Red Cat Holdings, Inc. Q1 FY2023 Earnings Call

Ladies and gentlemen, thank you for standing by. Good morning and welcome to the Red Cat Holdings Fiscal 2023 First Quarter Financial Results and Corporate Update Conference Call. Participants of this call are advised that the audio of this conference call is being broadcast live over the Internet and is also being recorded for playback purposes. A webcast replay of the call will be available approximately 1 hour after the end of the call through December 12, 2022. I would now like to turn the call over to Mr. Joey Delahoussaye, Vice President of Core IR the company’s Investor Relations firm. Please go ahead, sir.

Thank you, Andrew. Good morning, everyone and thank you for joining us for the Red Cat Holdings’ fiscal 2023 first quarter financial results and corporate update conference call. Joining us today from Red Cat Holdings are Jeff Thompson, Chief Executive Officer and Joseph Hernon, Chief Financial Officer. During this call, management will be making forward-looking statements including statements that address Red Cat’s expectations for future performance or operational results. Forward-looking statements involve risks and other factors that may cause actual results to differ materially from those statements. For more information about these risks, please refer to the risk factors described in Red Cat’s most recently filed periodic reports on Form 10-K and Form 10-Q and in Red Cat’s press release that accompanies this call, particularly the cautionary statements in it. The content of this call contains time-sensitive information that is accurate only as of today, September 12, 2022. Except as required by law, Red Cat disclaims any obligation to publicly update or revise any information to reflect events or circumstances that occur after this call. It is now my pleasure to turn the call over to Jeff Thompson, Chief Executive Officer. Jeff?

Thanks, Joey and thank you. Welcome to our first quarter fiscal year 2023 earnings conference call. This is an exciting conference call for Red Cat. This is the first quarter with organic revenue from Teal Drones production line and Fat Shark digital goggles. I will start with summaries of each subsidiary, including progress on the Army Tranche 2 program and high-level status on Requests for Proposals across the globe. So, let me start with Rotor Riot. Rotor Riot continues to improve revenue and margins and is just starting to see in-person community events like quads and coffee return. In-person events are similar to music concerts that promote a record release. Rotor Riot had a record quarter and with a new digital advertising campaign. New digital goggle launches should provide tailwinds for the consumer segment for the next 12 to 18 months. Let’s now talk about Fat Shark. In Q1, Fat Shark launched the new headset and saw the largest pre-order first day sales of any headset to date. And Fat Shark has been around since 2007. The Dominator headset is getting great reviews and we hope to see follow-through for the next few quarters. Skypersonic, the Skycopter drone can be piloted virtually anywhere from virtually anywhere as the Skypersonic team recently demonstrated on Mt. Etna in July using Skypersonic’s long-range real-time remote piloting system. The drone on an active volcano in Italy was controlled by personnel in Houston, Texas in real-time. Whereas most drones cannot be piloted without connecting to the GPS network, Skycopter uses technology that is able to control and track the drone in locations such as Mars where GPS is not available. We believe the Skycopter will be a leader in infrastructure inspections next year. But we also believe that technology can be very useful on the battlefield and for first responders. Being able to fly indoors in caves and tunnels in GPS-denied locations is game-changing not only for infrastructure inspections but also for the dismounted warfighter. And I will talk about Teal Drones. Let’s start with the production line. We are currently switching from PVT, production validation tests to ramp-up in mass production. Mass production enables Teal to continue to improve ongoing yields, qualify additional tools or vendors, and make design changes based on customer feedback, any early field failures or cost reduction efforts. We have significant design improvements as we go into mass production, specifically with the camera payload. We believe that having a made-in-USA factory up and running at mass production is a strategic advantage for the RFPs we are working on and the Tranche 2 production contract. That brings us to SRR Tranche 2 short-range reconnaissance program for the Army and the DIU. Teal Drones continues to meet the scheduled milestones for the Tranche 2 prototype design and expects to have a flying prototype by the end of the calendar year. The Tranche 2 production contract is still expected early in the first half of next year. Now, let me talk about some of the potential sales pipeline for the Golden Eagle. We are fielding multiple Requests for Proposals with NATO allies for the Teal Golden Eagle and the Skypersonic Skycopter. We continue to work with these customers and prospective customers to translate their interest into firm purchase orders and contracts. We are seeing many opportunities and demand growing. We believe this will set Red Cat up for a strong fiscal 2023. In summary, we have new products, new software capabilities, a new production facility and organic growth from Rotor Riot, Fat Shark and Teal Drones, and expect the Skycopter, our least mature product, to be a very important revenue generator next year. We have much to do, but we are close to firing on all cylinders. And with that, I will hand the call over to Joseph, our CFO.

Thank you, Jeff and to everyone for joining the call today. I will now provide a review of our financial results for the first quarter of fiscal 2023, which ended on July 31, 2022. I am very pleased to confirm that fiscal '23 is off to a resounding start as revenues for the first quarter totaled $3.1 million, which represents 120% growth compared to the first quarter of fiscal 2022. Another comparative measure of the strength of the quarter is that revenues for the first quarter of fiscal '23 equaled almost half or 48% of our revenues for the full year of fiscal 2022. Q1 revenue growth was led by strong shipments of the Dominator, the new digital goggle released by Fat Shark. In addition, revenues for Teal continue to grow, even as we spend much of our focus on completing its manufacturing capacity expansion. Looking forward, we remain confident that we will deliver strong revenue growth in fiscal '23. Operating expenses increased significantly in Q1 of fiscal '23, totaling $4.1 million compared to $1.8 million for the first quarter of fiscal '22. This increase was planned and expected and primarily relates to the acquisition of Teal Drones, which occurred after the end of the first quarter of fiscal '22. Since acquiring Teal in August of 2022, we have invested significantly in building out the Teal organization and preparing Teal for the multitude of revenue opportunities that are emerging. We have doubled the size of its facilities both to increase its manufacturing capacity and to house its workforce, which has increased significantly since we acquired Teal. While this strategy adversely impacts short-term operating results, it is necessary to position us to take advantage of much larger long-term growth opportunities. As expected, other income and expenses in the first quarter of fiscal '23 were minimal compared to some of the large and fluctuating amounts that we reported in prior quarters. Most of these variable charges related to derivative features that were embedded in convertible notes and warrants that we issued in fiscal 2021. To-date, all of the notes have been converted into common stock and approximately 25% of the warrants have been exercised. As a result, future amounts related to these derivative features are expected to continue to be modest. Our net loss for the first quarter of fiscal '23 totaled $3.8 million or $0.07 per share compared to $1.6 million or $0.05 per share for the first quarter of fiscal '22. Cash used in operations totaled $4.8 million in Q1 of '23 compared to $4.1 million in Q1 of '22. A key driver of our cash burn in addition to building the Teal organization has been building inventory levels, which totaled $6.4 million at the end of the first fiscal quarter of '23. These higher-than-normal inventory balances can be partly attributed to the supply chain issues, including the availability of computer chips, which are essential to many of our products. In addition, we have increased inventory levels to support the launch of the Dominator by Fat Shark and forecast sales growth for Teal. We ended the first quarter of fiscal '23 with almost $43 million in cash and marketable securities and less than $2 million in debt. We remain in a strong financial position to execute on our growth initiatives. I will now turn the call over to the operator for questions.

The first question comes from Ashok Kumar with ThinkEquity. Please go ahead.

Thank you, Jeff and Joseph, congratulations. Two questions. One, you applied to the NATO allies RFPs, can you please give us some color on size and potential? Second question is any color on the Tranche 2 that would also be helpful? Thank you very much.

Great. Thanks, Ashok. Thanks for being on today. Yes, so we have – our business development team has been demoing the Golden Eagle, as I have mentioned in previous calls all over the globe. And actually, I was at a few of the events at USASOC down in Fort Bragg area recently. We are getting some great feedback and we have applied for a lot of RFPs to many of the Eastern European countries. We have a couple for about 600 systems, some for 300 systems, and 2 for over 2,000 systems. So, we don’t expect to win every single deal and some of them will probably be multi-vendor, but these are large possible proposals and contracts that we could win. Being a made-in-U.S.A company and approved by the DoD, we think gives us a strong position to do so. We are in the middle of some of these; we hope to hear from a couple of them within about a month, while some of them go along in different stages where we have already been down-selected for the first stage and are already in the second stage. So, we don’t give guidance yet, but we have probably close to over 3,500 drones in proposals right now. And on the Tranche 2 process, we have gotten through some of the hardest parts, which is the product requirements document, which has to be approved. The DIU is running a very tough process, but we are getting through those stages and we are meeting the requirements of the drone that is being proposed for Tranche 2. Again, we are getting ourselves into mass production. If we win Tranche 2, we will be capable of basically hitting the ground running and producing this drone as quickly as possible.

Great. Thank you very much and all the best.

The next question comes from Kevin Dede with H.C. Wainwright. Please go ahead.

Good morning, Jeff, Joe. How are you guys doing?

Hey, Kevin. It sounds like you are at the conference already. We assume.

Yes, I am. I apologize for the background noise. Looking forward to having you here. I think listen, Joe, I know you spent a lot of time reviewing the organic versus acquisitive contribution to sales, but could you just speak specifically to the fourth quarter to first quarter change please? You lost me a little bit on the Teal side.

Yes, Teal revenue so far, Kevin, has been pretty modest. It’s growing gradually. It was almost all of the enterprise revenue in the first quarter, so it was about $1 million in the first quarter. Consumer accounted for about two-thirds of the revenue in the first quarter and that was split pretty evenly between Fat Shark and Rotor Riot. Consumer continues to get closer to operating breakeven. So we expect Teal revenue to continue to gradually increase, but it’s coming off of a fairly low base number. Right now, I don’t have a breakout of the Q4 revenues, but I can say that the growth – the sequential growth was largely driven by consumer although enterprise did help a little bit.

Okay. So, consumer two-thirds of the $3 million, roughly $3 million?

Yes.

Okay. And then the balance roughly Teal?

Almost all Teal; Skypersonic was negligible. And one of the things, Kevin, just one of the things we are doing beginning with the first quarter of this year is we are reporting on a segment basis, so that information will also be in our 10-Q.

Awesome. Okay. How about progress update on construction of the manufacturing facilities, just to look into material sourcing and your comfort in meeting the timeline?

Yes, that’s a great question, specifically, how manufacturing is crucial to our continued growth of Teal. To just add a comment to what Joseph just mentioned, we basically went from almost zero revenue to a $1 million in revenue for Teal in just one quarter and being the first couple of months of the factory getting up online. So, that’s a very early stage production line, which is now maturing. As I mentioned in my press releases, we have now gone from PVT to mass production and ramped up. We take all the things that we learned from the PVT stage and basically fix any issues and problems with vendors and tooling that we want to automate the production line so that we can really scale it. If we get any of these RFPs, we will need to start producing a lot of drones very quickly. We are pretty good with the supply chain; there are some components we are still having some challenges with. We believe we have almost all of that resolved currently. While still cautious, we did a lot of ordering and thanks to the Teal team and Dr. Evans for getting us to place orders last year, we are in pretty good shape with our supply chain and chipsets to continue ramping up Teal’s revenue from where it was two quarters ago basically zero to a $1 million and to pretty dramatic revenue growth over the next few quarters. So, yes, the production is getting there. It’s not the factory; as Joseph mentioned, we also doubled it in size. Right away, as we started building, we realized we needed more. That’s where we are right now with manufacturing.

Yes. So, I remember speaking with you last time and you were still working through the construction of the facility. Now, where are you regarding that? Is that the addition there? Has that been completed?

No, the addition is – I will give you exactly where it is. We have a complete, same-size location right next to the first location that we opened. We had the production line up and running. We decided to open up a wall and bring the other side in because we have a lot of inventory control capabilities inside the facility, specifically when you are selling to the military; it has to be very secure. Sometimes that slows down the existing production line because of all the construction dust and things of that nature. We hope to have the construction done in the next month or two and put this behind us. That will also bring us into full mass production.

Can you peel the onion back a little bit on DoD contracts? Are your drones expected to be weaponized and is that like an additional level of security and process?

Yes. The difficult thing that’s happening right now is with the Ukraine war going on, as people are realizing the small drones are so crucial for warfare. You may have seen the Fat Shark goggles, if you Google it, are being used for the 93rd Brigade in Ukraine to use racing drones for small racing drones with kinetics on them. Fat Sharks are also looking at ways to make sure that the new Dominator goggle can be mounted on a warfighter’s helmet and have the proper antenna placement for things of that nature. The next step where you see kinetics put on any drone that we make is a lengthy process to get approved to do that. If there are RFPs for drones with kinetics, we would partner with someone that’s already approved and gone through the two-year process to do so. We have been working closely; I was recently at – last time we spoke was a few weeks away from using the sock to demo the 4-Ship product and the revealed partnership we recently announced where we demonstrated how to go, look at the target, surround the target and get real warfighter information to guide them to that target without being seen, knowing where line of sight is and when non-line of sight comes into play. A lot of data can be derived from our 4-Ship products and the reconnaissance that they can do. The next step is how to take small drones, like class one drones, to be an even more lethal product for the warfighter. We are not there yet, but we are helping the other technologies that are out there that take out tanks, like the switchblade and things of that nature. We are trying to help the warfighter with as many tools as we can give them to mitigate their safety.

So, I did see that. I may have sent you the link when we saw it actually, when the 93rd used. Yes. So, I saw that, but I got the sense that that was sort of an aftermarket modification, right? Am I right with that assumption?

Yes. That was an aftermarket application where people are typically putting a specific grenade that detonates when it strikes the facility. There are some upcoming RFPs for one-way kinetic class one drones. There are also some RFPs with armed drones that would have a six-shooter on them, reloadable. A completely different world of new class one drones is coming out over the next year or two.

So, you mentioned a partnership in helping you meet those milestones. Can you categorize where you might be in that negotiation process? Is there a milestone we could look forward to hearing about and seeing how Red Cat is positioned to participate in that market?

There are – here are some short-term and long-term milestones, just to give everyone some goalposts on the call, not just specific to what you just asked. Some of the short-term goals include continuing to work with Border Patrol on that $90 million contract we got in January. We expect to talk about that shortly. Some of the RFPs I mentioned with some NATO allies, we think we are in a good position. We are on a couple of those. Those are some of the short-term goals that we have. There are some other moon shots we are looking at for early next year. The next large milestone would be the Tranche 2 production contract in early next year. The last production contract was for $100 million for Tranche 1 before the Ukraine war broke out. Small class one drones are much more important now than they were when the Tranche 2 production contract was awarded two years ago. Those are some of the milestones. In the short-term, it’s mostly the RFPs. The partners we are discussing for the kinetics are based out of California and have been doing it for years. When we have something to announce with them, we will make sure that everyone is aware.

Okay. The Tranche 2 deal Joe though – Jeff has not been awarded, just to confirm and what’s…?

Yes. This is a good housekeeping because people get a little confused with it. It’s a SRR, small range reconnaissance program, a three tranche program. Tranche 1, Tranche 2, Tranche 3. Tranche 1 – each tranche has prototype contracts, and when you get a prototype contract, you are in the running to win a production contract. Tranche 1 was awarded over two years ago, and Teal was one of the five companies selected to build a prototype and won a prototype contract. Skydio was one of those five also, and they won the production contract two years ago. For Tranche 2, there were 37 companies that applied and demoed their drone in Georgia, and two were selected for the prototype contracts. Of those two, one will win the production contract. The same process will happen for Tranche 3. We are very well positioned for Tranche 2, not only because of our financial condition, but also because we will have a mature production line by the time Tranche 2 is awarded. We think our supply chain will be in really good shape by then.

Okay. Then – apologies for hogging the call, Jeff. Just give us a little insight on the timeline for Tranche 3 and maybe your estimation of the size of that contract.

Yes. So, like I said, Tranche 1 was $100 million. They don’t really announce the sizes of Tranche 2 and Tranche 3. We expect Tranche 2 to be $100 million to $200 million based on the knowledge we have, but we have no way to verify that. Tranche 3 is expected to continue to be large as well. However, the timelines and dates for Tranche 3 will typically be announced after the production for Tranche 2 is awarded.

Okay. Fair enough. Thank you. Appreciate all the color gentlemen. Congrats on the progress. Thanks for having me.

Thank you. That makes sense.

This concludes the question-and-answer session of the call. I would now return the call to CEO, Jeff Thompson for closing remarks.

Thanks everybody for joining the call. I want to thank all the employees from all the different teams. You have done a great job over the last year, especially the finance team for getting earnings done early. I look forward to seeing a whole bunch of you folks today and tomorrow at the H.C. Wainwright Conference. Thanks for joining.

The conference has concluded. Thank you for attending. You may now disconnect your line.