Red Cat Holdings, Inc. Q3 FY2023 Earnings Call

Ladies and gentlemen, thank you for standing by. Good morning, and welcome to the Red Cat Holdings Fiscal 2023 Third Quarter Financial Results and Corporate Update Conference Call. At this time, all participants are in a listen-only mode. After today's presentation, there will be an opportunity to ask questions. 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 one hour after the end of the call through June 7, 2023. I would now like to turn the call over to Scott Gordon, President of CoreIR, the company's Investor Relations firm. Please go ahead.

Thank you, Kate. Good morning, everyone. Thank you for joining us on the Red Cat Holdings fiscal 2023 third 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, 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, March 7, 2023. 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, please go ahead.

Great. Thank you. Welcome to our fiscal year 2023 third quarter earnings conference call. I'm going to keep my prepared remarks brief as I was just told we have quite a few email questions. So let's get some housekeeping out of the way, and I'll start with the status of the sale of the consumer division. Unusual Machines is expected to have its IPO later this month or early April, which would cause the closing of this deal. The voting proxy now has a quorum and we will shed those results on the vote very soon. As a reminder, the sale of the consumer division will be a non-dilutive event and will raise cash for Red Cat. It allows us to focus on our core customers: the military and first responders. The Salt Lake City factory is complete and ready to go. We now have a state-of-the-art drone factory. We have chips to make thousands of drones, and we're only producing the new Teal 2 drone with the new camera payload. The Teal team has done an incredible job completing this in just 12 months. We now have the capacity to produce thousands of drones per month. Let's switch gears and talk about Tranche 2 or Short Range Reconnaissance, SRR, program of record. As I previously mentioned, Tranche 3 has been pushed into Tranche 2. We will receive more funds from the Army to include these new features into Tranche 2. We do not know the size of the awards yet, but this should happen in the next couple of months. Next up is Border Patrol. We made our first shipment to the Border Patrol for 54 systems in mid-January. This was only a few weeks after production started on the new Teal 2. We believe there's a significant opportunity for additional orders this calendar year, and are very encouraged by the feedback from the Border Patrol. On to Skypersonic, our indoor drone division has two significant opportunities coming out. One is a Navy SBIR or Small Business Innovation Research project for compact aerial inspection systems for elevated and small spaces. This is a Navy SBIR, as I just mentioned. The program matches the Skycopter perfectly, and this is being actually submitted tomorrow, March 8. And we're hoping to get into another program through Skypersonic. The second is the Drone Infrastructure Inspection Grant Act. This is a bipartisan grant for $100 million that is expected to pass the Senate soon and has already passed the House. We also believe we are well positioned to be part of this grant. So I am doing this call from Torino, Italy. This is where Skypersonic is located, and we are co-located in the Leonardo campus. Leonardo is a large Italian defense contractor. In Torino, last week, we were invited to the Diana NATO meeting. One of the goals of this organization is to introduce small companies to governments that need defense products. We had great introductions, and we were only one of two presenters. In the previous two weeks, I've been with the business development team and visited at least five different countries. We believe it's been a very successful trip, and the Teal 2 drone is getting a great response from operators and more fighters. We also received initial orders and we believe we are well positioned to be awarded a sole source contract for hundreds of drones. Red Cat also became certified in a European country to be included in their defense catalog, breaking the log jam to be able to sell to these European countries. And finally, we have identified opportunities to get the new Teal 2 to Ukrainian warfighters, and I will address that in a little bit more detail in the Q&A. In summary, before I hand the call over to Joseph, we have completed a new state-of-the-art factory in Salt Lake City, with chip supplies to build thousands of drones. We have the best in class drone and great response from the market, mostly military, and recently, as in yesterday, for first responders. We'll have more to come on this new development in the next couple of weeks. We have our outdoor drones and our indoor drones for our military customers. We expect the next six months to be the most exciting in company history with material sales, partnerships and new products. So with that, I'm going to hand the call over to Joseph. I look forward to your questions.

Thank you, Jeff, and to everyone for joining the call today. I will now provide a review of our financial results through our fiscal quarter which ended on January 31, 2023. Revenues exceeded $3 million for the second of three quarters in fiscal 2023, and have increased more than 50% on a year-to-date basis compared to the first three quarters of fiscal 2022. Gross margin remained challenged as we continue to refine and scale manufacturing at our expanded facility in Salt Lake City. We expect gross margins to improve going forward as product shipments increase and we improve the efficiency of our manufacturing and assembly processes. Operating expenses decreased almost 20% in the third quarter compared to the second quarter as the level of nonrecurring costs associated with the expansion of the Teal manufacturing facility and its headcount have subsided. We expect operating costs to stabilize for the balance of the fiscal year and through the end of 2023. Net loss for the fiscal third quarter totaled $5.7 million or $0.10 per share, representing a 9% decrease from the prior quarter and more than a doubling compared to the third fiscal quarter of the prior year. This significant increase is directly related to the doubling in size and the build-out of the manufacturing facility at Teal, as well as a more than tripling of its headcount. We ended the third fiscal quarter with approximately $25 million in cash and investments. In addition, we have invested $7 million in raw materials, including chips, drones in production and finished products for Teal. We expect this investment in inventory to yield and support strong sales over the balance of the year. At this point, the Teal manufacturing facility expansion has been completed, a sales force has been built and trained, our sales pipeline is building and expanding, and we are looking forward to new and repeat orders over the balance of calendar 2023.

First question is from Scott Michael, a Private Investor. Please go ahead.

Hi. Thank you for taking my call. Can you clarify the number of chips that we have in reserve?

Yeah. Well, the number hasn't changed since we put in the initial order of approximately 3,700 chip sets almost two years ago. With that said, we're not going to give you a 100% yield. You're going to have some that don’t make it; we end up scrapping some. But we think that those could produce between 3,200 and 3,500 drones.

Okay. Thank you. Do we have a source for chips? Should we get any large orders that exceed this production capability?

Yes. Everyone understands that the supply chain has improved, although it is not perfect yet. Customers who place large orders can expect to receive shipments at scheduled times. For example, if you order 5,000 drones, you'll get 1,000 drones on a specific day, followed by an additional thousand at a later time. Our main focus is not so much on obtaining supply at this moment, but rather on ensuring that our factory operates at high capacity during both shifts, especially if we receive substantial orders. We can also add another production line since we have the space for it. We have made the necessary investments, and our engineers are actively overseeing factory operations, personnel, and inventory. They have dedicated office space, and we now have a designated area for testing. The challenges we faced during construction are behind us, and we are now equipped to fulfill any large orders that come our way.

Okay. Thank you. Two more questions. You referenced that Tranche 2 and 3 are being combined and in your statement. You mentioned that we should have news in the next couple of months. Was that pertaining to the size or is that regarding the Tranche 2 award? There was an article that was posted suggesting that army testing will not happen until the fall of this year. If I read it correctly, I may have read it incorrectly. To me, that would suggest the Tranche 2 award would be into the beginning of next year or the end of this year. Is that accurate?

Yes, I saw that same article and received a heads up about it. They mentioned that they conducted the initial alpha test on January 9, where each company had a day to fly. I can report that our drones performed nearly flawlessly during this alpha testing phase, and I am very proud of the Teal team, the engineering team, and everyone who participated that day; we had an excellent demo. Anyone in the drone industry knows that this level of performance is not usually expected. I was referring to the fact that there were initially three tranches, each with a prototype contract, which we secured in Tranche 1, but we did not win the production contract for Tranche 1 nearly three years ago. Tranche 2 included a prototype contract, which three of us were awarded. Following Tranche 2, Tranche 3, which was supposed to start afterward, has been pushed back. Therefore, the funding we would typically receive for Tranche 3, expected in about six to nine months to a year, will instead come through Tranche 2. We anticipate that award will occur in the next couple of months.

Excellent. Is there a possibility that that award will be split up among the three, which I believe is Vantage and Skydio? Is there that possibility that it will be awarded to simply one entity?

We believe it's going to be awarded to one entity. I don’t want to correct you, but it’s not Skypersonic, it's Skydio. I don't know if you saw, but they recently did a financing for $230 million or a two-point-something billion valuation. That makes us look inexpensive considering, I think, our position in the industry. But we believe we're well positioned for Tranche 2, and we solely focus on the military. That's just one of the customers that they deal with. I think they're mostly doing consumers and some first responder stuff now, but our sole purpose is to ensure the warfighter has the tools for reconnaissance and to help with missile guidance and things of that nature, something I don’t think the other companies are well positioned to do or even want to do.

Excellent. One final question; I appreciate your time. The four potential NATO contracts, have we been signed off by the DoD so that we won't have any trip-ups in terms of NATO interest or NATO country interest in our product? Or do we have to wait for the DoD to sign off on any sales?

No. We have all the proper paperwork for the original drones that we sold to NATO countries. We hope so. If someone orders them, we get through all of the ITAR regulations and all those things are squared away. So nothing will hold us up in that aspect.

Excellent. Thank you for your time.

Thank you.

This concludes the question-and-answer session from call participants. I will now return the call to Scott Gordon of CoreIR to read pre-submitted questions from management. Scott?

Thanks again, Kate. Jeff, we received a few questions from investors recently and thought this would be a good forum for you to address them. So I'll just kind of ask these in sequence. Do you have an update on the Border Patrol contract following the initial shipment of 54 drones to them? Do you expect more sales to the Border Patrol?

Yeah. We did receive the first order, which we shipped in January. We're getting some great feedback from them, and we've learned a lot about the program. Let me just start with this: After getting to know some of these folks, these border agents are super users. They fly, I think, one in the air force. They fly tens of thousands of hours every month. These guys are heroes. They're out there sometimes by themselves flying these drones. So we're very happy to provide them products that can help them, specifically thermal cameras that can ensure that no one sneaks up on them. To address the market for Border Patrol from what we've gathered: They typically have about 400 drones in service, and they need to have about 200 other drones to make sure these 400 always stay in service. So I think the total addressable market for the Border Patrol could possibly be close to 600 drones. We're not saying that we will get a 600-drone order in the next couple of months, but we believe that is an option to replace these older drones they’ve been using.

Excellent. Switching over to Ukraine and other NATO countries, do you have anything to share from your recent trip to Europe? I mean, obviously, you shared some. Any success with Ukraine or other NATO countries? I think you touched on that a little bit, but maybe you can amplify.

Yeah. Let me back up a little bit. Most of the sales that are happening with other defense companies already have programs of record that have been in place for years. One of them would be, like, with the Switchblade and they've done some sales in the Puma, which have long-term programs of record. We don't have a program of record in place. If we did, we probably would have already sold hundreds of millions of dollars’ worth of drones for the Ukraine invasion. So since we don't have that yet through the program of record of Tranche 2, people have to be creative to get drones into the Ukrainian army. We found out that we’ve had to get to the right people who want to use the drones. An article mentioned what the operators on the front line want. They want a very high-end thermal drone that can have great detection. The ones they're using right now are not effective, which would enable them to fly missions at night since 90% of all missions are done at night. Our EO camera, our daytime camera is also magnificent. We went from a 12-megapixel to a 64-megapixel; our software updates have significantly improved the performance. We now know how it works and we're working closely to get these drones to them. We hope to have some results very soon.

Switching gears. So this question addresses financing needs: will Red Cat need to do a financing to meet contracts?

So just a few reminders: we are likely to receive the Army Tranche 3, although we don't know the size yet. This represents a 100% margin revenue for something we were already planning to do. The sale of the consumer division will generate cash and provide Red Cat shareholders with significant ownership in the IPO. They have a strong team at Unusual Machines, and they are experiencing rapid growth. We believe they will have a very successful IPO, and I am confident in that. I will be glad to be a part of it, which will further benefit Red Cat. We are excited about the IPO as it will allow us to concentrate on military and first responders. All of these factors contribute to new additional capital, and without that capital, our investments in chipsets and factory development mean that we are now prepared to focus on sales. I anticipate that these sales will generate significant revenue, improving our cash flow even with a lengthy runway ahead. Once we receive our first couple of substantial orders, that runway could extend to five to ten years. Therefore, there is no immediate need for financing.

The last question was addressed in the live Q&A. So that concludes our questions submitted. Thank you. Operator, I'll turn the call back over to Jeff for closing remarks.

Well, great. Thanks. Thanks to everybody for joining. We've been doing a lot of hard work. I want to thank all the employees. Everyone's been doing a great job. This dev team, I now know what they go through. We sat in fields for hours flying drones and freezing in harsh conditions. So I just want to thank everyone for all the hard work. I'm going to reiterate my summary and my remarks because we now have a completed new state-of-the-art factory in Salt Lake City. We have tons of chips to build thousands of drones. Our drone is the best in class now getting a great response. We will have new news with first responders coming over the next few weeks, and Skypersonic is starting to gain its legs in the military. So lots of opportunity, lots of exciting things coming your way. I'm very excited to be here with you. Thank you for joining the call. That’s all I have.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.