Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A")

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A")

Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is designed to provide a reader of our consolidated financial statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A should be read in conjunction with the other sections of this Annual Report on Form 10-K, including Part I, Item 1A: “Risk Factors”; Part II, Item 6: “Selected Financial Data”; and Part II, Item 8: “Financial Statements and Supplementary Data.” The various sections of this MD&A contain a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this filing. The tables in the MD&A sections below are derived from exact numbers and may have immaterial rounding differences.

Overview

Axon is a market-leading provider of law enforcement technology solutions. Our core mission is to protect life. We fulfill that mission through developing hardware and software products that advance the long term objectives of a) obsoleting the bullet, b) reducing social conflict, and c) enabling a fair and effective justice system.

2019 Outlook

For the year ending December 31, 2019, we expect revenue of $480 million to $490 million. We expect a normalized income tax rate of between 20% and 25%; this rate can fluctuate depending on geography of income and the effects of discrete items, including changes in our stock price.

Results of Operations

The following table presents data from our consolidated statements of operations as well as the percentage relationship to total net sales of items included in our statements of operations (dollars in thousands):



	Year Ended December 31,
	2018					2017 (1)				2016 (1)
Net sales from products	$	327,635		78.0	%	$	285,859	83.1	%	$	238,573		88.9	%
Net sales from services	92,433			22.0	%	57,939		16.9	%	29,672			11.1	%
Net sales	420,068			100.0	%	343,798		100.0	%	268,245			100.0	%
Cost of product sales	139,337			33.2	%	117,997		34.3	%	91,536			34.1	%
Cost of service sales	22,148			5.3	%	18,713		5.5	%	6,173			2.3	%
Cost of sales	161,485			38.5	%	136,710		39.8	%	97,709			36.4	%
Gross margin	258,583			61.5	%	207,088		60.2	%	170,536			63.6	%
Operating expenses:
Sales, general and administrative	156,886			37.3	%	138,692		40.3	%	108,076			40.3	%
Research and development	76,856			18.3	%	55,373		16.1	%	30,609			11.4	%
Total operating expenses	233,742			55.6	%	194,065		56.4	%	138,685			51.7	%
Income from operations	24,841			5.9	%	13,023		3.8	%	31,851			11.9	%
Interest and other income (expense), net	3,263			0.8	%	2,738		0.8	%	(354		)	(0.1	)%
Income before provision for income taxes	28,104			6.7	%	15,761		4.6	%	31,497			11.7	%
Provision (benefit) for income taxes	(1,101		)	(0.3	)%	10,554		3.1	%	14,200			5.3	%
Net income	$	29,205		7.0	%	$	5,207	1.5	%	$	17,297		6.4	%

Net sales to the U.S. and other countries are summarized as follows (dollars in thousands):



	Year Ended December 31,
	2018				2017 (1)				2016 (1)
United States	$	335,310	79.8	%	$	282,810	82.3	%	$	218,757	81.6	%
Other Countries	84,758		20.2	%	60,988		17.7	%	49,488		18.4	%
Total	$	420,068	100.0	%	$	343,798	100.0	%	$	268,245	100.0	%

(1) Amounts for the years ended December 31, 2017 and 2016 have not been adjusted under the modified retrospective method of adoption of Topic 606, and are presented consistent with the prior period amounts reported under ASC 605.

International revenue grew 39.0% from 2017 to 2018, driven by increased sales in Australia, France, Singapore and the U.K.

Our operations are comprised of two reportable segments: the manufacture and sale of CEWs, batteries, accessories and extended warranties and other products and services (collectively, the “TASER” segment); and the development, manufacture, and sale of software and sensors, which includes the sale of devices, wearables, applications, cloud and mobile products (collectively, the "Software and Sensors" segment). Within the Software and Sensors segment, we specify sales of products and services. Revenue from our “products” in the Software and Sensors segment are generally from sales of sensors, including on-officer body cameras, Axon Fleet cameras, other hardware sensors, warranties on sensors, and other products, and is sometimes referred to as "Sensors and Other revenue." Revenue from our “services” in the Software and Sensors segment comprise sales related to the Axon Cloud, which includes Axon Evidence, cloud-based evidence management software revenue, other recurring cloud-hosted software revenue and related professional services, and is sometimes referred to as "Axon Cloud revenue." Within the Software and Sensors segment, we include only revenues and costs attributable to that segment which costs include: costs of sales for both products and services, direct labor, selling expenses for the sales team, product management and R&D for products included, or to be included, within the Software and Sensors segment. All other costs are included in the TASER segment.

For the Years Ended December 31, 2018 and 2017

Net Sales

Net sales by product line were as follows for the years ended December 31, 2018 and 2017 (dollars in thousands):



	Year Ended December 31,								Dollar Change			Percent Change
	2018				2017 (1)
TASER segment:
TASER 7	$	7,358	1.8	%	$	—	—	%	$	7,358		*
TASER X26P	70,638		16.8	%	64,426		18.7	%	6,212			9.6	%
TASER X2	78,837		18.8	%	81,417		23.7	%	(2,580		)	(3.2	)%
TASER Pulse and Bolt	5,182		1.2	%	4,340		1.3	%	842			19.4	%
Cartridges	68,258		16.3	%	63,203		18.4	%	5,055			8.0	%
Extended warranties	15,753		3.8	%	12,426		3.6	%	3,327			26.8	%
Other	7,089		1.7	%	8,700		2.5	%	(1,611		)	(18.5	)%
TASER segment	253,115		60.4	%	234,512		68.2	%	18,603			7.9	%
Software and Sensors segment:
Axon Body	21,883		5.2	%	15,184		4.4	%	6,699			44.1	%
Axon Flex	6,509		1.5	%	10,083		2.9	%	(3,574		)	(35.4	)%
Axon Fleet	12,527		3.0	%	2,954		0.9	%	9,573			324.1	%
Axon Dock	10,706		2.5	%	9,736		2.8	%	970			10.0	%
Axon Evidence and cloud services	90,291		21.5	%	57,841		16.8	%	32,450			56.1	%
TASER Cam	3,871		0.9	%	3,358		1.0	%	513			15.3	%
Extended warranties	11,860		2.8	%	7,110		2.1	%	4,750			66.8	%
Other	9,306		2.2	%	3,020		0.9	%	6,286			208.1	%
Software and Sensors segment	166,953		39.6	%	109,286		31.8	%	57,667			52.8	%
Total net sales	$	420,068	100.0	%	$	343,798	100.0	%	$	76,270		22.2	%

Not meaningful

(1) Amounts for the year ended December 31, 2017 have not been adjusted under the modified retrospective method of adoption of Topic 606, and are presented consistent with the prior period amounts reported under ASC 605.

Net unit sales were as follows:



	Year Ended December 31,
	2018	2017	Unit Change		Percent Change
TASER 7	5,759	—	5,759		*
TASER X26P	71,823	70,381	1,442		2.0	%
TASER X2	65,855	76,106	(10,251	)	(13.5	)%
TASER Pulse and Bolt	18,398	12,504	5,894		47.1	%
Cartridges	2,342,897	2,408,471	(65,574	)	(2.7	)%
Axon Body	85,965	89,808	(3,843	)	(4.3	)%
Axon Flex	15,541	26,025	(10,484	)	(40.3	)%
Axon Fleet	9,445	3,795	5,650		148.9	%
Axon Dock	17,762	23,492	(5,730	)	(24.4	)%
TASER Cam	8,310	6,432	1,878		29.2	%

*Not meaningful

Net sales for the TASER segment increased $18.6 million, or 7.9%, primarily as a result of increased sales of TASER devices primarily attributable to increased sales under the Officer Safety Plan ("OSP") and TASER 60 installment payment programs, including sales of TASER 7 devices, which commenced during the three months ended December 31, 2018. Unit sales for law enforcement TASER devices decreased as compared to 2017 primarily as a result of the timing of the TASER 7 release and limited production of that device in 2018. We continue to see an increase in extended warranty revenue primarily as a result of the increased number of CEW devices in the field. Cartridge sales also increased compared to 2017 as an increase in the average sales price more than offset a slight decrease in unit sales. During the first quarter of 2017, the Home Office of the U.K. government approved our X2 devices for sale which resulted in increased sales within the U.K. of $6.4 million for the year ended December 31, 2018 compared to 2017.

Net sales for the Software and Sensors segment increased $57.7 million, or 52.8%, primarily due to continued adoption of on-officer cameras and related technologies, including our Axon Evidence digital evidence management software suite. Axon Evidence revenues increased $32.5 million, primarily driven by the continued increase in active users on the platform. Revenues related to Axon Fleet, which was introduced in the third quarter of 2017, increased $9.6 million. Combined net sales related to our Axon Body, Axon Flex, and Axon Dock products increased approximately $4.1 million as an increase in the average sales price more than offset the decrease in unit sales.

To gain more immediate feedback regarding activity for Axon camera products and Axon Evidence services, we also review bookings for these products. We consider bookings to be a statistical measure defined as the sales price of orders (not invoiced sales), including contractual optional periods we expect to be exercised, net of cancellations, placed in the relevant fiscal period, regardless of when the products or services ultimately will be provided. Most bookings will be invoiced in subsequent periods. Due to municipal government funding rules, in some cases certain of the future period amounts included in bookings are subject to budget appropriation or other contract cancellation clauses. Although we have entered into contracts for the delivery of products and services in the future and anticipate the contracts will be fulfilled, if agencies do not exercise contractual options, do not appropriate funds in future year budgets, or do enact a cancellation clause, revenue associated with these bookings may not ultimately be recognized, resulting in a future reduction to bookings. Bookings related to our Software and Sensors segment, net of cancellations, were $389.1 million during 2018, compared to $291.2 million in 2017, an increase of 33.6%.

The chart below illustrates our quarterly Software and Sensors bookings for each of the previous six fiscal quarters (in thousands):

Backlog - As of December 31, 2018 compared to December 31, 2017

Our backlog for products and services includes all orders that have been received and are believed to be firm.

In the TASER segment, we define backlog as equal to deferred revenue. Deferred revenue represents amounts invoiced to customers for goods and services to be delivered in subsequent periods. We process orders within the TASER segment quickly, and our best estimate of firm orders outstanding as of period end represents those that have been paid for but remain undelivered. The TASER segment backlog balance was $54.6 million as of December 31, 2018. We expect to realize $22.2 million of this deferred revenue balance as revenue during the next 12 months. This represents cash received and accounts receivable from customers on or prior to December 31, 2018 for products and services expected to be delivered in the next 12 months.

In the Software and Sensors segment, we define backlog as cumulative bookings, net of cancellations, less product and service revenue recognized to date. Bookings are generally realized as revenue over multiple years. The Software and Sensors backlog balance was $758.1 million as of December 31, 2018. This backlog balance includes $126.8 million of deferred revenue, and $631.3 million that has been recorded as bookings but not yet invoiced, all as of December 31, 2018. We expect to realize approximately $225.0 million of the December 31, 2018 backlog balance as revenue during the next 12 months.



	TASER		Software and Sensors		Total
	(in thousands)
Balance, beginning of period	$	46,685	$	536,016	$	582,701
Add: additions to backlog, net of cancellations	261,027		389,062		650,089
Less: revenue recognized during period	253,115		166,953		420,068
Balance end of period	$	54,597	$	758,125	$	812,722

Our backlog of $812.7 million as of December 31, 2018 has increased significantly from $582.7 million as of December 31, 2017. The increase in TASER segment backlog is not expected to have a material impact on revenue or operating margins. Our significant increase in backlog, primarily in the Software and Sensors segment is indicative of expected revenue growth in this segment. Revenue growth in the Software and Sensors segment is expected to result in improved operating margins over time as additional revenue will cover a larger portion of our selling, general and

administrative expenses, and research and development costs, while we do not expect any material changes in gross margins.

Cost of Product and Service Sales (dollars in thousands):



	Year Ended December 31,								Dollar Change		Percent Change
	2018				2017 (1)
TASER segment:
Cost of product sales	$	80,354	31.7	%	$	72,054	30.7	%	$	8,300	11.5	%
Software and Sensors segment:
Cost of product sales	58,983		35.3	%	45,943		42.0	%	13,040		28.4	%
Cost of service sales	22,148		13.3	%	18,713		17.1	%	3,435		18.4	%
Total cost of sales	81,131		48.6	%	64,656		59.2	%	16,475		25.5	%
Total cost of product and service sales	$	161,485	38.4	%	$	136,710	39.8	%	$	24,775	18.1	%

Within the TASER segment, cost of product sales increased $8.3 million, or 11.5%, to $80.4 million in 2018, compared to $72.1 million in 2017, and increased as a percentage of sales to 31.7% from 30.7%. We did not experience significant changes in variable manufacturing costs during the year ended December 31, 2018 as compared to 2017. The overall increase in cost of product sales was attributable to higher unit sales. The increase in cost of product sales as a percentage of sales was primarily attributable to initial production costs for the TASER 7 device.

Within the Software and Sensors segment, cost of product and service sales was $81.1 million, an increase of $16.5 million, or 25.5%, from 2017. As a percentage of net sales, cost of product and service sales decreased to 48.6% in 2018 from 59.2% in 2017. The increase in cost of product sales was primarily attributable to higher sales volumes, and the increase in cost of service sales was driven by increased cloud storage costs. The decrease in total cost of sales as a percentage of total net sales was primarily due to the reduction of non-recurring expenses related to our data migration to our new cloud-storage provider that was completed in 2018, as well as increased leveraging of fixed costs related to cloud-storage.

Gross Margin (dollars in thousands):



	Year Ended December 31,
							Dollar Change		Percent Change
	2018			2017 (1)
TASER segment	$	172,761		$	162,458		$	10,303	6.3	%
Software and Sensors segment	85,822			44,630			41,192		92.3	%
Total gross margin	$	258,583		$	207,088		$	51,495	24.9	%
Gross margin as % of net sales	61.6		%	60.2		%

Gross margin increased $51.5 million to $258.6 million for the year ended December 31, 2018 compared to $207.1 million for 2017. As a percentage of net sales, gross margin increased to 61.6% for 2018 from 60.2% for 2017. As a percentage of net sales, gross margin for the TASER segment decreased slightly to 68.3% for the year ended December 31, 2018 from 69.3% for the year ended December 31, 2017. Within the Software and Sensors segment, gross margin as a percentage of net sales was 51.4% and 40.8% for the years ended 2018 and 2017, respectively. Within the Software and Sensors segment, hardware gross margin was 20.8% for the year ended December 31, 2018 and 10.5%

for the same period in 2017, while the service margins were 76.0% and 67.7% during those same periods, respectively. The increase in hardware gross margins during 2018 was primarily attributable to accounting changes required under the new revenue accounting standard. Previously, the level of discounting in our contracts resulted in a portion of the contractual consideration allocated to the delivered hardware being recognized as revenue ratably over the Axon Evidence subscription term, while the full cost of the product was recognized when the hardware was delivered to the customer resulting in lower gross margins initially. Under the new revenue accounting standard, generally the full amount of revenue related to the delivered hardware is recognized in the period in which it is delivered, resulting in better matching of the revenues and related costs. The increase in service margins during the year ended December 31, 2018 as compared to 2017 was attributable to the reduction of non-recurring expenses related to our data migration to our new cloud-storage provider that was completed in 2018, as well as increased leveraging of fixed costs related to cloud-storage.

Sales, General and Administrative ("SG&A") Expenses (dollars in thousands):



	Year Ended December 31,						Dollar Change			Percent Change
	2018			2017 (1)
Salaries, benefits and bonus	$	63,185		$	58,450		$	4,735		8.1	%
Stock-based compensation	12,710			9,047			3,663			40.5	%
Professional, consulting and lobbying	24,469			24,267			202			0.8	%
Sales and marketing	19,427			17,368			2,059			11.9	%
Travel and meals	9,908			10,637			(729		)	(6.9	)%
Depreciation and amortization	6,051			3,517			2,534			72.1	%
Other	21,136			15,406			5,730			37.2	%
Total sales, general and administrative expenses	$	156,886		$	138,692		$	18,194		13.1	%
Sales, general, and administrative as a percentage of net sales	37.3		%	40.3		%

SG&A by type and by segment were as follows for the years ended December 31, 2018 and 2017 (dollars in thousands):



	Year Ended December 31,								Dollar Change			Percent Change
	2018				2017 (1)
TASER segment:
Salaries, benefits and bonus	$	35,024	22.3	%	$	32,009	23.1	%	$	3,015		9.4	%
Stock-based compensation	11,178		7.1	%	6,115		4.4	%	5,063			82.8	%
Professional, consulting and lobbying	14,861		9.5	%	12,017		8.7	%	2,844			23.7	%
Sales and marketing	7,535		4.8	%	8,357		6.0	%	(822		)	(9.8	)%
Travel and meals	4,765		3.0	%	4,867		3.5	%	(102		)	(2.1	)%
Depreciation and amortization	2,945		1.9	%	607		0.4	%	2,338			385.2	%
Other	14,602		9.3	%	14,230		10.3	%	372			2.6	%
TASER segment	90,910		57.9	%	78,202		56.4	%	12,708			16.3	%
Software and Sensors segment:
Salaries, benefits and bonus	28,161		17.9	%	26,441		19.1	%	1,720			6.5	%
Stock-based compensation	1,532		1.0	%	2,932		2.1	%	(1,400		)	(47.7	)%
Professional, consulting and lobbying	9,608		6.1	%	12,250		8.8	%	(2,642		)	(21.6	)%
Sales and marketing	11,892		7.6	%	9,011		6.5	%	2,881			32.0	%
Travel and meals	5,143		3.3	%	5,770		4.2	%	(627		)	(10.9	)%
Depreciation and amortization	3,106		2.0	%	2,910		2.1	%	196			6.7	%
Other	6,534		4.2	%	1,176		0.8	%	5,358			455.6	%
Software and Sensors segment	65,976		42.1	%	60,490		43.6	%	5,486			9.1	%
Total sales, general and administrative expenses	$	156,886	100.0	%	$	138,692	100.0	%	$	18,194		13.1	%

(1) Amounts related to commissions expense for the year ended December 31, 2017 have not been adjusted under the modified retrospective method of adoption of Topic 606, and are presented consistent with the prior period amounts reported under ASC 605.

Within the TASER segment, SG&A increased $12.7 million, or 16.3%. Of the increase, $8.1 million related to higher salaries, benefits, bonus and stock-based compensation related primarily to sales and marketing, professional staff and general support staff, including $3.3 million of stock-based compensation expense related to the CEO Performance Award. Refer to Note 12 of the notes to our consolidated financial statements within this Annual Report on Form 10-K for additional discussion of the CEO Performance Award. Additionally, professional, consulting and lobbying expenses increased $2.8 million primarily related to increased legal fees, and depreciation and amortization expenses increased $2.3 million related to the expansion of our facilities and amortization of additional intangible assets over the past year.

Within the Software and Sensors segment, SG&A increased $5.5 million, or 9.1%, but decreased to 39.5% of sales as compared to 55.4% in the prior year. Commissions increased $2.3 million on higher sales, and salaries, benefits and bonus increased $1.7 million for additional headcount. Additionally, during 2018, we abandoned certain developed technology acquired in a business combination resulting in an impairment charge of approximately $2.0 million, which is included in the "Other" category. The remaining increases were primarily attributable to the overall growth of operations during 2018. Partially offsetting the increases was a $2.6 million decrease in professional, consulting and lobbying expense as spending normalized compared to the prior year.

Research and Development ("R&D") Expenses (dollars in thousands):



	Year Ended December 31,						Dollar Change			Percent Change
	2018			2017
Salaries, benefits and bonus	$	49,792		$	33,682		$	16,110		47.8	%
Stock-based compensation	8,658			6,055			2,603			43.0	%
Professional and consulting	4,183			4,351			(168		)	(3.9	)%
Travel and meals	2,192			1,674			518			30.9	%
Other	12,031			9,611			2,420			25.2	%
Total research and development expenses	$	76,856		$	55,373		$	21,483		38.8	%
Research and development as a percentage of net sales	18.3		%	16.1		%

R&D by type and by segment were as follows for the years ended December 31, 2018 and 2017 (dollars in thousands):



	Year Ended December 31,								Dollar Change			Percent Change
	2018				2017
TASER segment:
Salaries, benefits and bonus	$	9,174	11.9	%	$	4,243	7.7	%	$	4,931		116.2	%
Stock-based compensation	1,594		2.1	%	517		0.9	%	1,077			208.3	%
Professional and consulting	1,192		1.6	%	1,098		2.0	%	94			8.6	%
Travel and meals	511		0.7	%	388		0.7	%	123			31.7	%
Other	4,541		5.9	%	2,131		3.8	%	2,410			113.1	%
TASER segment	17,012		22.2	%	8,377		15.1	%	8,635			103.1	%
Software and Sensors segment:
Salaries, benefits and bonus	40,618		52.8	%	29,439		53.2	%	11,179			38.0	%
Stock-based compensation	7,064		9.2	%	5,538		10.0	%	1,526			27.6	%
Professional and consulting	2,991		3.9	%	3,253		5.9	%	(262		)	(8.1	)%
Travel and meals	1,681		2.2	%	1,286		2.3	%	395			30.7	%
Other	7,490		9.7	%	7,480		13.5	%	10			0.1	%
Software and Sensors segment	59,844		77.8	%	46,996		84.9	%	12,848			27.3	%
Total research and development expenses	$	76,856	100.0	%	$	55,373	100.0	%	$	21,483		38.8	%

Within the TASER segment, R&D expenses increased $8.6 million or 103.1%. Salaries, benefits, bonus and stock-based compensation in the TASER segment increased $6.0 million in 2018 compared to 2017 as we continue to invest in personnel allocated to the development of new CEW related technologies. Additionally, test build materials included in the "Other" category were higher than the prior year primarily related to the launch of the TASER 7 device.

Our Software and Sensors segment was responsible for 59.8% of the overall increase in R&D expense. Within this segment, R&D expenses increased $12.8 million or 27.3%, but decreased to 35.8% of sales as compared to 43.0% in the prior year. Of the increase, $12.7 million related to salaries, benefits, bonus, and stock-based compensation. Partially offsetting the increase was a $1.0 million decrease in impairment expense as compared to 2017; during 2017, we abandoned certain developed technology acquired in a business combination.

We expect R&D expense to continue to increase in absolute dollars as we invest in the deployment of new CEW technologies and focus on growing the Software and Sensors segment as we add headcount and additional resources to develop new products and services to further advance our scalable cloud-connected device platform. We believe that these investments will result in an increase in our subscription revenue base, which over time will result in revenue increasing faster than the increase in SG&A expenses and R&D costs, as we reach economies of scale.

Interest and Other Income (Expense), Net

Interest and other income (expense), net was $3.3 million and $2.7 million for the years ended December 31, 2018 and 2017, respectively.

For the year ended December 31, 2018, we earned interest income of $4.4 million and had losses from foreign currency transaction adjustments of $1.1 million and interest expense of $0.1 million. For the year ended December 31, 2017, we earned interest income of $1.6 million and had gains from foreign currency transaction adjustments of $1.4 million which were partially offset by interest expense of $0.2 million.

Provision for Income Taxes

The income tax benefit was $1.1 million for the year ended December 31, 2018. The effective income tax rate for 2018 was (3.9%). The benefits related to excess stock-based compensation of $8.9 million and research and development credits of $6.9 million were partially offset by the tax effects of permanently non-deductible expenses for executive compensation of $1.2 million, an increase in uncertain tax benefits of $1.8 million and return to provision adjustments of $1.8 million. Additionally, we recorded a $2.0 million increase to our valuation allowance as of December 31, 2018 related to research and development tax credits that may not be utilized prior to expiration, partially offset by changes in certain foreign jurisdictions.

The provision for income taxes was $10.6 million for the year ended December 31, 2017. The effective income tax rate for 2017 was 66.9%. In connection with our initial analysis of the impact of the Tax Act, we were able to make reasonable estimates of the impact of the Tax Act and recorded a provisional net tax expense of $8.0 million in the period ended December 31, 2017, primarily related to the impact of the tax rate reduction on our deferred tax assets and deferred tax liabilities. This was partially offset by a $1.8 million benefit related to excess stock-based compensation deductions, as well as a $2.4 million benefit for research and development credits during the year ended December 31, 2017. An additional valuation allowance in the amount of $1.9 million was recorded as of December 31, 2017, related to certain research and development credits that may not be utilized prior to expiration and losses in certain foreign jurisdictions in which there was a cumulative loss.

Net Income

Our net income increased by $24.0 million to $29.2 million for the year ended December 31, 2018 compared to $5.2 million in 2017. Net income per basic and diluted share was $0.52 and $0.50, respectively, for 2018 compared to $0.10 per basic and diluted share for 2017.

Three Months Ended December 31, 2018 Compared to September 30, 2018

Net sales by product line were as follows (dollars in thousands):



	Three Months Ended December 31, 2018				Three Months Ended September 30, 2018				Dollar Change			Percent Change
TASER segment:
TASER 7	$	7,358	6.4	%	$	—	—	%	$	7,358		*
TASER X26P	18,020		15.7	%	17,998		17.2	%	22			0.1	%
TASER X2	16,151		14.1	%	20,392		19.4	%	(4,241		)	(20.8	)%
TASER Pulse and Bolt	1,333		1.2	%	1,402		1.3	%	(69		)	(4.9	)%
Cartridges	16,495		14.4	%	18,406		17.6	%	(1,911		)	(10.4	)%
Extended warranties	4,186		3.6	%	4,123		3.9	%	63			1.5	%
Other	1,758		1.5	%	1,345		1.3	%	413			30.7	%
TASER segment	65,301		56.9	%	63,666		60.7	%	1,635			2.6	%
Software and Sensors segment:
Axon Body	6,801		5.9	%	4,744		4.5	%	2,057			43.4	%
Axon Flex	1,980		1.7	%	1,325		1.3	%	655			49.4	%
Axon Fleet	5,887		5.1	%	1,809		1.7	%	4,078			225.4	%
Axon Dock	3,374		3.0	%	2,178		2.1	%	1,196			54.9	%
Axon Evidence and cloud services	25,778		22.5	%	23,915		22.8	%	1,863			7.8	%
TASER Cam	1,032		0.9	%	717		0.7	%	315			43.9	%
Extended warranties	3,339		2.9	%	3,161		3.0	%	178			5.6	%
Other	1,299		1.1	%	3,321		3.2	%	(2,022		)	(60.9	)%
Software and Sensors segment	49,490		43.1	%	41,170		39.3	%	8,320			20.2	%
Total net sales	$	114,791	100.0	%	$	104,836	100.0	%	$	9,955		9.5	%

*Not meaningful

Net unit sales were as follows:



	Three Months Ended
	December 31, 2018	September 30, 2018	Unit Change		Percent Change
TASER 7	5,759	—	5,759		*
TASER X26P	18,597	18,842	(245	)	(1.3	)%
TASER X2	13,088	16,729	(3,641	)	(21.8	)%
TASER Pulse and Bolt	7,490	3,750	3,740		99.7	%
Cartridges	600,690	598,119	2,571		0.4	%
Axon Body	26,167	17,622	8,545		48.5	%
Axon Flex	5,080	3,487	1,593		45.7	%
Axon Fleet	3,908	1,601	2,307		144.1	%
Axon Dock	3,859	3,525	334		9.5	%
TASER Cam	1,952	1,339	613		45.8	%

*Not meaningful

Net sales for the TASER segment increased $1.6 million, or 2.6%, on a sequential basis primarily due to an overall increase in TASER device handles, including initial sales of TASER 7. This increase was partially offset by lower sequential cartridge revenue, which was primarily attributable to timing.

Net sales for the Software and Sensors segment increased $8.3 million, or 20.2%, on a sequential basis. Axon Fleet contributed $4.1 million of the increase, driven by an increase in both units and average sales price following the release of the Fleet 2 device. Combined net sales related to our Axon Body, Axon Flex, and Axon Dock products contributed an additional increase of $3.9 million, primarily due to an increase in units. Axon Evidence revenues increased $1.9 million driven by the continued increase in active users on the platform. The increases were partially offset by a decrease in other revenue.

International sales were $24.3 million in for the three months ended December 31, 2018 compared to $16.7 million for the three months ended September 30, 2018, an increase of $7.6 million, driven by increased sales from Australia and Canada.

For the Years Ended December 31, 2017 and 2016

Net Sales

Net sales by product line were as follows for the years ended December 31, 2017 and 2016 (dollars in thousands):



	Year Ended December 31,								Dollar Change			Percent Change
	2017 (1)				2016 (1)
TASER segment:
TASER X26P	$	64,426	18.7	%	$	72,490	27.0	%	$	(8,064	)	(11.1	)%
TASER X2	81,417		23.7	%	52,665		19.6	%	28,752			54.6	%
TASER Pulse and Bolt	4,340		1.3	%	3,580		1.3	%	760			21.2	%
Cartridges	63,203		18.4	%	52,305		19.5	%	10,898			20.8	%
Extended warranties	12,426		3.6	%	9,880		3.7	%	2,546			25.8	%
Other	8,700		2.5	%	11,724		4.4	%	(3,024		)	(25.8	)%
TASER segment	234,512		68.2	%	202,644		75.5	%	31,868			15.7	%
Software and Sensors segment:
Axon Body	15,184		4.4	%	12,911		4.8	%	2,273			17.6	%
Axon Flex	10,083		2.9	%	5,323		2.0	%	4,760			89.4	%
Axon Fleet	2,954		0.9	%	—		—	%	2,954			*
Axon Dock	9,736		2.8	%	7,422		2.8	%	2,314			31.2	%
Axon Evidence and cloud services	57,841		16.8	%	29,260		10.9	%	28,581			97.7	%
TASER Cam	3,358		1.0	%	4,888		1.8	%	(1,530		)	(31.3	)%
Extended warranties	7,110		2.1	%	3,710		1.4	%	3,400			91.6	%
Other	3,020		0.9	%	2,087		0.8	%	933			44.7	%
Software and Sensors segment	109,286		31.8	%	65,601		24.5	%	43,685			66.6	%
Total net sales	$	343,798	100.0	%	$	268,245	100.0	%	$	75,553		28.2	%

Net unit sales were as follows:



	Year Ended December 31,
	2017	2016	Unit Change		Percent Change
TASER X26P	70,381	79,218	(8,837	)	(11.2	)%
TASER X2	76,106	47,700	28,406		59.6	%
TASER Pulse and Bolt	12,504	9,549	2,955		30.9	%
Cartridges	2,408,471	1,979,051	429,420		21.7	%
Axon Body	89,808	66,154	23,654		35.8	%
Axon Flex	26,025	14,173	11,852		83.6	%
Axon Fleet	3,795	—	3,795		*
Axon Dock	23,492	16,983	6,509		38.3	%
TASER Cam	6,432	9,566	(3,134	)	(32.8	)%

The increase in net sales for 2017 compared to 2016 in the TASER segment was primarily attributable to increased sales under the OSP and TASER 60 installment payment programs. During the first quarter of 2017, the Home Office of the U.K. government approved our X2 devices for sale which resulted in increased TASER X2 sales within the U.K. of $8.5 million for the year ended December 31, 2017 compared to no sales during 2016. Additionally, we increased cartridge sales by $10.9 million to $63.2 million during the year ended December 31, 2017 as compared to $52.3 million during the same period in 2016 which was primarily attributable to an increase in total devices in the field.

Net sales for the Software and Sensors segment were $109.3 million and $65.6 million for the years ended December 31, 2017 and 2016, respectively, an increase of $43.7 million, or 66.6%. The overall increase in the Software and Sensors segment was driven by continued adoption of on-officer cameras and related technologies, including our Axon Evidence digital evidence management software suite. Combined net sales related to our Axon Body, Axon Flex, and Axon Dock products increased approximately $9.3 million. We recorded net sales of $3.0 million related to Axon Fleet, our then-newly introduced in-car camera system, with no amounts recorded during the same period in 2016. Axon Evidence revenues for the year ended December 31, 2017 increased $28.6 million to $57.8 million as compared to the same period in 2016. This increase was primarily driven by the continued increase in active users on our Axon Evidence platform.

Cost of Product and Service Sales (dollars in thousands):



	Year Ended December 31,								Dollar Change		Percent Change
	2017 (1)				2016 (1)
TASER segment:
Cost of product sales	$	72,054	30.7	%	$	61,930	30.6	%	$	10,124	16.3	%
Software and Sensors segment:
Cost of product sales	45,943		42.0	%	29,606		45.1	%	16,337		55.2	%
Cost of service sales	18,713		17.1	%	6,173		9.4	%	12,540		203.1	%
Total cost of sales	64,656		59.2	%	35,779		54.5	%	28,877		80.7	%
Total cost of product and service sales	$	136,710	39.8	%	$	97,709	36.4	%	$	39,001	39.9	%

Within the TASER segment, cost of product sales increased $10.1 million, or 16.3%, to $72.1 million in 2017, compared to $61.9 million in 2016, and remained relatively consistent as a percentage of sales at 30.7% from 30.6%.

We did not experience significant changes in variable manufacturing costs during the year ended December 31, 2017 as compared to 2016. The overall increase in cost of products sold was attributable to higher unit sales.

Within the Software and Sensors segment, cost of product and service sales was $64.7 million, an increase of $28.9 million, or 80.7%, from 2016. As a percentage of net sales, cost of product and service sales increased to 59.2% in 2017 from 54.5% in 2016. The increase in cost of product sales was primarily attributable to higher sales volumes, and the increase in cost of service sales was driven by increased cloud storage costs. The increase in total cost of sales as a percentage of total net sales was primarily attributable to non-recurring expenses related to our data migration to a new cloud-storage provider.

Gross Margin (dollars in thousands):



	Year Ended December 31,
							Dollar Change		Percent Change
	2017			2016
TASER segment	$	162,458		$	140,714		$	21,744	15.5	%
Software and Sensors Segment	44,630			29,822			14,808		49.7	%
Total gross margin	$	207,088		$	170,536		$	36,552	21.4	%
Gross margin as % of net sales	60.2		%	63.6		%

Gross margin increased $36.6 million to $207.1 million for the year ended December 31, 2017 compared to $170.5 million for 2016 . As a percentage of net sales, gross margin decreased to 60.2% for 2017 from 63.6% for 2016 . As a percentage of net sales, gross margin for the TASER segment was relatively consistent at 69.3% and 69.4% for the years ended December 31, 2017 and 2016, respectively. Within the Software and Sensors segment gross margin as a percentage of net sales was 40.8% and 45.5% for the years ended 2017 and 2016, respectively. Within the Software and Sensors segment, hardware gross margin was 10.5% for the year ended December 31, 2017 and 17.6% for the same period in 2016, while the service margins were 67.7% and 79.2% during those same periods, respectively. The decreased hardware margins were primarily attributable to higher discounting. In certain customer contracts, primarily within the Software and Sensors segment, the level of discounting resulted in a portion of the contractual consideration allocated to the delivered hardware to be recognized as revenue ratably over the Axon Evidence subscription term. However, the full cost of the product is recognized when the hardware is delivered to the customer resulting in lower gross margins initially. The decrease in service margins was primarily attributable to non-recurring expenses related to our data migration to a new cloud-storage provider.

Sales, General and Administrative Expenses (dollars in thousands):



	Year Ended December 31,						Dollar Change		Percent Change
	2017			2016
Salaries, benefits and bonus	$	58,450		$	43,058		$	15,392	35.7	%
Stock-based compensation	9,047			5,707			3,340		58.5	%
Professional, consulting and lobbying	24,267			19,321			4,946		25.6	%
Sales and marketing	17,368			15,132			2,236		14.8	%
Travel and meals	10,637			8,970			1,667		18.6	%
Other	18,923			15,888			3,035		19.1	%
Total sales, general and administrative expenses	$	138,692		$	108,076		$	30,616	28.3	%
Sales, general, and administrative as a percentage of net sales	40.3		%	54.6		%

SG&A by type and by segment were as follows for the years ended December 31, 2017 and 2016 (dollars in thousands):



	Year Ended December 31,								Dollar Change			Percent Change
	2017				2016
TASER segment:
Salaries, benefits and bonus	$	32,009	23.1	%	$	24,534	22.7	%	$	7,475		30.5	%
Stock-based compensation	6,115		4.4	%	3,339		3.1	%	2,776			83.1	%
Professional, consulting and lobbying	12,017		8.7	%	10,128		9.4	%	1,889			18.7	%
Sales and marketing	8,357		6.0	%	8,305		7.7	%	52			0.6	%
Travel and meals	4,867		3.5	%	4,277		4.0	%	590			13.8	%
Other	14,837		10.3	%	13,034		12.1	%	1,196			9.2	%
TASER segment	78,202		56.4	%	63,617		58.9	%	14,585			22.9	%
Software and Sensors segment:
Salaries, benefits and bonus	26,441		19.1	%	18,524		17.1	%	7,917			42.7	%
Stock-based compensation	2,932		2.1	%	2,368		2.2	%	564			23.8	%
Professional, consulting and lobbying	12,250		8.8	%	9,193		8.5	%	3,057			33.3	%
Sales and marketing	9,011		6.5	%	6,827		6.3	%	2,184			32.0	%
Travel and meals	5,770		4.2	%	4,693		4.3	%	1,077			22.9	%
Other	4,086		0.8	%	2,854		2.6	%	(1,678		)	(58.8	)%
Software and Sensors segment	60,490		43.6	%	44,459		41.1	%	16,031			36.1	%
Total sales, general and administrative expenses	$	138,692	100.0	%	$	108,076	100.0	%	$	30,616		28.3	%

(1) Amounts related to commissions expense for the years ended December 31, 2017 and 2016 have not been adjusted under the modified retrospective method of adoption of Topic 606, and are presented consistent with the prior period amounts reported under ASC 605.

Within the TASER segment, SG&A increased $14.6 million, or 22.9%, to $78.2 million from $63.6 million in 2016. This increase was primarily attributable to our continued efforts to build the necessary infrastructure to facilitate future growth which was evidenced by higher salaries, benefits, bonus and stock-based compensation of $10.3 million for the year ended December 31, 2017 as compared to 2016. Increased professional, consulting and lobbying fees of $1.9 million were primarily related to accounting and finance consulting costs attributable to our adoption of the new revenue recognition rules, international tax restructuring,and efforts towards remediation of internal control matters. The remaining other operating expenses were primarily attributable to the overall growth of operations during 2017.

Within the Software and Sensors segment, SG&A increased $16.0 million, or 36.1%, to $60.5 million in 2017 in comparison to the prior year. Salaries, benefits, bonus and stock-based compensation in the Software and Sensors segment increased $8.5 million as we continued to hire additional engineering, product management personnel, sales and marketing personnel and general support staff to further expand upon existing product offerings as well as the development of new products such as records management systems and computer aided dispatch systems. The increase in professional, consulting and lobbying expenses of $3.1 million was related to higher professional and consulting costs related to the implementation of a new revenue accounting software platform. Additionally, we incurred higher marketing consulting fees related to hosted events and conferences for customers as well as internal sales meetings. The increase in sales and marketing expense of $2.2 million relates to higher commissions on increased bookings, increased customer samples attributable to our delivery of on-officer cameras, Signal Sidearm, among other technologies, to prospective customers for evaluation purposes, as well as increased spending on sponsorships for major city police chief associations and major county sheriffs' associations. The remaining other operating expenses are primarily attributable to the overall growth of operations during 2017.

Research and Development Expenses (dollars in thousands):



	Year Ended December 31,						Dollar Change		Percent Change
	2017			2016
Salaries, benefits and bonus	$	33,682		$	17,205		$	16,477	95.8	%
Stock-based compensation	6,055			3,320			2,735		82.4	%
Professional and consulting	4,351			3,212			1,139		35.5	%
Travel and meals	1,674			969			705		72.8	%
Other	9,611			5,903			3,708		62.8	%
Total research and development expenses	$	55,373		$	30,609		$	24,764	80.9	%
Research and development as a percentage of net sales	16.1		%	11.4		%

R&D by type and by segment were as follows for the years ended December 31, 2017 and 2016 (dollars in thousands):



	Year Ended December 31,								Dollar Change			Percent Change
	2017				2016
TASER segment:
Salaries, benefits and bonus	$	4,243	7.7	%	$	2,301	7.5	%	$	1,942		84.4	%
Stock-based compensation	517		0.9	%	639		2.1	%	(122		)	(19.1	)%
Professional and consulting	1,098		2.0	%	1,167		3.8	%	(69		)	(5.9	)%
Travel and meals	388		0.7	%	345		1.1	%	43			12.5	%
Other	2,131		3.8	%	1,435		4.7	%	696			48.5	%
TASER segment	8,377		15.1	%	5,887		19.2	%	2,490			42.3	%
Software and Sensors segment:
Salaries, benefits and bonus	29,439		53.2	%	14,904		48.7	%	14,535			97.5	%
Stock-based compensation	5,538		10.0	%	2,681		8.8	%	2,857			106.6	%
Professional and consulting	3,253		5.9	%	2,045		6.7	%	1,208			59.1	%
Travel and meals	1,286		2.3	%	624		2.0	%	662			106.1	%
Other	7,480		13.5	%	4,468		14.6	%	3,012			67.4	%
Software and Sensors segment	46,996		84.9	%	24,722		80.8	%	22,274			90.1	%
Total research and development expenses	$	55,373	100.0	%	$	30,609	100.0	%	$	24,764		80.9	%

Within the TASER segment, R&D expenses increased $2.5 million, or 42.3%, to $8.4 million in 2017. Salaries, benefits, bonus and stock-based compensation in the TASER segment increased $1.8 million in 2017 compared to 2016. The increase for 2017 compared to 2016 was primarily driven by additional headcount as we continued to invest in the development of new CEW related technologies.

Within the Software and Sensors segment, R&D expenses increased $22.3 million, or 90.1%, to $47.0 million in 2017 from the prior year. Our Software and Sensors segment was responsible for approximately 85% of the overall expenses in R&D. Of the $22.3 million increase in R&D for the Software and Sensors segment, $17.4 million related to salaries, benefits, bonus, and stock-based compensation. The increase in professional and consulting expense of $1.2 million was primarily attributable to increased technical consulting fees related to the development and release of Signal Sidearm. Included in other R&D expenses for the Software and Services segment was $1.9 million of amortization of intangible assets related to acquired developed technology that was yet to be put into service. Additionally, during 2017, we abandoned certain developed technology acquired in a business combination resulting in an impairment charge of $1.0 million which was included in other R&D expenses.

Interest and Other Income (Expense), Net

Interest and other income (expense), net was $2.7 million and $(0.4) million for the years ended December 31, 2017 and 2016, respectively.

For the year ended December 31, 2017, we earned interest income of $1.6 million and had gains from foreign currency transaction adjustments of $1.4 million which were partially offset by interest expense of $0.2 million. For the year ended December 31, 2016, interest income of $0.7 million was more than offset by losses on foreign currency transaction adjustments of $1.1 million.

Provision for Income Taxes

The provision for income taxes was $10.6 million for the year ended December 31, 2017. The effective income tax rate for 2017 was 66.9%. In connection with our initial analysis of the impact of the Tax Act, we were able to make reasonable estimates of the impact of the Tax Act and recorded a provisional net tax expense of $8.0 million in the period ended December 31, 2017, primarily related to the impact of the tax rate reduction on our deferred tax assets and deferred tax liabilities. This was partially offset by a $1.8 million benefit related to excess stock-based compensation deductions, as well as a $2.4 million benefit for research and development credits during the year ended December 31, 2017. In addition, an additional valuation allowance in the amount of $1.9 million was recorded as of December 31, 2017, related to certain research and development credits that may not be utilized prior to expiration and losses in certain foreign jurisdictions in which there was a cumulative loss.

The provision for income taxes was $14.2 million for the year ended December 31, 2016. The effective income tax rate for 2016 was 45.1%. The effect of state income taxes of $0.9 million and the tax effects of intercompany transactions of $0.6 million were offset by a benefit of $1.9 million for research and development credits in the current year. The difference between statutory and foreign tax rates of $1.5 million was largely driven by losses incurred in a foreign entity for which no tax benefit will be realized. In addition, a valuation allowance in the amount of $1.8 million was recorded as of December 31, 2016 related to certain research and development tax credits that may not be utilized prior to expiration and losses in certain foreign jurisdictions in which there was a cumulative loss.

Net Income

Our net income decreased by $12.1 million to $5.2 million for the year ended December 31, 2017 compared to $17.3 million in 2016. Net income per basic and diluted share was $0.10 for 2017 compared to $0.33 and $0.32 per basic and diluted share, respectively, for 2016.

Non-GAAP Financial Measures

To supplement our financial results presented in accordance with accounting principles generally accepted in the U.S. ("GAAP"), we present the non-GAAP financial measures of EBITDA and Adjusted EBITDA (CEO Performance Award). Our management uses these non-GAAP financial measures in evaluating our performance in comparison to prior periods. We believe that both management and investors benefit from referring to these non-GAAP financial measures in assessing our performance, and when planning and forecasting our future periods. A reconciliation of GAAP to the non-GAAP financial measures is presented below.


•	EBITDA (Most comparable GAAP Measure: Net income) - Earnings before interest expense, investment interest income, taxes, depreciation and amortization.


•	Adjusted EBITDA (CEO Performance Award) (Most comparable GAAP Measure: Net income) - Earnings before interest expense, investment interest income, taxes, depreciation, amortization and non-cash stock-based compensation expense.

Although these non-GAAP financial measures are not consistent with GAAP, management believes investors will benefit by referring to these non-GAAP financial measures when assessing our operating results, as well as when forecasting and analyzing future periods. However, management recognizes that:


•	these non-GAAP financial measures are limited in their usefulness and should be considered only as a supplement to our GAAP financial measures;


•	these non-GAAP financial measures should not be considered in isolation from, or as a substitute for, our GAAP financial measures;


•	these non-GAAP financial measures should not be considered to be superior to our GAAP financial measures; and


•	these non-GAAP financial measures were not prepared in accordance with GAAP and investors should not assume that the non-GAAP financial measures presented in this Annual Report on Form 10-K were prepared under a comprehensive set of rules or principles.

EBITDA and Adjusted EBITDA (CEO Performance Award) reconcile to net income as follows (dollars in thousands):



	For the Years Ended December 31,
	2018			2017
Net income	$	29,205		$	5,207
Depreciation and amortization	10,615			8,041
Interest expense	86			186
Investment interest income	(3,002		)	(904		)
Provision for (benefit from) income taxes	(1,101		)	10,554
EBITDA	$	35,803		$	23,084

Adjustments:
Stock-based compensation expense	21,879			15,610
Adjusted EBITDA (CEO Performance Award)	$	57,682		$	38,694

Liquidity and Capital Resources

Summary

As of December 31, 2018, we had $349.5 million of cash and cash equivalents, an increase of $274.4 million from December 31, 2017.

Cash Flows

The following table summarizes our cash flows from operating, investing and financing activities (in thousands):



	Year Ended December 31,
	2018			2017			2016
Operating activities	$	63,875		$	18,471		$	21,135
Investing activities	(9,860		)	19,082			(3,045		)
Financing activities	219,348			(3,820		)	(34,554		)
Effect of exchange rate changes on cash and cash equivalents	(774		)	737			906
Net increase (decrease) in cash and cash equivalents	$	272,589		$	34,470		$	(15,558	)

Operating activities

Net cash provided by operating activities in 2018 of $63.9 million consisted of $29.2 million in net income, the net add-back of non-cash income statement items totaling $32.5 million and a positive $2.2 million net change in operating assets and liabilities. Included in the non-cash items were $10.6 million in depreciation and amortization expense, $2.1 million related to the disposal and abandonment of intangible assets, $21.9 million in stock-based compensation expense, and $3.6 million related to deferred income taxes. The most significant increase to the portion of cash provided by operating activities related to the changes in operating assets and liabilities was a $54.2 million increase in deferred revenue. Of the increase, $2.8 million resulted from additional extended warranty sales, $23.2 million resulted from increased hardware deferred revenue from TASER Assurance Program ("TAP"), OSP and TASER 7 sales, and $30.1 million related to prepayments for Software and Sensors services. Operating cash flows were also impacted by decreased inventory of $14.8 million resulting from continued inventory optimization efforts. These increases were offset by increased accounts and notes receivable of $67.6 million and prepaid expenses and other assets of $12.7 million during 2018. The increases in accounts and notes receivable were due to increased sales during 2018, primarily sales made under the OSP and TASER 60 installment plans. The increase in prepaid expenses and other asset accounts of $12.7 million during 2018 was driven primarily by an increase in deferred commissions of $13.0 million representing amounts earned when a contract is booked which is then subsequently amortized.

Net cash provided by operating activities in 2017 of $18.5 million consisted of $5.2 million in net income, the net add-back of non-cash income statement items totaling $28.0 million and a negative $14.8 million net change in operating assets and liabilities. Included in the non-cash items are $8.0 million in depreciation and amortization expense, $1.1 million related to the disposal and abandonment of intangible assets, $15.6 million in stock-based compensation expense, $0.7 million of bond premium amortization and $2.8 million related to deferred income taxes. The most significant increase to the portion of cash provided by operating activities related to the changes in operating assets and liabilities was a $39.7 million increase in deferred revenue. Of the increase, $7.4 million resulted from additional extended warranty sales, $20.2 million resulted from increased hardware deferred revenue from TAP and OSP sales, and $12.5 million related to prepayments for Software and Sensors services. These increases were offset by increased accounts and notes receivable of $35.3 million, inventory of $11.7 million and prepaid expenses and other assets of $9.0 million during 2017. The increases in accounts and notes receivable were due to increased sales during 2017, specifically sales made under the OSP and TASER 60 installment plans. Operating cash flows were also impacted by increased inventory of $11.7 million in anticipation of higher sales in 2018 and for our National Field Trial Offer for body cameras. The increase in prepaid expenses and other asset accounts of $9.0 million during 2017 was driven primarily by increased deferred cost of product sales of $5.0 million related to contracts where the product had shipped but revenue was deferred due to contractual provisions resulting in the cost of product sales being deferred as an asset to be recognized in subsequent periods when revenue recognition criteria have been met, an increase in deferred commissions of $2.1 million representing amounts earned when a contract is booked, which is then subsequently amortized over the contractual period as products and services are delivered, and increased prepaid income taxes of $3.4 million.

Net cash provided by operating activities in 2016 of $21.1 million consisted of $17.3 million in net income, the net add-back of non-cash income statement items totaling approximately $8.8 million and a negative $4.9 million net change in operating assets and liabilities. Included in the non-cash items are $3.7 million in depreciation and amortization expense, $9.4 million in stock-based compensation expense, and $1.3 million of bond premium amortization. These additions were partially offset by an $1.4 million reduction related to excess tax benefit from stock-based compensation and $5.2 million related to deferred income taxes. The most significant increase to the portion of cash provided by operating activities related to the changes in operating assets and liabilities was a $34.3 million increase in deferred revenue. Of the increase, $8.1 million resulted from additional extended warranty sales, $15.6 million resulted from increased hardware deferred revenue from TAP and OSP sales, and $10.5 million related to prepayments for Software and Sensors services. We also had increases in cash provided from operating activities of $17.6 million for increases in accounts payable and accrued liabilities related primarily to increased inventory purchases. These increases were offset by increased prepaid expenses and other current assets of $10.6 million, inventory of $18.7 million and accounts and notes receivable of $28.4 million during 2016. The increases in accounts and notes receivable were due to increased sales during 2016, and increases in inventory resulted from higher anticipated sales for 2017. The increase in prepaid expenses and other asset accounts during 2016 was driven primarily increased deferred commissions of $1.8 million

attributable to higher sales, increased balances under corporate-owed life insurance policies of $1.1 million, $3.3 million of restricted cash related primarily to a customer contract requiring certain contractual payments to be deposited in escrow until approved for release, and $1.7 million of long-term contingent consideration deposited in escrow in connection with a business combination that was completed in December 2016.

Investing activities

Primarily as the result of equipment purchases and business acquisitions during the year, we used $9.9 million for investing activities in 2018. Calls and maturities on our investments, net of purchases, were $6.8 million. During 2018, we invested $5.0 million in cash for the acquisition of VIEVU, LLC, a public safety camera and cloud-based evidence management system provider for law enforcement agencies. We also invested $11.7 million in the purchase of property and equipment and intangibles, net of proceeds related to disposals.

Primarily as the result of investments that matured during the year, we generated $19.1 million from investing activities in 2017. Calls and maturities on our investments, net of purchases, were $41.1 million. During 2017, we invested $10.6 million in cash for the acquisition of Dextro, Inc., to continue building upon our Axon Artificial Intelligence group, and for the acquisition of Breon, our former distributor in Australia. We also invested $11.4 million in the purchase of property and equipment and intangibles, net of proceeds related to disposals.

Primarily as a result of investing cash generated from operating activities, we used $3.0 million in investing activities in 2016. Calls and maturities on our investments, net of purchases, were $8.9 million. During 2016, we invested $3.5 million in cash for the acquisition of developed technology and hiring of personnel to form the Axon Artificial Intelligence group. We also invested $8.4 million in the purchase of property and equipment and intangibles, net of proceeds related to disposals.

Financing activities

Net cash provided by financing activities was $219.3 million for the year ended December 31, 2018. In May 2018, we completed a public follow-on equity offering that generated net proceeds of $234.0 million. During 2018, we paid income and payroll taxes of $14.1 million on behalf of employees who net-settled stock awards during the period. Additionally, we paid $2.3 million for contingent consideration amounts earned during 2018 related to the acquisition of certain assets from Fossil Group, Inc. and Fossil Vietnam, Limited Liability Company in 2016 and to the acquisition of Dextro in 2017. These cash outflows were partially offset by $1.8 million of proceeds from the exercise of stock options.

Net cash used by financing activities was $3.8 million for the year ended December 31, 2017 . During 2017, we paid income and payroll taxes of $3.5 million on behalf of employees who net-settled stock awards during the period. Additionally, we paid $1.8 million for contingent consideration amounts earned during 2017 related to the acquisition of certain assets from Fossil Group, Inc. and Fossil Vietnam, Limited Liability Company in 2016. These cash outflows were partially offset by $1.4 million of proceeds from the exercise of stock options.

Net cash used by financing activities was $34.6 million for the year ended December 31, 2016. During 2016, we repurchased $33.7 million of our common stock, which was purchased for a weighted average cost of $18.90 per share, inclusive of applicable administrative costs. Additionally, we paid income and payroll taxes of $1.8 million on behalf of employees who net-settled stock awards during the period. These cash outflows were partially offset by $0.5 million of proceeds from the exercise of stock options, and $1.4 million of excess tax benefit from stock-based compensation. The purchase of common stock was made under a stock repurchase program authorized by our Board of Directors.

Liquidity and Capital Resources

Our most significant source of liquidity continues to be funds generated by operating activities and available cash and cash equivalents. In addition, our $100.0 million revolving credit facility is available for additional working capital needs or investment opportunities. Under the terms of the line of credit, available borrowings are reduced by outstanding letters of credit. Advances under the line of credit bear interest at LIBOR plus 1.0 to 1.5% per year determined in

accordance with a pricing grid based on our funded debt to earnings before interest, taxes, depreciation and amortization ("EBITDA") ratio.

As of December 31, 2018, we had letters of credit outstanding of $3.1 million, leaving the net amount available for borrowing of $96.9 million. The facility matures on December 31, 2021 and has an accordion feature which allows for an increase in the total line of credit up to $100.0 million, subject to certain conditions, including the availability of additional bank commitments. There can be no assurance that we will continue to generate cash flows at or above current levels or that we will be able to maintain our ability to borrow under our revolving credit facility. At December 31, 2018 and 2017, there were no borrowings under the line.

Our agreement with the bank requires us to comply with a maximum funded debt to EBITDA ratio, as defined, of no greater than 2.50 to 1.00 based upon a trailing four fiscal quarter period. At December 31, 2018, the Company’s funded debt to EBITDA ratio was 0.001 to 1.00.

TASER 60 installment purchase arrangements typically involve amounts invoiced in five equal installments at the beginning of each year of the five-year term. This is in contrast to a traditional CEW sale in which the entire amount being charged for the hardware is invoiced upon shipment. This impacts liquidity in a commensurate fashion, with the cash for the TASER 60 arrangement received in five annual installments rather than up front. It is our strategic intent to shift an increasing amount of our business to a subscription model, to better match the municipal budgeting process of our customers as well as to allow for multiple product offerings to be bundled into existing subscriptions. We carefully considered the cash flow impacts of this strategic shift and regularly revisit our cash flow forecast with the goal of maintaining a comfortable level of liquidity as we introduce commercial offerings in which we incur upfront cash costs to produce and fulfill hardware sales ahead of the cash inflows from our customers. We anticipate, and have prepared for, the majority of our arrangements in both reportable segments to be offered in similar subscription-type offerings over the coming years. With the launch of the TASER 7, which is primarily being sold in subscription offerings, we expect this strategic shift to accelerate.

Based on our strong balance sheet and the fact that we had just $0.1 million in total long-term debt and capital lease obligations at December 31, 2018, we believe financing will be available, both through our existing credit line and possible additional financing. However, there is no assurance that such funding will be available on terms acceptable to us, or at all.

We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions and other liquidity requirements through at least the next 12 months. We and our Board of Directors may consider repurchases of our common stock. Further repurchases of our common stock would take place on the open market, would be financed with available cash and are subject to authorization as well as market and business conditions.

Contractual Obligations

The following table outlines our future contractual financial obligations by period in which payment is expected, as of December 31, 2018 (dollars in thousands):



	Total		Less than 1 Year		1 - 3 Years		3 - 5 Years		More than 5 Years
Non-cancelable operating leases	$	12,777	$	3,670	$	6,533	$	2,574	$	—
Capital leases including interest	76		40		36		—		—
Open purchase orders	66,613		66,613		—		—		—
Total contractual obligations	$	79,466	$	70,323	$	6,569	$	2,574	$	—

Open purchase orders in the above table represent both cancelable and non-cancelable purchase orders with key vendors, which are included in this table due to our strategic relationships with these vendors.

We are subject to U.S. federal income tax as well as income taxes imposed by several states and foreign jurisdictions. As of December 31, 2018, we had $6.1 million of gross unrecognized tax benefits related to uncertain tax positions. The settlement period for our long-term income tax liabilities cannot be determined; however, the liabilities are expected to increase by approximately $1.4 million within the next 12 months.

Off-Balance Sheet Arrangements

The discussion of off-balance sheet arrangements in Note 9 to the consolidated financial statements included in Part II, Item 8 of this Annual Report on Form 10-K is incorporated by reference herein.

Critical Accounting Estimates

We have identified the following accounting estimates as critical to our business operations and the understanding of our results of operations. The preparation of this Annual Report on Form 10-K requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. While we do not believe that a change in these estimates is reasonably likely, there can be no assurance that our actual results will not differ from these estimates. The effect of these estimates on our business operations is discussed below.

Product Warranties

We warranty our CEWs, Axon cameras and certain related accessories from manufacturing defects on a limited basis for a period of one year after purchase and, thereafter, will replace any defective unit for a fee. Estimated costs for the standard warranty are charged to cost of products sold when revenue is recorded for the related product. Future warranty costs are estimated based on historical data related to warranty claims on a quarterly basis and this rate is applied to current product sales. Historically, reserve amounts have been increased if management becomes aware of a component failure or other issue that could result in larger than anticipated warranty claims from customers. The warranty reserve is reviewed quarterly to verify that it sufficiently reflects the remaining warranty obligations based on the anticipated expenditures over the balance of the warranty obligation period, and adjustments are made when actual warranty claim experience differs from estimates. As of December 31, 2018 and 2017, our warranty reserve was approximately $0.9 million and $0.6 million, respectively. Warranty expense for the years ended December 31, 2018, 2017 and 2016 was $0.7 million, $0.1 million and $0.6 million, respectively. The increase in warranty expense for the year ended December 31, 2018 was primarily driven by higher than initially expected warranty claims for the Axon Flex 2 on-officer body camera. Warranty expense for the year ended December 31, 2017, was impacted by lower than initially expected warranty claims for the Axon Body 2 on-officer body camera. As of December 31, 2018, our reserve also included initial reserves related to TASER 7, Signal Sidearm, and Axon Fleet 2.

Revenue related to separately-priced extended warranties is initially recorded as deferred revenue at its contractual amount and subsequently recognized as net sales on a straight-line basis over the warranty service period. Costs related to extended warranties are charged to cost of product and service sales when incurred.

Inventory

Inventories are stated at the lower of cost and net realizable value. Cost is determined using the weighted average cost of raw materials, which approximates the first-in, first-out (“FIFO”) method and includes allocations of manufacturing labor and overhead. Provisions are made to reduce potentially excess, obsolete or slow-moving inventories, as well as trial and evaluation inventories to their net realizable value. These provisions are based on management’s best estimate after considering historical demand, projected future demand, inventory purchase commitments, industry and market trends and conditions among other factors. We evaluate inventory costs for abnormal costs due to excess production capacity and treats such costs as period costs.

During the year ended December 31, 2018, we recorded provisions to reduce inventories to their lower of cost and net realizable value of approximately $3.8 million compared to $2.0 million during 2017. The increase in provisions made during 2018 was primarily attributable to the impact of phasing out previous generations of VIEVU cameras in an effort to convert existing customers to Axon body camera deployments. The remaining change in the provision for 2018 was driven by analyses looking at projected sales data for existing products and making corresponding adjustments to state inventories at their lower of cost and net realizable value.

Revenue Recognition, Deferred Revenue and Accounts and Notes Receivable

We derive revenue from two primary sources: (1) the sale of physical products, including CEWs, Axon cameras, Axon Signal enabled devices, corresponding hardware extended warranties, and related accessories such as Axon docks, cartridges and batteries, among others, and (2) subscriptions to our Axon Evidence digital evidence management software as a service ("SaaS") (including data storage fees and other ancillary services), which includes varying levels of support. To a lesser extent, we also recognize training, professional services and revenue related to other software and SaaS services. We apply the five-step model outlined in Topic 606.

Many of our products and services are sold on a standalone basis.We also bundle our hardware products and services together and sell them to our customers in single transactions, where the customer can make payments over a multi-year period. For the the years ended December 31, 2018, 2017 and 2016, the composition of revenue recognized from contracts containing multiple performance obligations and those not containing multiple performance obligations was as follows (dollars in thousands):



	For the Year Ended December 31, 2018
	TASER				Software and Sensors				Total
Contracts with Multiple Performance Obligations	$	72,355	28.6	%	$	159,318	95.4	%	$	231,673	55.2	%
Contracts without Multiple Performance Obligations	180,760		71.4		7,635		4.6		188,395		44.8
Total	$	253,115	100.0	%	$	166,953	100.0	%	$	420,068	100.0	%



	For the Year Ended December 31, 2017 (1)
	TASER				Software and Sensors				Total
Contracts with Multiple Performance Obligations	$	53,865	23.0	%	$	102,529	93.8	%	$	156,394	45.5	%
Contracts without Multiple Performance Obligations	180,647		77.0		6,757		6.2		187,404		54.5
Total	$	234,512	100.0	%	$	109,286	100.0	%	$	343,798	100.0	%



	For the Year Ended December 31, 2016 (1)
	TASER				Software and Sensors				Total
Contracts with Multiple Performance Obligations	$	34,558	17.1	%	$	56,270	85.8	%	$	90,828	33.9	%
Contracts without Multiple Performance Obligations	168,086		82.9		9,331		14.2		177,417		66.1
Total	$	202,644	100.0	%	$	65,601	100.0	%	$	268,245	100.0	%

Additionally, we offer customers the ability to purchase CEW cartridges and certain services on an unlimited basis over the contractual term. Due to the unlimited nature of these arrangements whereby we are obligated to deliver

unlimited products at the customer’s request, we account for these arrangements as stand-ready obligations, and recognize revenue ratably over the contract period. Cost of product sales is recognized as the products are shipped to the customer.

Revenues are recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We enter into contracts that can include various combinations of products and services, each of which is generally distinct and accounted for as a separate performance obligation. Revenue is recognized net of allowances for returns and any taxes collected from customers, which are subsequently remitted to governmental taxing authorities.

A performance obligation is a promise in a contract to transfer a distinct good or service to the customer, and is the unit of account in Topic 606. For contracts with multiple performance obligations, we allocate the contract transaction price to each performance obligation using our estimate of the standalone selling price ("SSP") of each distinct good or service in the contract.

Performance obligations to deliver products, including CEWs, cameras and related accessories such as cartridges, batteries and docks, are generally satisfied at the point in time we ship the product, as this is when the customer obtains control of the asset under our standard terms and conditions. In certain contracts with non-standard terms and conditions, these performance obligations may not be satisfied until formal customer acceptance occurs. Performance obligations to fulfill service-type extended warranties and provide our SaaS offerings, including Axon Evidence and other cloud services, are generally satisfied over time as the customer receives and consumes the benefits of these services over the stated service period.

We have elected to recognize shipping costs as an expense in cost of product sales when the control of hardware products or accessories have transferred to the customer.

Sales tax collected on sales is netted against government remittances and thus, recorded on a net basis.

Deferred revenue consists of payments received in advance related to products and services for which the criteria for revenue recognition have not yet been met. Deferred revenue that will be recognized during the subsequent twelve month period from the balance sheet date is recorded as current deferred revenue and the remaining portion is recorded as long-term. Generally, customers are billed in annual installments.

Sales are typically made on credit, and we generally do not require collateral. Management performs ongoing credit evaluations of its customers’ financial condition, and maintains an allowance for doubtful accounts. Uncollectible accounts are charged to expense when deemed uncollectible, and accounts and notes receivable are presented net of an allowance for doubtful accounts. This allowance represents management’s best estimate and application of judgment considering a number of factors, including third-party credit reports, actual payment history, cash discounts, customer-specific financial information and broader market and economic trends and conditions.

Valuation of Goodwill, Intangibles and Long-lived Assets

We do not amortize goodwill and intangible assets with indefinite useful lives. Such assets are required to be tested for impairment at least annually, or sooner whenever events or changes in circumstances indicate that the assets may be impaired. We perform our annual impairment assessment in the fourth quarter of each year. Finite-lived intangible assets and other long-lived assets are amortized over their estimated useful lives. Management evaluates whether events and circumstances have occurred that indicate the remaining estimated useful life of long-lived assets and intangible assets may warrant revision or that the remaining balance of these assets, including intangible assets with indefinite lives, may not be recoverable.

Circumstances that might indicate long-lived assets might not be recoverable could include, but are not limited to, a change in the product mix, a change in the way products and services are created, produced or delivered, or a significant change in the way our products are branded and marketed. When performing a review for recoverability, management estimates the future undiscounted cash flows expected to result from the use of the assets and their eventual

disposition. The amount of the impairment loss, if impairment exists, is calculated based on the excess of the carrying amounts of the assets over their estimated fair value computed using discounted cash flows. During the year ended December 31, 2018, we abandoned certain developed technology acquired in a business combination resulting in an impairment charge of $2.0 million. During the year ended December 31, 2017, we abandoned certain developed technology acquired in a business combination resulting in an impairment charge of $1.0 million. The impairment charges were recorded within the Software and Sensors Segment. No impairment losses were recorded during the year ended December 31, 2016.

Income Taxes

We recognize federal, state and foreign current tax liabilities or assets based on our estimate of taxes payable or refundable in the current fiscal year by tax jurisdiction. We also recognize federal, state and foreign deferred tax assets or liabilities, as appropriate, for our estimate of future tax effects attributable to temporary differences and carry forwards.

We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such positions are measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate resolution. We must also assess whether uncertain tax positions as filed could result in the recognition of a liability for possible interest and penalties if any. We have completed research and development tax credit studies for each year a tax credit was claimed for federal, Arizona, and California income tax purposes. We determined that it was more likely than not that the full benefit of the research and development tax credit would not be sustained on examination and accordingly, have established a liability for unrecognized tax benefits of $5.2 million as of December 31, 2018. In addition, we established a $0.1 million liability related to uncertain tax positions for certain federal income tax liabilities, for a total unrecognized tax benefit of $5.3 million. We expect the amount of the unrecognized tax benefit to increase by approximately $1.4 million within the next 12 months. Should the unrecognized tax benefit of $5.3 million be recognized, our effective tax rate would be favorably impacted. Our estimates are based on information available to us at the time we prepare the income tax provision. Our income tax returns are subject to audit by federal, state, and local governments, generally years after the returns are filed. These returns could be subject to material adjustments or differing interpretations of the tax laws.

Our calculation of current and deferred tax assets and liabilities is based on certain estimates and judgments and involves dealing with uncertainties in the application of complex tax laws. Our estimates of current and deferred tax assets and liabilities may change based, in part, on added certainty or finality to an anticipated outcome, changes in accounting or tax laws in the U.S. and internationally, or changes in other facts or circumstances. In addition, we recognize liabilities for potential tax contingencies based on our estimate of whether, and the extent to which, additional taxes may be due. If we determine that payment of these amounts is unnecessary, or if the recorded tax liability is greater than our current assessment, we may be required to recognize an income tax benefit, or additional income tax expense, respectively, in our consolidated financial statements.

In preparing our consolidated financial statements, we assess the likelihood that our deferred tax assets will be realized from future taxable income. In evaluating our ability to recover our deferred income tax assets, we consider all available positive and negative evidence, including operating results, ongoing tax planning and forecasts of future taxable income on a jurisdiction by jurisdiction basis. A valuation allowance is established if we determine that it is more likely than not that some portion or all of the net deferred tax assets will not be realized.

Although we believe that our tax estimates are reasonable, the ultimate tax determination involves significant judgments that could become subject to audit by tax authorities in the ordinary course of business. As of December 31, 2018, we would need to generate approximately $55.1 million of pre-tax income in the U.S. in order to realize the net deferred tax assets for which a benefit has been recorded. This estimate considers the reversal of approximately $14.1 million in gross deferred tax liabilities, $3.5 million tax-effected. We have state net operating losses ("NOLs") of $2.5 million, which produce deferred tax assets of $0.2 million, which expire at various dates between 2029 and 2036. We anticipate our future income to continue to trend upward from our 2018 results, with sufficient pre-tax book income to realize a large portion of our deferred tax assets. However, based on specific income projections for years in which

Arizona R&D tax credits are set to expire, and cumulative losses in certain foreign jurisdictions, a reserve of $7.4 million has been recorded as a valuation allowance against deferred tax assets as of December 31, 2018.

Stock-Based Compensation

We have historically granted stock-based compensation to key employees and non-employee directors as a means of attracting and retaining highly qualified personnel. Stock-based compensation awards primarily consist of service-based RSUs. RSUs are classified as equity and measured at the fair market value of the underlying stock at the grant date. We recognize RSU expense using the straight-line attribution method over the requisite service period. We also issue performance-based RSUs, the vesting of which is contingent upon the achievement of certain performance criteria related to our operating performance, as well as successful and timely development and market acceptance of future product introductions. For performance-based RSUs containing only performance conditions, compensation cost is recognized using the graded attribution model over the explicit or implicit service period. For awards containing multiple service, performance or market conditions, and all conditions must be satisfied prior to vesting, compensation expense is recognized over the requisite service period, which is defined as the longest explicit, implicit or derived service period, based on management’s estimate of the probability of the performance criteria being satisfied, adjusted at each balance sheet date. For both service-based and performance-based RSUs,we account for forfeitures as they occur as a reduction to stock-based compensation expense and additional paid-in-capital.

For performance-based options, stock-based compensation expense is recognized over the expected performance achievement period of individual performance goals when the achievement of each individual performance goal becomes probable. For performance-based awards with a vesting schedule based entirely on the attainment of both performance and market conditions, stock-based compensation expense is recognized for each pair of performance and market conditions over the longer of the expected achievement period of the performance and market conditions, beginning at the point in time that the relevant performance condition is considered probable of achievement. The fair value of such awards is estimated on the grant date using Monte Carlo simulations. Refer to Note 12 of the notes to our consolidated financial statements within this Annual Report on Form 10-K.

We have granted a total of approximately 8.5 million performance-based awards (options and restricted stock units) of which approximately 6.8 million are outstanding as of December 31, 2018, the vesting of which is contingent upon the achievement of certain performance criteria including the successful development and market acceptance of future product introductions as well as our future sales targets and operating performance. These awards will vest and compensation expense will be recognized based on management’s best estimate of the probability of the performance criteria being satisfied using the most currently available projections of future product adoption and operating performance, adjusted at each balance sheet date. Changes in the subjective and probability-based assumptions can materially affect the estimate of the fair value of stock-based compensation and consequently, the related amount recognized in our statements of operations and comprehensive income.

Contingencies and Accrued Litigation Expense

We are subject to the possibility of various loss contingencies arising in the ordinary course of business, including product-related litigation. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required. Refer to Note 9 of our consolidated financial statements within this Annual Report on Form 10-K.

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