Good day, ladies and gentlemen, and welcome to the Axon Enterprise Q2 2017 financial results conference call. At this time, all participants are in listen only mode. Later, we will conduct a question and answer session, and instructions will be given at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone telephone. As a reminder, this conference call may be recorded. I would now like to introduce your host for today's conference, President of Axon, Mr. Luke Larson. You may begin, sir.
Thank you, and good afternoon to everyone. Welcome to Axon's second quarter 2017 earnings conference call. Joining on today's call from management are Rick Smith, CEO and Founder, Jawad Ahsan, CFO. Before we get started, I'm going to turn the call over to Arvind Bobra, our Director of Finance, to read the safe harbor statement.
Thanks, Luke. Our earnings are available on the SEC website and our investor relations site. The identical release contained in the 8-K will be crossing the wire momentarily. This call is being broadcast on the Internet and is available on the investor relations section of the Axon Enterprise website. Please note that the earnings release as well as supplemental materials, including our key operating metrics, are available on our website. Today, we will open the call with prepared remarks. We will follow the prepared remarks with our standard live question and answer session. Statements made on today's call will include forward-looking statements, including statements regarding our expectations, beliefs, intentions, or strategies regarding 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 on current information and expectations regarding Axon Enterprise. These estimates and statements speak only as of the date on which they are made, are not guarantees of future performance, and involve certain risks, uncertainties, and assumptions that are difficult to predict. All forward-looking statements that are made on today's call are subject to the risks and uncertainties that could cause our actual results to differ materially. These risks are discussed in our press release we issued today and in greater detail on our annual reports on Form 10-K and quarterly reports on Form 10-Q under the caption Risk Factors. You may find these filings as well as other SEC filings on our website, www.axon.com. With that, I will now hand the call over to Rick Smith, our CEO and Founder.
Thank you, Arvind, good afternoon, everyone. We just finished our first quarter since rebranding the company as Axon, our recent results underscore the timeliness of our name change. I am thrilled to report record Axon bookings of $82 million for the second quarter, approaching $10 million higher than any other prior period. Future contracted revenue continues to grow. At $446 million, we are rapidly approaching the half billion mark. Our record bookings reinforce our strategic direction and validate our innovation leadership. We continue to consolidate and win market share because we're making compelling solutions for our customers. While we welcome the signing of large customers, the increase in bookings in the second quarter came from a diverse group of agencies. This speaks to the quality of our expanding technologies and the trust that law enforcement officers have for us across the board.
It also leads to greater predictability in our performance over the long term as we generate recurring revenues from a larger and growing customer base. The quarter was very strong, we're just getting started. Our pipeline of new product offerings has never been better, we continue to expand our international footprint. Our in-car fleet offering, which began shipping in the second quarter, our international bookings combined represented less than 10% of total bookings in the period. We continue to receive very positive feedback from Axon Fleet, we expect our solution will gain wide adoption and become a larger contributor to both bookings and in-turn revenue. Once again this quarter, for agencies which added fleet to their orders, we saw annual contract value per user was approximately double our average.
Early feedback from customers has been encouraging, from one customer, they reached out saying, quote, "I'm so confident in Axon, their product, their people, I'd be more than willing to host additional agencies here so they can come and see Axon Fleet for themselves." We had two very significant win-backs of agencies who had previously deployed a competing body camera solution. After extensive testing and evaluation, Alameda County, one of the major county sheriff's offices, converted over 1,200 officers over onto the Axon network, Boulder, Colorado deployed 200 Axon Body 2 cameras, as well as 50 fleet vehicles. Our cloud-connected in-car video system is one more integrated capability that increases the total value of the Axon network and our ecosystem for our customers.
While international accounted for a small portion of bookings in the quarter, we continue to gain traction in our target markets that should lead to increased bookings in the next few quarters. Law enforcement agencies across the world, which tend to be larger and more centralized than domestic agencies, are beginning to recognize the challenges associated with organizing and analyzing a massive influx of digital evidence. This provides us with a clear and compelling opportunity for our products, just as it does in our domestic markets. We expand to new geographies, we will continue to put the right people in place to grow the Axon network abroad. I am particularly excited about some of the great work our team in Australia is doing the traction we have on a variety of opportunities across the country.
One key customer, the Queensland Police Service, has been studying the use of Axon solutions in domestic violence. With over 21,000 domestic violence-related files now in evidence.com, they have seen a 22% increase in reported assaults, coupled with a 60%-70% decrease in police summary hearings. Meaning offenders are taking pleas rather than going to court in light of strong video evidence. This ensures more fair and efficient pursuit of justice in these cases. As a result, Queensland recently expanded the number of Axon cameras and licenses from 2,700 to 5,000 starting earlier this summer. Queensland took appropriate pride in announcing that this is the largest rollout of body cameras in Australia and the third largest in the world. Turning to product pipeline, one of our new technologies that is particularly timely, given some recent events, is Signal Sidearm, which we announced earlier this year.
Signal Sidearm is a wireless technology that alerts body cameras when a firearm is removed from an officer's holster. Our solution is unique in that it wirelessly alerts every camera within a range of about 30 feet and is compatible with existing holsters. When law enforcement officers must draw a weapon, the last thing they should worry about is their technology. The Axon network gives officers the confidence they need to focus on the work they do. It also assures the public that transparency isn't limited to certain situations. Considering some of these recent events, Signal Sidearm is needed now more than ever, and releasing this product is imperative to allow our Axon cameras to capture escalated encounters. It is also an important step in extending the reach of the Axon network to connect to other devices.
Signal Sidearm is in trial now and will be ready to ship later this year. Sheriff Leon Lott of Richland County commented to CNN that he is, quote, "Very excited about this new capability, which will provide a new level of transparency to his agency." Our technological innovation is central to the work we do, and just as our team at Axon works diligently to develop cutting-edge products for law enforcement, we work with the same measure to protect what we have built. We aggressively defend our innovative technologies and reject any efforts of competitors to trade on our goodwill and reputation for quality. We have a proven track record in litigating these cases of patent infringement against infringers, and we regard the recent injunction in July against a competitor as a huge success. We shut down the third consecutive infringer.
We believe we're also well-positioned as it relates to outstanding litigation regarding video IP. We felt it's important to make our position clear, as we are seeing what we believe are some misrepresentations perpetrated by others out in the public domain. In terms of our national free trial offer, the program continues to be a success. We've had over 1,500 customers inquiries about the offer, and it's serving to restart or accelerate discussions with agencies across the country. We currently have many trials in place, and additionally, as customers learn more about our connected solution, several of them have decided to bypass the trial process and proceed straight into procurement. This, again, is telling of how compelling our offering is for the needs of our customers.
We've been so pleased with the outcome of the trial here in the U.S. that we've extended the offer to all law enforcement agencies in Canada. We are now more than halfway through 2017, I'm excited for the road ahead. From our bookings to our free trial to our exciting new technology solutions, we have tremendous momentum moving forward. I remain excited about the opportunity in our domestic and international weapons businesses. There's so much more to come as we introduce new hardware products, develop record management systems, and release our artificial intelligence capabilities. With that, I'm now going to hand over to Luke Larson to go through the operational update.
Thanks, Rick. We had an exceptional bookings quarter and strong revenue this quarter. I'm proud to share the highlights of our accomplishments. Bookings on our Axon platform were $81.9 million in the second quarter, an increase of 14% compared to the second quarter of 2016, an increase of 36% sequentially. As Rick mentioned, this is a record for the company and speaks to the increased demand for the multiple capability sets we are offering on the Axon Network. Annual recurring revenue in the second quarter was $54.7 million, including the contribution from international customers, an increase of 18% sequentially and 159% over the prior year. In the second quarter, we booked approximately 20,600 incremental new seats on our Axon platform. That brings our cumulative total booked seats to 169,000 since inception and represents 14% growth sequentially.
Operating income for the Taser weapons segment was $17.6 million at a 33.2% margin in the second quarter of 2017, up $15.1 million at a similar margin in the prior year quarter. The increase was driven by a 10% increase in weapons units and a 40% increase in cartridge units, partially offset by higher selling, general, and administrative expenses. The ratio of lifetime value of a customer to the customer acquisition cost in the second quarter was 5.4x, up from the 4.3x in the prior quarter on higher new booked seats. As a reminder, this ratio is calculated only including current product at current price levels. We strongly believe the true value of each customer will be significantly higher as we are able to add premium service tiers and new products. We had several notable bookings in Q2 as we continue to lead the market.
We closed another major city that moved to full deployment of our body camera and evidence.com platform to over 4,000 patrol officers. We're working with this agency on the announcement but wanted to make sure this was noted as contracted in Q2. This win is yet another example of the trust and confidence large cities have in our platform and solution. I'm particularly pleased with the incremental contribution Fleet provided to bookings this quarter. The Fleet bookings demonstrate how we are expanding our ecosystem through technology innovation. Additionally, this quarter, we won a small in-car Fleet deal with an incumbent competitor. In fact, we've won several recent deals from incumbents. In the top 1,200 agencies, we won 12 deals in the quarter away from competitors. In aggregate, these 12 deals represented over 4,000 new book licenses. Displacing an incumbent provider is never an easy undertaking.
However, the benefits of our workflows and technology leadership far outweigh the near-term inconvenience for these agencies. I'm very proud of these wins as they reaffirm our R&D efforts are well-placed in generating strong returns. In June, we held our second annual Axon Accelerate Conference. It was an absolute success. We had over 600 attendees. Our customers were very excited about the solutions we're bringing to market to meet their needs and pain points. The conference featured 47 interactive sessions with our customers and provided them with an opportunity to learn about our new offerings and provide us feedback. We surveyed conference attendees who rated the event 4.7 on a scale of one to five. We believe Accelerate will become a unique conference to help our customers adapt to rapidly accelerating technologies and also give us a chance to promote our new platforms.
At the conference, we also previewed our record management system offering. Initial feedback on the solution, its intended capabilities has been very positive. Customers trust our vision and ability to execute. Several are willing to commit to us, even though our solution won't be available till next year. As a reminder, we are currently working with several partner agencies to develop and trial an early version of the product. Most important, we left Axon Accelerate with a high level of confidence that the value we are delivering to our clients is well established. In addition, the efforts we are making to extend our technology offerings are in the right areas for our customers and will translate into increased revenues over time.
We have tremendous energy and momentum as we move forward. I'm really excited about the strength of our team and the opportunities of our integrated solutions that we're bringing to law enforcement. Now I'll turn it over to our CFO, Jawad.
Thanks, Luke. We're coming off another strong quarter with great momentum in the business. Revenue in the second quarter was $79.6 million, a 36% increase from the prior year period. Year-over-year growth was driven by more than doubling in software and sensor segment revenue and a 16% increase in weapons segment revenue. Software and sensor segment revenue represented 33% of total revenue in the period. The $13.4 million year-over-year increase in software and sensor segment revenue to $26.6 million was attributable to a 161% increase in our Axon service revenue and a 66% increase in hardware revenue as we shipped over 36,000 cameras in the quarter. This quarter's record camera unit volume was driven by filling Flex 2 backlog, shipments to international customers, and contractual upgrades on customers who have hit the two-and-a-half year mark on their five-year contracts.
The second quarter also included $650,000 in catch-up service revenue previously held pending fulfillment of contractual terms or milestones. The $7.5 million, or 16% year-over-year increase in Weapons segment revenue to $53 million was driven primarily by an increase in international revenue and a small increase in domestic revenue. International revenue growth was driven by our continued focus in our Tier 1 markets. Domestic weapons growth was limited as certain Q2 opportunities moved to Q3. Further, domestic weapons sold on our TASER 60 and OSP payment plans dropped to approximately 25% in the quarter from 35% in the 2017 first quarter. As a reminder, we recognize the full purchase price of the weapons upfront on these payment plans. Despite the lower contributions from these programs in the second quarter, we still grew our weapons business in the period. A higher contribution from the Taser Assurance Plans moving forward.
Total international revenues in the second quarter increased to $6.9 million, or 105% from the prior year to $13.4 million. Growth was driven primarily by an increase in weapons revenue as well as an increase in video hardware and service revenue. The fulfillment of bills for TASER X2 weapons in the United Kingdom was limited compared to the 2017 first quarter, but is a long-term growth opportunity as the U.K. The ongoing revenue, which captures the growth of our subscription-based business at the end of the second quarter, was $54.4 million, representing an 18%, or $8.5 million, growth sequentially as we converted approximately 17,500 domestic seats to paid seats. However, we temporarily excluded the revenue in ARR from 4,500 seats in the quarter pending a contract amendment we expect to complete later this year. In addition to national seats ARR this quarter.
$81.9 million, we're up 14% from the prior year. This represents a $10 million increase from the 2016 second quarter bookings. As a reminder, the year-ago quarter included the $20.5 million LAPD win. This further underscores the strength of the recent quarter's record bookings, which weren't reliant on any one large order. Fleet bookings made an incremental contribution, but still represented a small % of total bookings. As we look back to the second half of the year, we have considerable bookings momentum across the domestic and international body-worn camera markets, as well as our fleet offerings. It's important to note that our bookings number includes contract renewals, which will become a larger contributor in the coming quarters. The incremental book seats we provide in our supplemental materials are intended to be net of renewals and upgrades. Total deferred revenue increased by $8.6 million sequentially to $100.2 million.
Over 80% of our domestic video hardware contracts include the Taser Assurance Plan feature, under which customers prepay for their future camera upgrades. Software and Sensors segment deferred hardware revenue or customer prepayments for future camera and dock upgrades represent $21.8 million of the total deferred revenue balance. These future hardware upgrades will have a lower implied discount than the initial camera purchase, and as such, will flow through the P&L at a higher average selling price. Gross margins in the second quarter were 57.3% on a consolidated basis. Weapons segment gross margin remains relatively consistent at 69.7%. In the Software and Sensors segment, we were unfavorably impacted by several items, leading to a 32.7% margin in the quarter. Software and Sensors hardware margin was lower due to shipments on certain multi-year contracts with heavily discounted upfront cameras and docks.
We are modifying new contracts to limit discounts on upfront cameras and docks and allocation of revenues to contingent hardware, which is recognized over the life of the contract rather than at the time the hardware is delivered. In Q3, we will still be shipping on some of the older contracts and expect to see some hardware gross margin improvement in Q3 and more improvement in Q4. This change partially accelerates the hardware gross margin improvement we expected in Q1 2018 under the new ASC 606 accounting guidelines to the second half of 2017. Software and Sensor hardware gross margin was further impacted by non-recurring costs related to higher scrap rates on the new Axon Flex 2 camera due to supplier-related issues during launch, which have now been resolved.
Software and Sensors gross margin was 70% and was unfavorably impacted by $600,000 of costs related to the previously disclosed migration from Amazon Web Services to Microsoft Azure's government cloud. We expect to complete the migration by the end of the third quarter, we will still incur an additional $750,000 of migration costs in the third quarter. Consistent with our comments on last quarter's call, we expect Software and Sensors hardware margin in excess of 25% by Q4 and service margins in excess of 75%. At those margin levels, our Software and Sensors gross profit in this quarter would have been $4.3 million or 50% higher. Total operating expenses in the quarter increased 3.5%, coming in favorable to our estimate of a 4%-6% sequential increase. SG&A costs increased 3.1%, primarily due to increased headcount costs related to our Axon Accelerate conference and our rebranding.
Research and development expenses increased 4.2%, primarily due to our investment in record management systems and advanced artificial intelligence capabilities. Other income of $1.7 million consisted of a $1.3 million gain related to foreign currency transaction adjustments and interest income, which includes interest on the TASER 60 program. Income tax expense in the second quarter was $232,000, for an effective tax rate of 9%. We had a favorable $400,000 discrete tax benefit associated with the gains related to stock-based compensation. This gain was driven by a change in accounting guidelines this year. Excluding this discrete item, our earnings per share would have been $0.03 compared to our reported EPS of $0.04. Our normalized tax rate for the year, excluding the benefit associated with gains related to stock-based compensation, is expected to be approximately 40% for the year.
Total inventory in the quarter increased to $60.7 million, a $12 million increase from the first quarter. Our inventory growth in recent quarters was driven by several factors. First, to support the potential high demand for dock cameras and docks for the national free trial program. Second, to support our significant increase in the volume across our products, including cameras, weapons, and cartridges. Third, we've increased our inventory to improve customer fulfillment times. Lastly, we're in the process of simplifying our international tax strategy, which has required us to carry two full sets of inventory. We have a plan in place to significantly reduce our inventory balance over the next six months. We've set a target to be below $50 million of inventory by the end of the year, with further reduction in 2018.
Turning to the third quarter, we expect revenue growth of approximately 15% year over year and continue to expect full-year revenue growth to slightly exceed our 15%-20% target range. We anticipate a 4%-6% sequential increase in operating expenses in the third quarter as we continue to invest in R&D initiatives, add customer-facing roles, and expand into new international markets. We could see a slight variance on either end of this range based on the timing of hires and some anticipated expenses within the quarter. This increase does not include expenses related to the national free trial offer. While the offer has generated significant traction, as Rick had mentioned, many of the customers who are getting deep into understanding how our solutions work are choosing to move straight to procurement.
For those who are arranging trials, we typically see larger agencies wanting to test a limited number of cameras rather than for every officer. We view this as a very positive outcome that will result in a lower-than-expected cost in the back half of the year. We now expect to have $2.5 million of expense in the back half of the year versus our prior estimate of $5 million. We expect margin improvement sequentially in Q3 2017 from Q2 as we incur fewer non-recurring camera hardware costs, improve hardware pricing, increase weapons revenue and add users to the Axon platform. Our margin improvement will be partially offset by expenses related to the national free trial offer. With that, we're now going to move into the question and answer portion of the call.
Thank you. Ladies and gentlemen, if you have any questions or comments at this time, please press the star and then the one key on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Once again, if you have any questions or comments, please press star then one. One moment for questions. Our first question comes from Mark Stroud with JPMorgan. You may proceed.
Hey, good evening, guys. Thanks for taking our questions. Congrats on the revenue and the bookings. I think we wanted to just dig into the cash flow statement, though, if we can to start. Cash from operations, you've been burning cash for the last two or three quarters now. Your balance sheet's still in very good shape, but just kind of wondering if you foresee any need for a capital raise anytime in the near future.
Just to reiterate, our biggest use of cash has been our increase in inventory. As we mentioned, we've got a plan in place to take that to normalize levels by the end of the year. Excluding inventory build, our cash from operations is a positive. Our potential additional cash at this point, anyway, it's to provide any additional temporary liquidity in the business. We do have facilities available to us, that with the reduction in inventory by the end of the year, that we won't need to draw on those facilities.
Okay, thanks. With some of the future investments in RMS and AI, just wondering if you have any updated comments around timing of when initial deployments of that technology could begin, and when we should expect that to become more material.
This is Rick. I'll take that one. We expect that we will be starting some field trials late this year. We'll likely be making some announcements at the IACP conference in October about some specific products related to some of these capabilities. We expect in 2018, we'll start to see revenue contribution.
Okay. Just lastly, Rick, you mentioned on the video IP lawsuits that are out there, you have one company or, I don't know, several companies maybe misrepresenting the case. I'm just kind of wondering if you can give a bit more detail on your view of how this all plays out.
Sure. Yeah. As you've seen, we've got a competitor that puts out press releases on just about every minor ruling in the case. Obviously, this is going to be a complex case. We believe there's very strong prior art to these patents. Some of the evidence is in the form of prior patents and filings that we've presented to the patent office, which should be noted, they've accepted one of our two challenges, and that challenge will proceed to hearing in February on the first patent. Additional evidence, particularly related to public disclosure of our own inventions and marketing of this technology at least three years prior to Digital Ally's patent filing, will be presented at the appropriate time in district court. We also have strong arguments that our technology designs do not infringe these patents.
Even if they somehow survive what we see as very clear prior art that we're presenting, we have strong arguments of non-infringement. Then finally, as with any thorough risk management plan, we've identified alternative technology pathways to achieve similar product value for our customers. We believe we're in a really pretty strong position.
Great. Okay. Thank you very much.
Our next question comes from Steve Dyer with Craig-Hallum. You may proceed.
Thanks. Good afternoon. If I could dig into operating expenses a little bit. It looks like about $25 million or so of operating expenses this quarter on the software and segments business. As I talk to people who try to get a better read on the real profitability of the video business, is there any way to kind of, I guess, estimate maybe what portion of that, particularly in R&D, is for projects that are not generating revenue, you call it this year?
Arvind, or I'm sorry, Jawad, why don't you take that one?
What we're doing, Steve, is continuing to invest in R&D initiatives and customer-facing roles to expand product offerings and geographic reach. We're not disclosing what the split of that is between existing products and new, but we are making, as you know, an investment in RMS in future products.
Yeah. The other thing that I would comment on, with our existing revenue streams that we have to market today, which is primarily around our body-worn cameras and the digital evidence management systems, we've got a long-term operating margin target. With these net new technologies that we're investing in, RMS, records management system, which will be a pure software play, it's not going to have the storage costs or the associated hardware costs, as well as artificial intelligence features. We expect these to have a lot higher operating margin that will bring up the total operating margin for the entire Axon segment.
Okay, got it. I guess as it relates to gross margin, it sounds like the issue there has been hardware gross margin and the guidance there is for improvement. Is it safe to say, I guess all things considered, that sort of near term Q2 will mark the operating margin trough for the business?
Yes, we still feel that that's the trough for the year.
Okay, great. I guess a couple of housekeeping issues. One, as it relates to the inventory, working down the inventory through the end of the year. Do you expect to have to write any of that down?
No. There may be some limited exposure, but the build has been primarily in high volume items.
Lastly, I don't know if I missed it, but the $1.7 million other income in the quarter, did you talk about what that was?
Yes. $1.3 million of that, Steve, was related to a gain in foreign currency transaction adjustments.
All right, great. Thank you.
Our next question comes from Jeremy Hamblin with Dougherty & Company. You may proceed.
Thanks for taking the questions and congrats on the momentum in the business. I wanted to just get a little more involved with your international side of your business. I think you had indicated that was $13.4 million in this quarter. Not seen as quite as much of a step up maybe in that as we had expected as a total mix of your business. Rick, or Luke, can you give us a sense of where you expect that international mix of business to flow in the second half of the year, and then really as we start to get into 2018? We sense that you're maybe on the cusp of some nice international wins, could you speak more to that?
This is Rick. Let me take that one. We don't give specific guidance, particularly on these international deals. They tend to be large. I can tell you we have some very large deals in the pipeline, it's hard to tell whether they'll close in the second half of this year or into 2018. I would say, overall, over the next 18-month horizon, we do expect international to be a growing contributor as a percentage.
Is that something where you think the international mix could be over 20%, though, by the back half of 2018?
It's certainly within the realm of possibility. Again, a lot of it's going to just depend on some of these larger deals.
Okay. In terms of some of the geographies you're looking at, without getting specific, historically, you've been doing pretty well with the English-speaking countries. I know a big push has been to progress around that to some of the non-English speaking countries. What kind of progress now with a new sales office in Europe opened up, what kind of progress are you making there?
Yeah, I think we're feeling really good. We've got a solid team in most of the major continental European countries now, and we're engaged in meaningful customer conversations across pretty much all the major European countries at this point. We've also been expanding our presence in Australasia. We've started to add some staff, not only in Australia, but up in Asia, and we'll continue to make a few more investments there. We've also added some salespeople in Africa. I think we're really sort of getting it dialed in. A few years ago, we really started to follow some of what we learned in the U.S., which was that particularly for the software and sensor business, that we really had to have direct salespeople engaging with the customer because these are fairly sophisticated sales that are really kind of hard to accomplish through third parties.
We've seen that result play out in U.K., in Australia. We've followed that same model, and I think we're seeing all the same early indicators of success happening now in continental Europe. We're I'd say even a little earlier in the process in some of the other Asian countries and in Africa. We're seeing a lot of the same sort of patterns that we saw early in the English-speaking countries, and we really have begun to internationalize both the product and the marketing. We feel really good about those investments long term.
Okay, great. I want to come back to just the margin question and getting an understanding of the guidance that I think had been put out there. Wanted to confirm, by Q4 was it? Was that when you're expecting gross margins in the 75% range in weapons and then back to 25% margins on sensors and software? Did I hear that correctly?
Jawad, over to you. I believe that 75% was referenced to. Well, anyway, Jawad, you got it.
Sorry. The 75% was for the service margins within the software and sensors segment, the 25% was on the hardware margins in that segment.
Sorry. Okay, great. Then just thinking about the hardware, in terms of giving us some confidence of working off that inventory, should we have the sense that by the end of this year that that is fully resolved, or is there still going to be some lingering issue heading into 2018?
Yes. This is a big focal point for me and for the leadership team, we expect to have that resolved completely by the end of the year.
Okay. Thanks for taking my questions. Good luck.
Thank you.
Our next question comes from George Godfrey with C.L. King. You may proceed.
Thank you. Thank you for taking my question. Rick, could you give us a number of how many free cameras are out actively in the field right now?
I don't think we've disclosed that. I don't think for strategic reasons that we're planning to disclose that at this point.
Okay. I think you said some of them have moved right to procurement to go to a fixed model right after getting it. Did I hear that right?
What we're seeing happen, so part of the reason for the inventory buildup was when we announced this program, we wanted to make sure we had sufficient inventory on hand to be able to fulfill on it. What we have found is that the program was extremely successful from a public messaging standpoint. Remember, we bundled this together with the name change of the company, and it literally drove, I think, over 500 independent news articles that really helped get the message out about the name change, and it really drove a lot of customer conversations. However, what we've seen is that customers, once they engage, in many cases, it's as much work for them to do a free trial, field trial, as it is to go ahead and move into a procurement process.
In many cases, it's actually less total work for them, maybe over the long haul, to just move into the procurement process rather than having a separate trial and then doing procurement later. We have seen a good number of agencies that reached out to us as part of the field trial process, and then I think they put it into their more standard procurement business process, which is great news. The other thing that's caused us to draw down our expectation for inventory needed for this program is that the larger agencies that are looking at the field trials are typically saying that they want to do a trial with a subset of officers, not necessarily take cameras for every officer in the agency. Again, our offer was compelling, and then it got their attention and they've engaged.
The net expense of the field trials are going to be significantly lower since they're testing with subsets. The main thing for us is we just want to get them into field trials or at least into in-depth procurement discussions. In that respect, it's really working quite well. We do have some additional large agencies that had gone with competing solutions that are back at the table, because of the field trial offer.
Are you constrained, either resource-constrained, human capital, cameras, or infrastructure to meet both the free demand as well as the paid demand?
On the body cameras, no. I would say on the fleet cameras that we're rolling out, some of the constraints around our ability to scale fleet are that there is more installation, and that's a new product. That portion of the business, we are making, and that's part of the other reason for some of the expense build-up is to support the installation and customer support infrastructure for fleet. The body cameras, we have all that infrastructure in place, so there just shouldn't be any operating limitations to support the field trials and the ongoing business.
My last question on the artificial intelligence side, have any police departments come to you and asked you to embed facial recognition software capabilities in the camera? If so, would that require a new camera or a significant upgrade to the platform, or can that be an add-on feature to the installed base? I'll leave it there. Thank you very much.
Great question. There certainly is interest in artificial intelligence for facial recognition. As we talked about earlier, we believe that's a very sensitive subject with the general public, and it's one where both we and our customers need to move carefully to make sure that we're doing this in a way that sort of respects privacy laws and general privacy rights in this country. That's an issue. We're in the late stages of forming an advisory panel on those ethics and privacy laws. The other piece I would tell you is while facial recognition technology is very promising, it's a bit early, we believe, to be putting it out in cameras for real-time identification.
Just the net error rates in facial recognition, even best-in-the-world cases, are still not at the level of reliability where you'd want to be feeding officers information on which they may make life-and-death decisions in the field. As we look at this technology, there's certainly customer interest. There's issues we have to navigate around the legal and ethics to make sure we get it right. There's also making sure that we get to the right points of maturity of the technology. At this point, it's not a limitation of the cameras per se. We have 1080p high-definition recording capabilities. That's plenty of resolution, at least relative to the types of facial recognition technology that are out there today.
We've seen that there are less controversial, more mature, and more high-value services that we can offer to our customers using AI that don't carry some of the risks and baggage of facial recognition at this point in time. Our team is really focused on some of those other areas at this point. We do have facial recognition as something that we're monitoring, given all those other factors, to find when the right product mix and timing would be.
Great. Thank you very much.
Our next question comes from Saliq Khan with Imperial Capital. You may proceed.
Hi, guys. Hi, Rick.
Hey, Rick. You noted on roughly 1,500 customers for the trial program. How many of those trial customers are in the region which Axon was not in previously?
I don't necessarily have a good read on that. I would say in terms of regions, we're in all over the country. We have thousands of customers. We have 95% of U.S. law enforcement agencies using Taser weapons, so in that respect, we're pretty ubiquitous. The Axon camera and evidence.com, we have customers in every region of the country. I'd say, I don't know that there were necessarily new regions where we didn't have a presence. We are seeing it sort of accelerate the conversation, though, particularly in agencies that may be in the Northeast, where the Northeast has been perhaps a little slower in some cases to adopt the body camera technology.
In that respect, I'd say it probably has helped pick up, I've had some personal conversations with some large agencies in the Northeast that had previously expressed specific disinterest in body cameras that are now finding it worthy of some exploration.
Perfect. Guys, just one other question that I have on my end, which is, now that you're more than halfway through the overall year, what is your outlook on the % of the trial users that could potentially become paying customers?
At this point, I would say we're only about a quarter into these trials, what's interesting, the smaller agencies are the ones who tend to make decisions relatively quickly. It's those smaller agencies where we're seeing, I would say, a significant portion of those, once they engage in a conversation, are moving really more in towards a procurement than an extended trial. The larger agencies tend to move slower in general. A lot of the larger agencies are still gearing up for how they would do these trials.
It's a bit of a barbell curve where the smaller guys are moving pretty quick and the bigger guys are sort of still getting moving, because for them, the limitation is less about the actual funding of the program, and it's more about the logistics and staffing and just sort of getting the program moving through a larger agency.
Yeah. Rick addressed the timing on that. I would just comment on what we believe the percentage of customers that convert after trials is very high. We haven't lost a single agency where they've trialed over 100 cameras, we feel very confident when customers are trialing our product. Our head of sales likes to say, our competitor's worst nightmare is a well-informed customer, we feel really good about these trial programs and expect a high conversion rate.
I know you guys talked about this previously, the bureaucratic process that is a part of this overall program of yours as well, has that been some sort of a hindrance to you and your ability to penetrate the marketplace? Is there a way for you to be able to work around this or work with the agencies to continue to deepen the penetration level?
No, absolutely. You've hit the nail on the head. I would say it's been a number of years since the Ferguson, Missouri incident, when we look at the penetration of body cameras in American policing, a lot of people say, "Well, what's the main obstacle?" It really is just inertia. It's getting these processes moving within these larger agencies. It just takes time, you've got to identify advocates, you're competing with other priorities. In that respect, the National Field Trial at least is having the intended effect of where it's getting us higher on their priority list as it's creating a rationale for why they need to do this sooner than later, that there's this opportunity over the course of the next year for them to have a no-charge field trial. It's helping, I would say that still remains the number one.
Our number one competitor is really inertia.
Got it. Thank you, guys.
Thank you. Great questions.
Our final question comes from Allen Klee with Sidoti & Company. You may begin, sir.
Hi. In the Axon segment, I'm sorry, you have a new name for it now. The product and service gross margins going to 25% and 75% in the fourth quarter. How do you think about how that can improve in 2018?
Excluding non-recurring items, we would've been at $4.3 million of profit or 50% higher. We still feel, for the long term, the guidance that we've given for that segment is 20% margins, which we feel is conservative. Without giving specific guidance, we do feel that there is considerable upside.
For the tax rate for the quarter, can you explain, it came in lower than I had modeled, and is there any reason why I should think that we should be using a lower tax rate going forward?
Again, this is very similar to the same phenomenon we experienced in the first quarter versus the change in the stock-based compensation that drove some favorability in Q1 of the previous year. We saw a benefit in the quarter of $400,000. As stock pricing increases, you're going to see favorability. We may continue to see some favorability, but at this point, we expect that our tax rate for the year normalized will be approximately 40%.
Maybe just a last question, bigger picture. I know you're spending to increase your total addressable market, but how do you think about balancing that with when you're going to get operating leverage to basically see the growth in the bottom line numbers? Is there any sense that needs to happen in a certain period of time or whatever color you can provide? Thank you.
My perspective here is that there's built a great momentum in the business, and [Rick and get us] long-term model. What I don't want to do is step on this great momentum. I think we should continue to invest in capitalizing the great momentum that we're building. I wouldn't put a horizon on when we would expect to see the margins improve. What we do know is that longer term, we're building a very profitable, sustainable, software-intensive business to go with our profitable hardware business. Put a horizon on it, obviously, that's something that we're very mindful of, that we want to do this in a way that's accretive.
Thank you.
That concludes our Q&A session for today. I will now turn the call back over to Mr. Smith to close remarks . Sir, you may begin.
Great. Thank you. Hey, everybody. We appreciate you spending time with us here today. Again, really excited at the momentum in the business. I'd like to reiterate George's comments at the end. We are looking at the long-term profitability of all the investments that we're making, and we believe the investments around fleet, artificial intelligence, RMS, and international, that each one of those can create highly profitable revenue flows that are comparable in scale to our existing digital evidence management and body camera business. When you look at it that way, the investments that we're making really are to build out sort of four revenue streams, all comparable to the revenue stream where we're already showing the significant momentum and growth.
When you view it through that lens, you'll understand, not only are these additional revenue streams, all of them help make the ecosystem more defensible, more valuable. Like you pointed out, some of the win backs we made this quarter were because we have the new in-car capability, that capability is helping us win body camera deals as well. Each of these capabilities are being built in a way where they are making our current solutions more valuable, increasing our win rate, increasing the net value to our customers, and frankly, the stickiness of the product and ecosystem long term. We're obviously very excited to see the growth continue and us begin to really see some of the international markets start to kick in in a more material way.
With that, we're going to thank you for joining us, and we look forward to joining you in another three months for our conference call results on the third quarter. Everybody, have a great day.
Ladies and gentlemen, thank you for attending today's conference. This does conclude the program. You may all disconnect. Everyone, have a great day.