Earnings Call Transcript - RCAT Q4 2023

Operator, Operator

Ladies and gentlemen, thank you for standing by. Good afternoon and welcome to the Red Cat Holdings Fiscal 2023 Year-End 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 1 hour after the end of the call through October 27, 2023. I now would like to turn the conference over to Joey Delahoussaye, Vice President of CoreIR, the company’s Investor Relations firm. Please go ahead, sir.

Joseph Delahoussaye, Vice President of CoreIR

Thank you, Keith. Good afternoon, everyone, and thank you for joining us for the Red Cat Holdings fiscal 2023 year-end 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, July 27, 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?

Jeffrey Thompson, CEO

Thank you, Joey. Good afternoon and thank you all for joining our fiscal 2023 year-end call and webcast. Also joining me today is Joseph Hernon, our Chief Financial Officer. First, some housekeeping. I am sorry to report that Mary Beth Long has resigned as a board member. She will be available to the company in an advisory capacity, but she is working on foreign affairs that are very important to the country. We wish her well; it has been an honor to have her on our Board, even for this short period of time. I would like to highlight the transformation our company started in the last year that will set us up for success in 2024. First, I would like to remind everyone that this is the first year that we separated our Enterprise and our Consumer segments. We did this as part of a strategic shift to focus on building out our capabilities at Teal Drones. The results are a brand new Teal 2 drone and a larger engineering team that is no longer just building drones, but also creating the new prototype for the Short Range Reconnaissance Program of Record. The key is to secure a program of record. So let’s talk about the Short Range Reconnaissance Program. We still do not know the size of the award for the now combined Tranche 2 and 3. Here’s the information we do have: Tranche 1 production award was for $100 million for approximately 1,000 drones. Tranche 2 and 3 is for approximately 12,000 drones and has been extended to almost 10 years. There is usually a 3-year replacement cycle in programs of this size. The situation in Ukraine has demonstrated the importance of Group One drones like the SRR program, and we believe this will be a significant program of record. We are well positioned as one of the three competitors in the Army’s Short Range Reconnaissance program. There has been a delay in the award cycle as the program has been made larger through the combination of Tranche 2 and Tranche 3, which I just discussed. We recently announced a new SRR contract of $1.2 million as an additional award for the extra work. We are confident that our offering will put us in a favorable position for this program of record. We also believe that the market is much larger than just the SRR, which is for the army. We are being told that the Air Force, Navy, and Marines are likely to want similar capabilities. Back to the Teal 2, the drone that we will be selling for the next 2 years. Timing on our approval by the GSA and the Blue UAS could not have been better. When you consider government sales, it is important to remember that the government fiscal year ends on September 30 and many budgets are use it or lose it; they dislike giving the money back. For that reason, we expect seasonality in our sales cycle with our biggest wins coming in August and September. For instance, the Border Patrol order for over $1 million that we shipped in January for the bake-off was finalized on September 29, 2022. We believe we are well positioned to compete for a large portion of the business available between now and the end of September, what we call sweeps. We anticipate this will create backlog that will stabilize our revenues for a large portion of fiscal year 2024, but orders are only as good as the capacity to fulfill them. Our 10-K shows our sizable investment in both production capacity and inventory. And now this machine is building drones and revenue. We have seen drone competitors in the U.S. that have not been able to ship orders they’ve received. Because of this, one of the first questions we get when we are dealing with Ukraine is how many can you make and when can you ship them? On that note, we recently completed our shipment of 200 FPV drones to Ukraine. I’m happy to say we no longer have 3,700 chipsets, and our production line is constantly producing Teal 2s, and we are shipping them out the door. As part of the strategic focus on programs of record, we decided to sell our Consumer segment. We approved this initial agreement with Unusual Machines last November, and we continue to work toward closing the sale. In the short term, this will raise Red Cat $3 million to $5 million of non-dilutive capital. We believe our shareholders should continue to benefit from the sale of the consumer business indirectly. It’s healthy, it’s growing, and the team is great. We believe it’ll be a successful IPO onto the New York Stock Exchange in early September. Fiscal year 2023 was a year of change and investment. Fiscal year 2024 will be a year of Teal 2 production, sales, and revenue, and possibly the first and largest program of record in the Group One drone category. And with that, I will hand it off to Joseph Hernon.

Joseph Hernon, CFO

Thanks, Jeff, and to everyone for joining the call today. I’m going to echo many of the statements that Jeff just made with some added financial perspective. As Jeff just noted, fiscal 2023 was a year in which the company reported strong revenue growth while making substantial investments designed to position the company for continued revenue growth in fiscal 2024 and beyond. Revenues totaled almost $10 million in fiscal 2023, representing an increase of 54% compared to fiscal 2022. This growth was led by Teal, whose revenues almost tripled in fiscal 2023. With the launch of the Teal 2 in April 2023, the pending sale of our Consumer segment and the consolidation of Skypersonic’s technology into Teal, we have clearly positioned Teal as our platform for success going forward. Negative gross margins reported for fiscal 2023 primarily relate to the accelerated expensing of inventory related to Teal’s legacy drone, the Golden Eagle. This action was largely driven by customer demand for the improved functionality and features of the Teal 2. Operating expenses in fiscal 2023 almost doubled compared to fiscal 2022, increasing from approximately $14 million in fiscal 2022 to almost $27 million in fiscal 2023. Substantially all of this increase was related to our increased focus on an expansion of the operations of Teal. Operations expenses increased from $1.4 million in fiscal 2022 to $4.4 million in fiscal 2023. Since acquiring Teal in August 2021, we have increased its headcount from 15 to 59. Almost all of these employees are focused on operations or research and development. Operating personnel are focused on building, refining, and expanding our production capacity, which is presently at 100 systems per month, which we believe can more than triple over the next few years. The year-over-year increase in operations expense more than doubled. However, during fiscal 2023, we also doubled the size of Teal’s facilities and built our initial production line. These are very expensive objectives, both of which were accomplished. Many of these costs are non-recurring. Research and development expenses doubled from $2.6 million in fiscal 2022 to $5.2 million in fiscal 2023. This investment culminated in the launch of the Teal 2 at the end of fiscal 2023. It is very expensive to complete the final stages of the development and commercial launch of a new product, but we are very excited to have the Teal 2 on the market at the beginning of fiscal 2024. Sales and marketing expenses more than tripled to approximately $4 million in fiscal 2023. Building relationships with government-related entities, including the military, is an expensive and lengthy process. However, once established, these relationships often result in long-term recurring revenues and contracts. During fiscal 2023, we recognized revenues through the Army’s Tranche 2 SRR program and shipped drones to U.S. border control as well as a NATO country, which plans to deploy the drones in Ukraine. Looking forward, we expect to realize additional revenues from these customers in fiscal 2024. We also expect additional government agencies, including other U.S. military branches, to place orders in fiscal 2024. Our investment in building an experienced and talented team of sales and business development professionals is yielding results. Jeff founded Red Cat with a vision that drones were one of the few technologies that would change the world in the next decade. Beginning in early 2020, Red Cat acquired four separate drone companies, each focused on a different segment of the drone industry. Since then, we have integrated these companies and established separate Consumer and Enterprise segments. In the middle of fiscal 2023, we entered into an agreement to sell the Consumer segment at an attractive valuation. More recently, we have decided to integrate Skypersonic’s technology into Teal and shift its business strategy to military and commercial applications more aligned with Teal’s business strategy. This change in strategy required us to record a non-cash impairment charge of $2.8 million to write off the goodwill, which we recorded when we acquired Skypersonic. However, this accounting charge does not change our perspective regarding the utility and potential of Skypersonic’s technology. Imagine the Skycopter exploring a bombed-out building instead of a soldier; that truly is life-saving technology. In summary, we spent a lot of money in fiscal 2023, building a world-class manufacturing facility, hiring a team of talented engineers and professionals who designed and launched the Teal 2, and establishing business relationships with U.S. Government agencies, which are traditionally difficult to secure but can lead to long-term customers once established, making this an expensive endeavor. The entire Red Cat team is proud to have accomplished all of these objectives. Looking forward, we reported more than $16 million in cash at the end of fiscal 2023. This balance is net of more than $14 million in inventory that we held at the end of fiscal 2023. We are very excited to convert this inventory into revenues in fiscal 2024. I will now turn the call over to the operator for questions.

Operator, Operator

Yes. Thank you. And the first question comes from Ashok Kumar with Think Equity.

Ashok Kumar, Analyst

Great. First question is on the sales side. Can you please elaborate on the new SRR contract you indicated for $1.2 million, and also on the orders that we can expect from the military in August and September? And then outside of the military, could you – I think you indicated on the Border Patrol, I think you shipped 54 systems in mid-January, right? What can we expect in terms of additional orders for this calendar year? And then also on the Drone Infrastructure Inspection Grant, right, so that’s a $100 million bipartisan grant. And given that you’re well positioned, what is the opportunity for this calendar year? Hello?

Operator, Operator

Jeff, are you there?

Jeffrey Thompson, CEO

Sorry, I was on mute. Yes, that’s a lot of questions there, Ashok, but I will try to go through them one by one. So, first, I think it was the SRR contract. We recently received a contract. The actual contract, if you read it, was for over $5 million. But the army actually reviews our press releases, and the appropriation is only through November, so that’s $1.2 million that we’ll get for the prototyping through November of this year of calendar 2023. And the rest of the contract that we have signed goes through the end of March, when they are supposed to do the final selection. There’s also supposed to be one more down selection in the fall. So two things could happen with that SRR contract, and I think people will be pretty excited if we get down selected in the October-November time frame, if they do it on time. And then once the rest of the money that we have assigned contract for is appropriated, it would be a total contract between now and March for $5.3 million, I think, the total was. The second question, Ashok, what was that? I’m sorry; I was trying to...

Ashok Kumar, Analyst

The orders we can expect in August and September, right, you’d mentioned on the military side.

Jeffrey Thompson, CEO

Yeah. So, again, I mentioned it in my comments, this is sweeps time. So we’ve been all over the place trying to demo our drones at all sorts of different military facilities throughout the U.S. We also just got back from Ukraine at a testing facility to get tested against GPS jamming, which went very well. We’re heading back there the week after next. So there’s a lot of activity in Ukraine. But, we think there’s going to be some pretty significant orders coming in this August-September timeframe that we’ve been working on for over a year. We have nothing of concrete purchase orders that I can announce, but we think it’ll be substantial from last year.

Ashok Kumar, Analyst

Great. Thank you. And any additional color on the Border Patrol and any additional orders we can expect for this year? And then on the Inspection Grant Act, any upside there, please?

Jeffrey Thompson, CEO

Yeah. So on the Border Patrol, there was a bake-off. It’s interesting; it’s between all the people that are in the SRR program. We all got an order for drones that we had to deliver in January, Skydio and Vantage. We’re hoping to get more orders. We haven’t received anything yet, but we would expect to see some play if we win before the end of September like we did last year. And the last question was the $100 million bipartisan?

Ashok Kumar, Analyst

On the Inspection Grant Act? Yes.

Jeffrey Thompson, CEO

Yeah, if you read that bill, it has to be a U.S. made drone. And we have one of the only U.S. companies now integrating into the Teal facility. The largest competitor for infrastructure for that type of drone is actually a non-U.S. company. So now that it’s a bipartisan bill, we expect that to hopefully put us in a good spot for that capability, and we haven’t heard anything yet from it, but we’ve stayed all over it. We’re also hoping we saw some activity in the Senate recently for the American Securities Drone Act. So if that goes through, that actually puts even more barriers for Chinese drones across the U.S., not just for the Department of Defense. So there’s a lot of activity that would lead to U.S. drone manufacturers getting quite a bit of business.

Ashok Kumar, Analyst

Great. Any quick responses on the operating expenses? I guess, given you’d indicated some of these are non-recurring costs, some of it headcount related and so on, do you expect it to stabilize in fiscal 2024? And then the gross margins that assume that should improve with product shipment increase and efficiency on the manufacturing and assembly process side?

Jeffrey Thompson, CEO

Yeah. So we expect once we start producing, we don’t have to invest anymore. The factory is working; we’re producing drones every single day and shipping, and the margins once we are building 100 drones plus a month are typically around 40%. And then if we are selling product, which we mostly sell with our partners like Athena AI artificial intelligence and targeting Tomahawk Robotics, which makes capabilities for the 4-Ship product, Reveal Technology that can increase our margins dramatically when we add these software sales in a partnered capability. So we expect the margins to go up throughout the rest of the year. We also won’t have any of these write-offs that we had for this year-end. So you’re going to see dramatic margin improvement throughout the year.

Ashok Kumar, Analyst

Got it. One last question on the chipsets, right? I think you had 3,700, which can support 3,200 or 3,500 drones. Is there any risk of inventory obsolescence? Are there any spec changes to your drones? Or do you feel…

Jeffrey Thompson, CEO

No, that’s not; that 3,700 was– a lot of it’s all going into the Teal 2, so we’re not going to have – that 3,700 was well protected. The stuff that we were talking about earlier on the Golden Eagle is completely different tech.

Ashok Kumar, Analyst

Great. Thank you and all the best.

Jeffrey Thompson, CEO

Sure.

Operator, Operator

Thank you. And the next question comes from Carlo Corzine with Dawson James Securities.

Carlo Corzine, Analyst

Hi, Jeff, how are you doing? Great certifications and making great progress. On the 200 drones that were delivered. They were to be delivered in June. Were they, in fact, in June or some in July? And when you do the partnerships, how do we break down what the sale price is, how much goes to Red Cat, how much goes to the other people? And I don’t have any idea right now as far as how much the sale price is for the Border Control versus the Teal?

Jeffrey Thompson, CEO

Yes. The typical Teal 2 is similar in price, as you see on the GSA to the old Golden Eagle, about $15,000 for the airframe and for the controller. And it’s a little difficult to pigeonhole partnership percentages because it depends on which country we’re selling to, who had the partnership, who brought the partnership in, whether it’s Athena that’s bringing us along because they have the sale, or if it’s us bringing Athena along, whether we brought the sale same with Tomahawk. Most of the time when we’re doing demonstrations like we’ve done all the last few weeks, we’re either doing a demonstration with Tomahawk using their grip and controller with the Athena AI on top of their KxM. So it could be even a three-way partnership. In some cases, Red Cat is bringing the main customer to the table, where we’re going to get a percentage of all of their revenue, or if they’re bringing it in, they’re going to get a percentage of our revenue. So, it’s kind of a difficult question to ask with exact numbers, but these partnerships always come with a license capability, and they’re beneficial for Red Cat.

Carlo Corzine, Analyst

So how should we figure that if you sell 50 drones and we got a $15,000? Obviously, maybe 50% of that is yours, 60% of that is yours? How can we…

Jeffrey Thompson, CEO

For the $15,000, that’s 100% ours. That’s just for the...

Carlo Corzine, Analyst

Oh, that is okay. Yeah.

Jeffrey Thompson, CEO

Yeah. And they’ll do the added features if they require it, and that would be additional revenue on top of that.

Carlo Corzine, Analyst

Okay. Got it. As far as research, who’s covering you right now?

Jeffrey Thompson, CEO

So far it’s ThinkEquity.

Carlo Corzine, Analyst

Stock wise? Yeah, stock wise. Well, not the person. Is ThinkEquity the only one, or is anybody else covering your research wise?

Jeffrey Thompson, CEO

This is the only research; there are a few newsletter guys that follow us pretty closely, but no, that’s pretty much it.

Carlo Corzine, Analyst

Okay. All right. Thank you.

Jeffrey Thompson, CEO

Thank you, Carlo.

Operator, Operator

Thank you. And the next question comes from Scott Michael, an investor.

Unidentified Analyst, Analyst

Hi, Jeff. Thanks for taking my call. To clarify, a question was asked earlier about the 200 drones, were they delivered in June, or June and July?

Jeffrey Thompson, CEO

I’m pretty sure most of them were shipped in June.

Unidentified Analyst, Analyst

Excellent. Thank you. Also the question on the chips you’d referenced earlier that you have 3,700, but where you’re producing now, I’m assuming that number is lowered. Do we have any supply line issues on the chips at this point or is that pretty much addressed?

Jeffrey Thompson, CEO

No, it’s pretty much everyone. We’re always cautious about supply chain, because you have to make such large decisions so far ahead of time. But like everyone else, we’re seeing supply chains getting better. But we have a lot of chips in a lot of different parts. And so if not every single part of that, so every chip is doing well with supply chain. You can’t breathe a sigh yet, but we’re in really good shape. Because of the amount of buying we’ve been doing over the last year, we’re usually getting some good preferences, and the Teal 2 is doing so well that everyone’s excited about it in our supply chain.

Unidentified Analyst, Analyst

Excellent. Thank you. And it looks like Giuseppe left Skypersonic. Does that affect the NASA contract at all?

Jeffrey Thompson, CEO

No. So the goal for the Skycopter was, one is we already started working on the remote piloting over a year ago. We had separate offices. We wanted to integrate as much as possible. And now someone already mentioned the $100 million bill for U.S.-made inspection drones, which we want to migrate to made in USA for Skypersonic. So we’re doing a lot of work to integrate, but it does not affect the massive deal.

Unidentified Analyst, Analyst

Excellent. Thank you. Can you clarify what our investment into Firestorm was? And do we have any reciprocal arrangement with them for production or anything like that?

Jeffrey Thompson, CEO

Not yet on the production levels, it’s in the 10-K that we invested $250,000 into their first round. What do you hope…

Unidentified Analyst, Analyst

It's actually about...

Jeffrey Thompson, CEO

Well, there are two things, right? We do hope to help them with production. We do have a factory. It’s very difficult to build a factory. We have electronics that have been flying for years now and that have all the bugs out. The electronics that fly the drone are very important, so you don’t have to start from scratch there. We hope we can help there. Our production facility, we hope we can help there. But they’ve got a great team and they’re moving along quickly. And we hope to be able to accelerate their time to market because of our head start in electronics and manufacturing.

Unidentified Analyst, Analyst

Excellent. Thank you. You said production is 100 per month. I think in the past, you’d referenced maybe 1,000 per month. Is the 100 per month going to increase or is that pretty much where we’re at for the rest of the year?

Jeffrey Thompson, CEO

No. I mean, we first just got to get the factory up and running and make sure that you have all the issues out of the production line to reliably do 100 a month. As some of our team says, we do 100 a month, no problem at ease right now. And that number is already growing slightly. But you don’t go off and build 1,000 drones because there are different frequencies. For instance, some of the organizations that we’ve been working with for demonstrations to hopefully get in fleets relatively soon want 1.8 gigahertz, so of them want 2.4 gigahertz, some of them want other frequencies that we’re not really talking about for other countries. And so you can’t just make batches and hope for the best of 1,000 and then ship them out. But we’ve been at a good clip and we can expand that capability if we had to if we got an order for 1,000; we would ramp that up dramatically in a few months.

Unidentified Analyst, Analyst

Excellent. Now, you referenced in the report that the cash in hand is $16 million and $14 million in product. Is that correct? Did I understand that correctly?

Jeffrey Thompson, CEO

Yes.

Joseph Hernon, CFO

A little over. Yeah. Go ahead, Scott.

Unidentified Analyst, Analyst

I’m sorry, that was a yes on that.

Joseph Hernon, CFO

Yeah. We ended fiscal 2023 with $16 million in the bank and slightly more than $14 million in inventory. That’s not all finished goods, but that’s a substantial amount of inventory, much of which is largely completed and ready to convert into sales.

Unidentified Analyst, Analyst

So, where cash in hand has significantly dropped from what it previously was? Is an offering something that we need to be concerned of as investors?

Joseph Hernon, CFO

Well, I think…

Jeffrey Thompson, CEO

Hold on. Let me start, and then you can finish up.

Joseph Hernon, CFO

Sure.

Jeffrey Thompson, CEO

For us, the $14 million that Jose mentioned will be quickly converted into cash as we generate sales. Additionally, the UMass agreement provides another means of raising non-dilutive cash. These are the methods we prefer for raising funds. Jose, feel free to elaborate, as we no longer have significant investments.

Joseph Hernon, CFO

Yeah. One of the things that I tried to emphasize in my statements was that there were a lot of unusual expenses in fiscal 2023 that resulted in our spending a lot of money. I think we’ve been very candid about that. We built a brand new world-class facility; that’s a big investment. It’s scaling, it’s done, it’s completed. We built a great team out in Salt Lake. It’s hard to attract talented engineers and technical professionals, and we have them, and we don’t see that kind of capital investment going forward. The $14 million is ready to convert into revenue. So there are lots of positives why we feel we’re pretty well positioned. We’re an emerging technology company. We’re not yet profitable, but we feel we’re in a pretty good position because the manufacturing facility is completed, it’s done, it’s ready to produce drones. It’s doing it every month. I don’t personally recall us ever saying we could produce 1,000 a month. 1,000 a month at $15,000 per drone, I don’t have a calculator in front of me, but that’s an incredible amount of revenue. We feel in a good financial position, especially after investing so much money in our facilities and our people and our product development in fiscal 2023.

Unidentified Analyst, Analyst

Okay, thank you so much. I appreciate your time.

Operator, Operator

Thank you. This concludes today’s teleconference. Thank you for attending today’s presentation. You may now disconnect your lines.