Red Cat Holdings, Inc. Q1 FY2024 Earnings Call

Ladies and gentlemen, thank you for standing by. Good afternoon and welcome to the Red Cat Holdings Fiscal First Quarter 2024 Financial Results and Corporate Update Conference Call. At this time, all participants are in 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 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 December 18, 2023. I would now like to turn the call over to Joey Delahoussaye, Vice President of CoreIR, the company's Investor Relations firm. Please go ahead, sir.

Thank you, Sarah. Good afternoon, everyone, and thank you for joining us for the Red Cat Holdings Fiscal First Quarter 2024 Financial Results and Business 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 19, 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?

Thanks, Joey. Thank you. Welcome, everyone to our fiscal year 2024 first quarter earnings conference call. I'll start by summarizing our recent performance and achievements, and then I will provide information related to our outlook for fiscal year 2024. After which, Joseph will review our financial results, and then we will take your questions. I am pleased to report that the Teal 2 drone is receiving a warm welcome as the most unique and capable nighttime drone in the Group 1 class. We announced the Teal 2 at the Army Aviation Association of America Conference on April 26, just before our fiscal year-end. The Teal Drones revenue for fiscal Q1 was $1.75 million. We cannot make a year-over-year comparison because the Teal 2 did not exist, but if you were a start-up and launched a brand-new product and did almost $2 million in revenue in your first quarter, it would be considered a home run, especially if there was follow-through, but more on that in our guidance update. We've met with a lot of investors recently, many of whom are new to the story, so I want to back up and discuss some of the regulatory tailwinds that have contributed to the current status of the United States growing market. In December 2020, DJI, the largest drone manufacturer on the planet, was placed on the US government's entity list. In December 2021, DJI was also put on the economic blacklist. Fast forward to July 2023, the American Securities Drone ACT, ASDA, passed the Senate unanimously and we expect it to become law in the next few months. In August 2023, Red Cat's Teal 2 received Remote ID certification from the FAA. This was a huge achievement; the documentation was over 300 pages and acquiring certification from the FAA was extremely challenging. Only a few manufacturers have achieved this so far. The difficulty was such that some companies delayed their applications for six months. So what do these regulatory tailwinds mean? It means that the largest drone manufacturer in the world, whose number one market was the United States, can no longer be purchased by anyone that receives federal dollars. This is not just the Department of Defense, it extends to local groups, fire departments, and any organization reliant on federal funding. This has created a substantial market and a significant vacuum for only us and one other manufacturer in the US that can scale to fill it. This is a very unique opportunity that does not occur often. Now let’s discuss revenue and investment tailwinds. I will first address our organic revenue growth and then touch on the DoD's newly announced and funded replicator initiative, which we see as mid-term revenue within the next three to six months. Following that, I will discuss the short-range reconnaissance (SRR) program of record, a 10-year program that many on this call are anticipating, which offers significant potential. Today, we reported Q1 revenue of $1.75 million. For Q2, our guidance is $3 million, representing 71% sequential organic growth. For Q3, our guidance is $5 million, or 67% sequential growth on top of that. This guidance is based on signed purchase orders, and we expect to secure more in the next 11 days. Q3 revenue of $5 million puts us on a path to a $20 million run rate after selling the Teal 2 for just under five months. This is an incredible growth story, and I want to thank the entire Teal team for making it happen. Moving to mid-term revenue opportunities, which we anticipate in the next three to six months, let's discuss the replicator initiative. The Pentagon has unveiled a revolutionary new strategy focused on fielding thousands of affordable, smart, and autonomous war drones across multiple domains within 18 to 24 months to counter China's military. According to the Wall Street Journal, Deputy Secretary of Defense Kathleen Hicks stated that the Department of Defense plans to develop AI systems intended to be small, smart, and affordable to address threats posed by China and other countries. Overall, Hicks emphasized that we will be delivering thousands of drones to the warfighter in 18 months. Last week, we announced our replicator initiative, which is aimed at overcoming the production challenges we face as we scale all domain attributable autonomous systems. What does this mean? Tens of thousands of expendable drones need to be delivered to the warfighter in 18 months, which implies that orders will likely need to be placed with suppliers in the next three to six months. We believe we are very well positioned and already engaging with this program. Now let's shift to long-term revenue opportunities, specifically the SRR program of record. For those new to the call, the SRR program of record started over three years ago and was originally intended to have three tranches: Tranche 1, 2, and 3. Tranche 1 would involve a prototype contract and a production contract, with similar expectations for Tranche 2 and Tranche 3. We were awarded the Tranche 1 prototype contract, but not the production contract, which was valued at $100 million for 1,083 drones. Tranche 2 was supposed to be awarded months ago, but the US Army notified us last December that they would merge Tranche 3 into Tranche 2 to expedite the process, ensuring the final product is delivered to the warfighter. This change was primarily motivated by the Ukraine war and the widespread recognition of the importance of small drones. The next down selection for Tranche 2 and 3, which have been combined, is tentatively scheduled for late December or early January. While we cannot predict the actual contract amount, the previous $100 million contract was for 1,083 drones, and the current contract scope expands to over 12,000 drones. I'm not implying linear math, and I’m not suggesting this will automatically translate into a $1.2 billion award, but I do believe it will be significant. Given the ongoing demand for thousands of drones, we cannot rule out an increase in the contract size due to the necessity of small drones. Now I will 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 operating results for the fiscal first quarter, which ended on July 31st, 2023. My comments will focus on a number of financial milestones and events, which leave us strongly positioned for the balance of fiscal '24 and beyond. As many of you know, we have a pending agreement to sell our consumer segment to Universal Machines, which I will also refer to as UM. The sales price includes an immediate cash payment of $3 million plus $17 million in shares of UM. We also expect to see a favorable working capital adjustment of approximately $4 million, which will be payable in additional stock. The sale of the consumer segment is contingent upon Universal Machines completing an initial public offering on a major stock exchange. UM has recently informed us that they have significantly progressed with the registration process with the SEC and they expect to complete the IPO during our fiscal second quarter. Therefore, under the accounting rules since the transaction is likely to close within the next 12 months, we are required to report the consumer segment as discontinued operations. The financial accounting and reporting for ongoing operations differs significantly from what we have historically reported. Essentially, the operating results from our consumer segment which includes Fat Shark and Rotor Riot have been condensed into a separate line in each of our financial statements. There is no combining of amounts related to our continuing operations, which consist of Teal and Skypersonic, and our discontinued operations, which comprise our consumer segment consisting of Rotor Riot and Fat Shark. Since we expect to receive approximately $21 million in shares of UM, making us a significant shareholder, I will briefly review the Q1 operating results for the consumer segment. Driven by robust growth at Rotor Riot, Q1 revenues nearly reached record levels. The operating loss for the consumer segment was modest, at less than $300,000. UM believes multiple opportunities exist to continue growing the consumer segment under its stewardship. We believe that our shares in UM will possess significant long-term value and represent a hidden asset relative to Red Cat's current market capitalization. Turning now to the enterprise segment, as Jeff mentioned, just before the start of fiscal 2024, we launched the Teal 2 in late April. The market response has been immediate and significant. We reported record sales for the Enterprise segment in the first quarter of fiscal 2024, and we believe that higher sales will be reported each quarter throughout fiscal 2024. We are already beginning to receive repeat orders and currently have an order backlog of approximately $6 million. As noted in prior calls, we initially established relatively high inventory levels in response to the supply chain challenges that emerged during COVID-19. These actions led by our COO, Allan Evans, enabled us to secure chips and other electronic components at a time when they were scarce and costly. This strategic move positions us well today. With the growing demand for the Teal 2, we estimate it will cost approximately $3 million to convert our existing $11 million of inventory into approximately 1,200 drones, which represents revenues of $18 million based on our base sales price of $50,000 per drone. This inventory conversion will yield net cash proceeds of approximately $15 million and represents one of the various cash sources we expect to tap into in fiscal 2024. Our anticipated cash proceeds of $3 million from the sale of the consumer segment represent another source of capital. While we can't immediately sell our 21 million shares of UM, the 180-day lockup period is relatively short and may begin to generate cash proceeds toward the end of fiscal 2024. We expect that orders from government agencies will continue to be the primary source of our enterprise revenues. Given the high certainty of funding sources for government-based orders, we have exceptional opportunities to secure financing based on these orders. Finally, one of our greatest assets is our manufacturing facility in Salt Lake City. Building this facility has been a major focus of our management, dedicated employees, and precious capital since we acquired Teal in 2021. The facility is fully operational and continues to scale its manufacturing output. At present, however, we are not fully leveraging its capabilities, resulting in lower than targeted gross margins. As Jeff noted, we expect orders for the Teal 2 to keep growing throughout fiscal 2024, allowing us to manufacture these additional drones at a lower unit cost, thereby enhancing gross margins and operating cash flows. Our drones are made in the USA, which is increasingly important to government agencies, including military branches. We believe this provides us with a significant competitive advantage in an industry poised for substantial long-term growth. I will now turn the call over to the operator for questions.

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

Thank you. Two questions. The first question, two parts. In terms of your Q3 fiscal guidance of $5 million and your current cost structure and improving margins, will that get you close to cash flow positive? And the second part of that question is, given your current cash position and the near-term burn, is there a need to raise capital? The second question is on the competitive front on the SRR program. You're competing with Skydio and Vantage and then you're in a bake-off for the Border Patrol Program with the same competitors. So could you please provide an update on the opportunity and the Border Patrol Program? Thank you.

Sure. Let me start with your last question and go backwards here. Yes, we all received orders earlier this year. We secured an order for about a million drones from the Border Patrol. Skydio also received orders, and Vantage Robotics received a much smaller order. So yes, we are in a bake-off to win their business. We have no new updates, but it is interesting, and that’s exactly the competition we’re facing for the large SRR short-range reconnaissance program of record. We hope to have news soon, as this time of the year could yield updates, and you'll be the first to know. Secondly, regarding your question about raising capital, we’ve been asked about this a lot at the conferences we attended last week, and it's a valid inquiry. However, I would like to clarify that the C-level team and the employees of the company are not hired guns. The employees and management own nearly 40% of the shares outstanding. We are not looking to dilute our shares. We do not want to do that, as that would negatively impact us as significant shareholders. Let me go through some details on this. As Joseph noted, we will be converting millions of dollars of inventory into sales in the next couple of quarters. In our first three quarters, we expect to report about $10 million in shipped revenue, which would be more than all of last year, and we’re not yet finished with sales. Those numbers could actually be higher. Furthermore, as Joseph pointed out, we expect to close the deal with UM in the next few weeks, which will generate approximately $3 million in non-dilutive capital. We estimate $1 million to $2 million or possibly more from inventory. Additionally, we expect to receive approximately $2.4 million from our SRR prototype contracts, which will commence in November and conclude in March. We've also recently received offers for small debt financing, not convertible debt, and as Joseph mentioned, we're exploring credit lines based on our government contracts, which typically come with much lower interest rates. To summarize, our non-dilutive capital sources over the next few months are approximately $7.4 million to $9.4 million. If we add a small debt offering, which could include $3 million to $5 million, that amounts to a total of $10.4 million to $14.4 million of non-dilutive capital, which should be sufficient to get us to cash flow positive. As for your question about whether the $5 million in revenue will get us to cash flow positive, we’re not ready to make that projection yet, but it’s looking quite promising at that point.

Great. Thank you very much and all the best.

Great. Thank you.

Our next question comes from Jim McIlree with Dawson James. Please go ahead.

Yeah, thanks, and good evening. In your commentary regarding inventory levels, it suggests that gross margin on this $15 million of revenue is about 22%. I'm assuming that's due to the high burden of the factory. When you achieve either reasonable capacity utilization or full utilization, what kind of gross margins would be reasonable to expect?

Yes. I'll touch on that at a high level, and Joseph may want to add his insights. This is an area I've reviewed with Dr. Evans, who has been building factories for the last decade. Starting from full factory utilization, if we were producing thousands of drones, our gross margins could go up to 70%. I completely agree with you. Initially, when you set up a factory, which we have just opened, and if you’re producing only a small number of drones, your margins can appear poor because the full factory overhead is allocated to those few units. However, our material margins are currently typically in the 40% to 50% range, although we are addressing this in accordance with GAAP, so your estimate of 22% is correct, but we expect to potentially reach up to 70% gross margins once fully operational due to large contracts with the replicator initiative or SRR which can deliver those types of margins.

I don't have much to add. I think the point I was trying to highlight is our strong cash flow situation in fiscal '24. We have already paid for much of the material cost needed to produce these 1,200 drones, which is an unusual scenario for us. Because of COVID and the shortage of electronic components, we proactively invested substantial funds raised in 2021 to ensure we wouldn’t face difficulties fulfilling orders. Thus, we're in a unique position right now. As for your initial question, yes, we are currently facing a capacity utilization challenge, which is common for emerging companies that have built a facility like ours. This is a challenge we have already addressed, and the fact that our facility is now operational enhances our outlook moving forward. This is a significant milestone for an emerging growth company like us and allows us to feel optimistic about fiscal '24 and beyond.

That's great. If I can just ask one more. On the SRR and replicator programs or contracts, are these fixed-price contracts, so you'll have the ability to improve margins as you enhance your manufacturing processes, or are they time and materials contracts?

No, these are not time and materials contracts. These are fixed-price contracts tied to our GSA pricing. Typically, we cannot adjust that pricing unless there's a significant volume increase. Therefore, our margins will improve substantially as we ramp up. All the orders we've announced prior have followed GSA pricing, so the SRR program will be based on fixed pricing. The replicator program, which we didn’t elaborate on earlier, is aimed at ensuring that small companies producing small drones do not fall into the pitfalls of production when dealing with large government contracts. For this replicator program, we expect to receive advance payments, which helps us avoid dilution as we are large shareholders.

That's great. And my last question is regarding the $5 million in OpEx this quarter. Is that a reasonable figure going forward?

Yes, I would say so.

Yes, I would concur. Unfortunately, I don’t see significant cost savings related to the sale of the consumer segment. While there are substantial fixed costs associated with being a public company, I believe the positive news is that an increase in revenues should not translate into dramatic spikes in expenses. You may have noticed that our operating expenses actually decreased in the fiscal first quarter. Therefore, we should be able to leverage both gross margin and our operating expenses so that as revenues grow, we won't see dramatic increments in OpEx.

Thank you very much. That's all from me.

Showing no further questions, this concludes our question-and-answer session of the call. I will now return the call to Jeff Thompson for closing remarks.

Sorry, folks, I was on mute. Well, thanks, everybody, for joining us. I want to thank the team at Teal. I want to thank our BizDev team. You guys are awesome. We'll be seeing many of you at upcoming conferences. I’d like to highlight the Dawson James Conference on the 12th and we will also participate in the LD Micro event in early October. Please come see us.

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