Red Cat Holdings, Inc. Q2 FY2024 Earnings Call

Ladies and gentlemen, thank you for standing by. Good afternoon, and welcome to the Red Cat Holdings Fiscal Second Quarter 2024 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 one hour after the end of the call through December 15, 2024. I would now like to turn the call over to Joey Delahoussaye, Vice President of Core IR, the company's Investor Relations firm. Please go ahead, sir.

Thank you, everyone, and thank you for joining us for the Red Cat Holdings Fiscal Second 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 related to cautionary statements in it. Content of this call contains time-sensitive information that is accurate only as of today, December 15, 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?

Welcome, everyone, to our fiscal year 2024 Second Quarter Earnings Conference Call. I'll start by summarizing our recent performance and achievements, and then we'll 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 the second quarter results exceeded expectations, exceeding our guidance of $3 million by 30%. Revenue was $3.9 million, representing 123% sequential growth from Q1. Our margins tripled to 30%. Joseph will supply more detail on this great achievement. On our last quarterly call, I talked about some of the regulatory tailwinds, hopefully leading to the passage of the American Securities Drone Act. I am happy to report that this passed the House and the Senate this week and is on the President's desk to become law. What does this mean? Well, it implies that the largest drone manufacturer in the world, whose largest market is in the United States, can no longer by law be bought by anyone that receives federal dollars. This includes local groups, fire departments, and anyone receiving federal dollars. This will significantly increase the total addressable market in the U.S. for Teal drones. I'll move on to revenue opportunities and investment tailwinds. I'm going to discuss the current organic revenue growth and the driver of our backlog. Today, we reported Q2 $3.9 million in revenue. Our guidance for Q3 is $5 million. We do not see a revenue drop from Q3 guidance for the 123% sequential growth in Q2. This guidance for Q3 is based on signed purchase orders. We also have $7.4 million of funded backlog and growing. As I said on our last call, Q3 revenues of $5 million puts us at a $20 million run rate after selling the Teal 2 for just under 5 months. This is an amazing growth story, and I would like to extend my gratitude to the entire TEAL team for making it happen. Now let's move on to long-term revenue opportunities. The Short-range reconnaissance program, or SRR program of record, started over three years ago and was originally set to have three tranches: Tranche 1, 2, and 3. Tranche 1 had a prototype contract along with a production contract. The same was supposed to happen for Tranche 2 and then Tranche 3. We were awarded a Tranche 1 prototype contract, but we were not awarded a production contract. That production contract a couple of years ago was worth $100 million for 1,083 drones. Tranche 2 should have been awarded months ago, but the Army notified us last December that they were absorbing Tranche 3 into Tranche 2 to expedite the final product and get it into the warfighter's hands. This adjustment was primarily due to the Ukraine war and the realization of how essential small drones are. Therefore, Tranche 3 was incorporated into Tranche 2. During our last quarterly call for Q1, I mentioned that we expected the finalists would be announced this December or January 2024. I'm pleased to report that we were downselected yesterday as a finalist for the large, long-term SRR program of record. Before I hand it over to Joseph, a quick summary: We provided guidance for this quarter of $3 million, and we delivered $3.9 million. We are reiterating our revenue guidance of $5 million for Q3. Last quarter, we anticipated being a finalist for the Army's SRR program of record. Yesterday, we were awarded a $3-plus million contract and downselected as a finalist. I will now hand the call over to Joseph.

Thank you, Jeff, and to everyone for joining the call today. As Jeff noted, we are reporting record revenues, record gross margin, and record backlog for the second quarter of fiscal 2024, which ended on October 31. Each of these financial milestones are clear indicators that the Teal 2 is resonating in the marketplace and that Red Cat has not only reached an inflection point but has turned a metaphorical corner and is on a clear runway to continued growth in revenues, increasing product gross margin, and a backlog that continues to grow despite record shipments. As Jeff noted, revenues of almost $4 million for the second quarter represent more than 400% growth year-over-year and 125% on a sequential basis. We have guided to continued growth in the current third quarter and are confident in our revenue outlook longer term. Our sequential improvement in gross margin on a percentage basis is very impressive. Two quarters ago, we had negative gross margin of 87%. In developing a fully integrated manufacturing process for the Teal 2 and our newly completed state-of-the-art manufacturing facility in Salt Lake City, there were multiple test runs and processes required, which led to negative gross margins. In our last quarter, our fiscal 2024, first quarter, we generated gross margins of 10%, indicating dramatic improvement. This quarter, we reported 30%, which is a tripling of our gross margin percentage on a sequential basis. To a financial professional like myself, that is an impressive performance by our operating team. Looking ahead, we believe we can achieve gross margins of 50% as production capacity scales and we spread our fixed manufacturing overhead over a greater number of units. There may be some variability going forward from quarter to quarter related to our contract work with the Army on our prototype. Gross margin on that contract can fluctuate quarter to quarter based on the mix of work we perform relative to what's needed for materials versus labor. This work is directly connected to our efforts to secure the Army SRR Phase 2 program contract. As Jeff mentioned, we were thrilled to be awarded an additional $3 million in funding to support the prototype milestones. Being announced as one of two finalists out of a starting field of 37 competitors speaks for itself; we are playing to win. Our backlog continues to grow even as we report record revenues. Backlog totaled $4.5 million at October 31, 2023, at the end of the second quarter, and has further increased in the fiscal third quarter to $7 million currently. This clearly demonstrates continuing and growing demand for the Teal 2. One of our key objectives during calendar 2024 will be to continue to grow revenues, increase our gross margin and control our operating costs. Our operating loss for the second quarter, net of stock-based compensation, which everyone knows is a noncash charge, totaled $3.4 million in the fiscal second quarter compared to $4.1 million for the fiscal first quarter, representing a 17% improvement on a quarter-over-quarter basis. That is impressive in my opinion. We aim to drive our quarterly operating loss lower during calendar 2024, and our recent capital raise now gives us the operating runway to execute on that objective. In summary, several key accomplishments the company has been diligently working on over the past three years are coming to fruition. Our state-of-the-art manufacturing facility in Salt Lake City, Utah, is complete and already demonstrating its ability to scale production. Our made in the USA platform gives us a huge competitive advantage in an industry that has historically relied on sourcing from China. We have completed a rigorous application and review process to secure key government approvals and certifications, including Blue sUAS, authority to operate, and approval to sell through the GSA. The long and arduous investment in building relationships and creating awareness of the capabilities of the Teal 2 by our sales team is yielding benefits, as evidenced by a growing backlog. As Chief Financial Officer, I won't predict when Red Cat will reach cash flow breakeven or report profitability. However, I can provide the following perspective: Revenues for the Teal 2 are increasing, gross margins are growing, and our operating loss is relatively modest in absolute dollars. It will not require an unrealistically steep rate of growth for us to reach breakeven. I believe that steady growth and a focus on controlling costs can get us there. Meanwhile, we have two huge opportunities that could dramatically change the company's financial position and market capitalization. The funded replicated program recently announced by the Department of Defense focuses on purchasing thousands of small form drones. Red Cat is an expert on small form drones. As Jeff noted, we are a finalist for the Tranche 2 program award. Tranche 1 was a $100 million program, and Tranche 2 is expected to be much larger. Winning either of these programs would have a huge impact on the company, including its market capitalization and stock price. I will now turn the call over to the operator for questions.

Our first question comes from Ashok Kumar with ThinkEquity.

You mentioned the Replicator initiative from the DoD during your last call, but it wasn't addressed today. Can you provide an update on that? Also, do you anticipate further margin expansion in the fiscal third quarter while maintaining your top line guidance of $5 million for the January quarter? Lastly, since you are one of the two finalists for the SRR, what can we expect next, and is there a possibility that both companies could be selected?

Yes. So the Replicator initiative has garnered a lot of attention; it's a very exciting initiative. We want to be respectful of the DoD and the DIU's mission, and we've become more involved. Their mission is to not discuss specifics, so we will adhere to that and will not disclose what type of assets they are acquiring to defend against China, as that initiative is primarily focused on China. Regarding margin expansion for Q3, we're excited about reaching 30% this quickly. Our goal is to achieve 50%, and we've made significant progress in just one quarter. We expect that as we add more units each quarter, margins will improve. There are non-recurring costs that arise when bidding for a large project like SRR, which can impact margins. Most of the SRR Tranche 2 work is due to conclude by the end of March, after which a lot of costs will no longer be a factor, and we anticipate margins to continue to grow throughout the remainder of the year. Currently, the SRR program operates as a winner-takes-all opportunity. However, given the increased need for drones, there's a chance they might select two manufacturers. As we've seen the demand, we hope to provide more Teal 2 drones. I believe I answered all three of your questions.

Our next question comes from Jim McIlree with Dawson James.

Can you talk about pricing this quarter versus last quarter and versus what's in the backlog?

Yes, our pricing is standard. Most of our products must be purchased via the GSA. The border patrol typically buys through the GSA, and so a drone and controller combo runs about $15,000. If you're just purchasing a drone with one controller, it costs approximately a little over $10,000 for the drone. These prices tend to remain stable unless there are significant volume guidelines, which we have not yet reached.

Yes, I was really inquiring about volume. Are you reaching any volume breakpoints soon?

What do you mean by breakpoints?

At some level of volume, would the customer receive a lower price?

No, they haven't reached those thresholds yet. There's a slight discount once they order 100 systems, but the next threshold is considerably higher.

Do you currently have approval for foreign military sales?

We haven't applied for foreign military sales currently. The FMS and FMFs, even with the NDA being signed today by the President, the NDAA does not fund FMS and FMF. The trip I took to Ukraine was to test our drone against electronic warfare and GPS jamming. Once we get our testing results back from there and submit the letter of request from the Ukrainian government to the U.S. Embassy, we can progress with DSCA for FMS.

This concludes the question-and-answer session with call participants. I will now turn the call over to Joey Delahoussaye of Core IR to read pre-submitted questions for management. Joey?

Yes, thank you. Jeff, we received a few pre-submitted questions from investors recently and thought this would be a good forum for you to address those. The first question is: last quarter, you mentioned that you did not believe you needed to do an equity raise and were exploring non-dilutive financing. Can you clarify what changed with the recent equity raise?

Absolutely. The bottom line is that all of the non-dilutive options were beyond our control. As we mentioned regarding Replicator, who knows when that will come to fruition. Securing an FMS award presents challenges, and the term sheets we were receiving were unfavorable and would have jeopardized the company. We didn't want to risk our good momentum amidst so many positives like great revenue growth and margin expansion. Therefore, we raised the needed funds, and you’ll notice our going concern is no longer an issue. We believe we are on solid ground now.

Do you feel you now have the capital necessary to reach breakeven?

Yes, this capital provides us with the opportunity to pursue non-dilutive avenues that we cannot control initially. The SRR program is set to be awarded between May and September, and we have sufficient funding to last until then. Additionally, if we secure FMS contracts from my recent trip to Ukraine, that will include upfront payments. We hope to receive our recent non-dilutive grant soon, as that timeline is taking longer than anticipated. So, we believe this funding gets us to breakeven.

That was the last of the previously submitted questions. Thank you for addressing each of those. Hopefully, this provided investors with valuable insight into the company. I'd now like to turn the call back over to you for any closing remarks, Jeff?

Great. I want to thank everyone. It’s unusual for us to have to do this on a Friday, but that is when our quarter ended. We typically do this on Wednesdays, but everything threw us off a little bit. We’ve accomplished much over the last two weeks. I’m excited as I thank the TEAL team for their great work and our Biz Dev team for effectively selling our drones. We look forward to an exciting 2024. Thank you, everyone.

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