going forward for fleet gross margins for new sales, you give us a sense of what type of range that gross margin would be? And then well, I'll just start with that.
Yes. I don't think we're prepared to release that number here today.
Okay. And then for the you said that you're going to add a profitability metric to management compensation. Could you just tell us what profitability metric that would be?
Yes. So the way that we calculate our bonus plan is we have an annual set of metrics that the entire company is paid out on. And we're going to have one of the key metrics be tied to EBITDA. And then for key executives, we do long term 3 year performance RSUs that will also be tied to EBITDA. And next at the Analyst Day Investor Conference, we're going to lay out a plan for 3 year growth on the top line and the bottom line, and we'll kind of be showing some targets that we're aiming at that we believe this incentive plan will align.
I actually want to just highlight something here. So what you can take away from this is that we don't have any of those profitability metrics in our compensation today. They've all been historically focused on top line growth and that's exactly what the organization has delivered. The system is working really well to do what it was designed to do. And now with this shift, this pivot towards profitability, we're fully expecting that we're going to execute on exactly the same thing and gain profitability.
So I'd point to our execution on our top line growth over the past few years as a proof point And more near term, there were some concerns recently about inventory, but we've executed on that and we're very much trending towards the guidance that we gave by year end. We've also held the line on cash flow. So I think the team's got a track record of executing. And when we introduce profitability into our compensation metrics, I'm fully
Our next question is a follow-up from Steve Dyer of Craig Hallum Capital. Your line is open.
Thanks. Just a couple of follow ups. I guess, directionally Jawad, the puts and takes of 606 in your business, I mean, are there any obvious swings that we should be thinking about? I mean, I have some familiarity with it. But as you look at what's gotten to be a fairly complex P and L, what jumps out at you as puts and takes and opportunities here?
Yes, it's a good question. So on an overall level, we're not expecting 606 to have a huge impact on the business. But there is a lot of complexity in our revenue recognition. And what we talked about as far as modifying or standardizing our contract language would in effect mimic the effect of 606, which would allow us to accelerate the revenue on hardware components that are delivered upfront. And there's really no other meaningful impact other than that they were expecting.
So just to be really clear, we expect to see hardware margins improve significantly based on 606, although there's going to be some other pressure the other direction from fleet being on that lower margin hardware product initially. That's exactly right.
Okay. Got it. And then I guess just bigger picture as it relates to operating expenses. I think one of the hard things about kind of getting operating leverage is there's always something new, a really interesting new opportunity to invest in, which sort of keeps it from keeps you guys from really optimizing the model. I think it sounds like you'll lay out some bogeys next week.
But just in terms of the OpEx spend, etcetera, is there any way you'd think about or be willing to sort of take a stab at what you guys are spending on a quarterly or annual basis on non revenue producing products or services? Because I mean the growth has been great and it's obviously important to see that pipeline, but I think it would help investors a lot to know sort of what's going into managing the business and what's going into 3 years from now's revenue?
Yes, that's a great question, Steve. Currently, we think about our business in 4 key value streams TASER, our digital evidence management and body worn camera business that includes ancillary products like Axon Signal. We've got Axon Fleet and then we have RMS. We will at our Investor Day talk about how we're thinking about signaling, how we're having DEMS in the body camera business contribute to the bottom line. One metric that we're discussing is showing percentage of R and D invested on net new products.
So great question. We'll have more to talk about at the Investor Day on how we're thinking about that.
All right, great. Thank you.
Our next question is a follow-up from George Godfrey of CL King. Your line is open.
Thank you. Just two quick ones, I hope. Headcount at the end of the quarter?
We'll get that. Yes, I
don't have it in hand.
Okay. And then just directionally, now that we'll be lapping the TASER 60 program, is working capital likely to be a drain or a generator of cash in 2018?
I'd say that we're going to so we're in this transition right now to the subscription model, whereas historically we've been initially selling more book and ship. And so you're going to see an impact on working capital. But as our top line continues to grow out, I would expect that to normalize.
Got it. Thank you very much.
There are no further questions. I'd like to turn the call back over to Mr. Smith for any closing remarks.
Great. So thanks everybody for joining us today. Obviously, we're delighted with the top line growth that we experienced in the quarter. And we know we've got some wood to chop. We've got on expense issues.
We've got some short term expenditures that we're making to really shore up our finance function. We're confident that that's putting the right rigor in place so that we can improve more dramatically on both the top and bottom line as we roll out into 2018 and beyond. We look forward to giving you guys some more details on that plan. Hope to see you all in New York. Thanks.
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.