Earnings Call Transcript - RCAT Q3 2022

Operator, Operator

Ladies and gentlemen, thank you for joining us. Good afternoon and welcome to the Red Cat Holdings Fiscal Third Quarter 2022 Financial Results and Corporate Update Conference Call. Participants are informed that this conference call is being broadcast live online and is also being recorded for later playback. A replay of the call will be available about an hour after it concludes until June 17, 2022. I will now hand the call over to Mr. Scott Gordon, President of Core IR, the company’s Investor Relations firm. Please proceed, sir.

Scott Gordon, Investor Relations

Thank you, everyone, and thank you for joining us for the Red Cat Holdings’ fiscal third quarter 2022 financial results and corporate update conference call. Joining us today from Red Cat Holdings are Jeff Thompson, Chief Executive Officer of Red Cat Holdings 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 particularly. 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 Red Cat’s press release that accompanies this call, particularly the cautionary statements in it. The contents of this call contain time-sensitive information that is accurate only as of today, March 17, 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, please go ahead.

Jeff Thompson, CEO

Thanks, Scott. Thanks for joining our third quarter 2022 earnings call. First, I would like to thank all the employees at Fat Shark, Rotor Riot, Skypersonic, and Teal Drones. They have all worked hard to get their businesses on a path to scale and grow and we expect different contributions at different timelines to grow revenues over the next three or four quarters. Again, great work, team. Fat Shark has new products coming. Skypersonic will be playing a key role in the infrastructure inspection space. Rotor Riot continues to grow and build an audience and their annual event rampage, which I hope to attend this year, is sold out. Next, let’s talk about Teal Drones. I am sure there is going to be a lot of activity surrounding this based on recent weeks. So, let me start with some housekeeping. The number one question we get is about the supply chain. We have just under 4,000 chipsets to build just under 4,000 Golden Eagles, which would equate to over $15 million in revenue. I want to start by discussing the demand for drones in Ukraine before we dive into the SRR Tranche 2 contract award that we received this week. Just last Thursday, we have been overwhelmed with inbound inquiries from many countries looking for thousands of drones not made by the Chinese to deliver to Ukraine. We have been working tirelessly all hours of the night and during weekends to respond to these proposals and we hope to have something soon to report on this as it just started development last week. From various sources, we expect large and continued demand for drones in the Teal category, particularly that Teal-style drone in Ukraine for obvious reasons—they are not looking for Chinese drones. This is already creating a significant demand vacuum, not just in Ukraine, but across all segments like police and first responders because every manufacturer that exists today or is currently being built is now sold out. So, regardless of whether the drones are sold to Ukraine or to the police, we expect this massive demand spike to outstrip the potential supply from all non-Chinese alternatives for at least the next 12 months. We are working as aggressively as possible to scale our production because of this. Let’s move on to the Teal Drones SRR contract. Teal Drones was awarded a prototype contract for SRR, which is Small Range Reconnaissance Tranche 2. This contract award was for $1.5 million. Teal was one of the two that received the Tranche 2 contract. Let’s get some details on the SRR program, as I get a lot of questions about it. Tranche 1 had 5 contracts awarded for prototypes. Teal was one of those 5 contracts. This was 2 years ago. There was one Tranche 1 production award for $100 million. There has been some confusion about that, primarily because it just came out in February even though it was awarded 2 years ago, mostly due to COVID. Tranche 2 has two prototype contracts, and we will be competing for the Tranche 2 production contract, very similar to what happened in Tranche 1. Each tranche has a production contract, so we are confident about this. We are very proud to be one of the two chosen, and this is exciting news. This will be a long-term relationship with the Army, and with those statistics, I think we have at least a 50:50 chance for the production contract. But anyway, I am looking forward to your questions. I am sure there will be many, as there is a lot going on in the world right now. With that, I’m going to hand it over to Joseph Hernon.

Joseph Hernon, CFO

Thanks, Jeff, and to everyone for joining the call today. I will now provide a review of our financial results for our fiscal third quarter, which ended on January 31, 2022. Revenues during the quarter totaled almost $2 million, which were flat with the previous quarter and down approximately 13% compared to the third quarter of fiscal 2021. During the 2021 period, we closed the Fat Shark acquisition, and we benefited from a new product launch by Fat Shark, which drove revenues unusually high at that time. However, year-to-date, our revenues for the 9 months ended in fiscal 2022 increased 64% compared to the 9 months ended January 31, 2021, reflecting contributions from all of our acquired subsidiaries. I think our year-to-date revenue growth is a much better measure of how we are gaining traction across all our subsidiaries as drone technology becomes more pervasive and visible in our lives. During the quarter, much of our focus, as Jeff touched upon, was on building out the Teal organization and preparing Teal for the multitude of revenue opportunities emerging. During the quarter, we doubled the size of the Teal facilities, both to increase its manufacturing output capabilities and to house its workforce, which has doubled in size since we acquired Teal. While this strategy adversely impacted short-term revenues, we strongly believe that it positions us to adequately capitalize on larger and more durable long-term sales opportunities. Operating expenses totaled $3.5 million in the third quarter compared to $1.7 million in the third quarter of last year. This represents an effective doubling of our operating expenses and can be attributed to the closing of both the Skypersonic and Teal acquisitions as well as the significant investments made in Teal since our acquisition at the end of August. During this past quarter, we also continued to build our internal sales and marketing team, which is, as Jeff mentioned, starting to gain impressive traction. Our net loss for the 3 and 9 months ended in the fiscal quarter on January 31 totaled $2.6 million and $6.9 million respectively. As both Jeff and I have noted, we have been making substantial capital investments in Teal, both in its facilities and its people to seize what we see as significant commercial opportunities for the Golden Eagle. Despite this increased spending, we remain in a very strong financial position. We closed the quarter with almost $56 million in cash and marketable securities. As I mentioned, our last and most recent quarter, excluding stock-based compensation, which is a non-cash charge, was less than $2.5 million. So, if you compare the $56 million in the bank to the $2.5 million in the most recent basic cash burn, you can quickly see that we are in a great position to execute on our growth initiatives. We are excited about finishing strong in 2022 and our outlook for fiscal 2023, which begins on May 1. I will now turn the call over to the operator for questions.

Operator, Operator

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

Ashok Kumar, Analyst

Hi, good afternoon. Thank you. Just an operational question, in terms of the revenue contributions for the January quarter, could you please highlight the Fat Shark and Teal contribution? And then, as it applies to gross margins, as you continue to see operational improvements and supply chain improvements, at what timeframe do you see your gross margins hit normalized levels? And the last operational question would be cash burn about $4 million a quarter. Do you see that sustained at current levels? And then looking forward, Jeff, could you also highlight – congratulations on the T2 prototype contract, what is the timeline for the production award? The same question would apply to the T1 program as well? Thank you.

Jeff Thompson, CEO

Sure. There are a lot of questions there, but let me do my best to answer them. So, to be very frank, we had significantly less Fat Shark revenue in the quarter, mostly because they are at the end of one product cycle going into a new product cycle. When that happens, it’s very similar to the iPhone; no one likes to buy iPhones in August when the new iPhone is coming out in September. So, we expect the revenue to bounce back in that phase. For the Teal contribution, it was not that significant because there were only 4 weeks available for them to be counted in this quarter. What’s interesting is we learned about being selected in, I think it was even November. So, as we started looking at how to scale, we were glad that it didn't get out until we were able to release it this week. So, we did a lot of extra work to the production line to get our capabilities ready for the demand cycle. And we are actually quite lucky that we did, because now with the Ukraine situation, we will be able to fulfill drones at levels that almost no other company can fulfill. The Teal Drone margins are about 40% as they start to ramp in scale. We can capture a couple of additional points due to better pricing on our supply chain. But we are very satisfied with what we think their margins will be. And regarding cash burn, our burn before we acquired Teal was about $1.4 million over the last 12 months. The majority of the burn has come from having a fully loaded company with a product that’s just about to launch but hasn’t yet. So, we will see – once these orders start coming in and we start producing drones, I don’t foresee that burn level sustaining for much longer; it should come down. And as Joseph mentioned, we have many quarters' worth of money in the bank. I don’t know if you want to add anything to that, Joseph.

Joseph Hernon, CFO

Yes. I would say that we don’t have a full quarter impact of all the hired employees for Teal and the full quarter of our overhead expenses corresponding to doubling the facilities for Teal. However, the additional incremental cost of a full quarter is not going to be substantial. So, this quarter reflects a bit of a step back, because anytime you double manufacturing capacity, it comes with a proportional increase in fixed overhead costs, thus making the hurdle a bit higher. But we gave this a lot of thought, and we see the demand for drones finally becoming mainstream. It’s amazing to watch on CNBC; you’ll hear several times across conversations, whether it’s a CEO of a business or a panelist, mention drones. We think we made a very deliberate increase in our spending for Teal, and while it might have mild short-term margin impact, it will certainly enhance our margin capabilities and dollars in the long term.

Ashok Kumar, Analyst

Alright. Well, just to clarify, Jeff and Joe, the T2, is that going to be all or nothing? Or you mentioned the odds of winning are 50-50, right? So I was wondering if you could just clarify the outcome there, please.

Jeff Thompson, CEO

Yes. So, all we have to go by is our experience from Tranche 1. There were five awards for Tranche 1 prototypes, and while Teal did not receive the production award, another company did get that for $100 million. That was a significant contract that caught many people off guard. And the SRR program is quite substantial, so we would expect similar production award numbers for Tranche 2. That production contract will be awarded to only one company, and we believe we have a strong chance now that we have a premier world-class drone facility operating domestically. I don’t want to put an exact timeframe on the production award, but it is worth noting that government timelines can fluctuate. The last cycle for Tranche 1 saw awards confirmed within 6 to 8 weeks after demonstrating the prototype, but Tranche 2, which we addressed back in September, didn’t see awards until November to December. The good news is the current environment seems to be accelerating the need for these drones, and I don’t anticipate any COVID-related delays affecting us at this stage.

Ashok Kumar, Analyst

And given your success with the domestic defense supply chain, would you be able to translate that into any opportunities with NATO members as well? What are the options there?

Jeff Thompson, CEO

Yes. Our team, including Geoff Hitchcock and others, were actively meeting with several NATO countries right before the war escalated. They even extended their stay once the conflict began. There is significant activity with the NATO countries, and many that are looking to support Ukraine are indeed from those discussions. We’ve been generating proposals all weekend to finalize contracts for these countries that wish to purchase our drones. We’re engaging with Ukraine along with numerous countries in the region that want drones readily available. It’s a high-pressure scenario for government entities right now as we seek to fulfill these drone requests. We just had meetings on how we can significantly increase production, if possible. It always comes down to chipsets—however, we currently have almost 4,000 drones worth of chips ready to deploy while we ramp our production to meet this new demand.

Ashok Kumar, Analyst

Alright. Again, thank you very much and congratulations.

Operator, Operator

The next question comes from Priyanka Mahajan with ThinkEquity. Please go ahead.

Priyanka Mahajan, Analyst

That’s Priyanka Mahajan from ThinkEquity. How is the Skypersonic and NASA collaboration going? Is there a way to quantify its impact on Red Cat’s top line in the short to medium time frame?

Jeff Thompson, CEO

Yes. The good news is they just started work on the Mars simulation. We are not only supplying them with aerial drones for the Mars simulation with remote piloting, but we’re also providing the rovers for them and supplying them a Skypersonic rover that features the remote piloting software from Skypersonic. We believe that those capabilities, along with some other assignments happening in Italy for inspections, are starting to progress nicely. While Skypersonic’s drone systems are still maturing, they are on the right track, particularly for infrastructure build-outs. There’s almost $280 billion earmarked for all of that, so they are well-positioned to capture some of the infrastructure spending for maintenance and inspections of critical infrastructures like sewers, bridges, and others that need evaluation prior to repair.

Priyanka Mahajan, Analyst

Great. Thank you.

Operator, Operator

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

Kevin Dede, Analyst

Hi, Jeff, Joe, thanks for having me on the call.

Jeff Thompson, CEO

Thanks for joining us.

Kevin Dede, Analyst

So Joe, you kind of brushed over the sequential comparison from October. Could you just sort of dig in on that at sort of flattish? I guess sort of the – yes, sorry, go ahead. Then I’ll give you another aspect of it.

Joseph Hernon, CFO

Yes. Let me start with this, Kevin. Teal could have been better, but we decided that it was more strategic long-term to focus on expanding. We effectively doubled the space we have for Teal. We made a thoughtful decision to ramp up our manufacturing capacity at the expense of short-term sales. As Jeff noted, Fat Shark is, unfortunately, caught in the downside of their most popular product life cycle, but Skypersonic is progressing, albeit slowly, and Rotor Riot had its best quarter since we acquired the company, coming very close to breakeven this quarter. Rotor Riot was a real surprise because we don’t look at that subsidiary as capturing much market attention, but it serves as a fantastic marketing platform for us. That’s kind of what happened this quarter compared to last quarter.

Kevin Dede, Analyst

Okay. So, I guess sort of a maybe the 20,000-foot strategic question is the balance between consumer focus and enterprise/military. Jeff, could you just sort of take a step back and walk us through how you’re addressing those markets?

Jeff Thompson, CEO

Yes, absolutely. We’ve broken the company into two distinct divisions—one is consumer-focused, and the other is commercial enterprise, with defense now ramping dramatically for us. On the consumer side, we have Fat Shark and Rotor Riot. As mentioned, Rotor Riot is developing well and growing. They’re doing great things. Even reaching breakeven is a tremendous asset because they serve as a launch platform for various products. Our biggest competitor in the drone market is DJI, who has often sponsored multiple episodes on Rotor Riot to launch their products. We find this partnership adds significant value. Fat Shark leads the goggle offering for FPV, and as anyone who has seen the Drone Racing League can attest, all pilots use Fat Shark goggles. We are at the end of their last product cycle, transitioning into a new and exciting product line. On the commercial side, we have Skypersonic and Teal. Skypersonic is primarily focused on the inspection sector. We have achieved promising preliminary trials in Italy, collaborating with Leonardo, a defense contractor there. We are hopeful to finalize contracts that will significantly impact our quarterly results soon. Their main focus is on the massive infrastructure bill, and they bring robust expertise in inspecting hard-to-reach areas, particularly sewer systems. This specific space is crucial as there are over 3 million miles of sewer requiring attention. Teal Drones is another area we’re investing heavily in. You may see on our balance sheet the chipsets we acquired; we are poised to grow significantly. Our focus remains on scaling production capacity to meet the demand. Our aim is to go from our current output to thousands of drones per month, and that’s the current focus; everyone is doing a great job to achieve that.

Kevin Dede, Analyst

So, regarding the Short Range Reconnaissance Tranche 2, granted you are in there. Is Tranche 1 sealed, signed, and done?

Jeff Thompson, CEO

Yes. Tranche 1 was completed a few years ago. Teal was awarded $3.1 million for the first prototype, which involved developing a new drone. Teal was one of the five prototype contracts. There was subsequently one production contract awarded. Regarding Tranche 2, we are currently competing for the production contract, and we believe we have a solid position due to our manufacturing capabilities and infrastructure. I want to clarify that we have already been accepted into Blue UAS 1.0 and also got accolades in Blue UAS 2.0. This is significant for NATO countries, as our DOD approval allows those nations to expedite their purchasing process without going through their own evaluation procedures.

Kevin Dede, Analyst

Right. Okay. Can you share a little insight on the military demand that you are seeing in light of recent international events?

Jeff Thompson, CEO

Yes. We have been receiving numerous inquiries directly to our business development team resulting from our tour in NATO countries. I have had former ambassadors and various department representatives reach out to me through LinkedIn. We’ve seen interest pouring in from numerous countries, with some needing thousands of drones immediately. The demand has shifted tremendously; previous assumptions of using consumer-grade Chinese drones are now seen as infeasible, so we expect substantial orders to be made imminently, following up proposals we’ve submitted just this week.

Kevin Dede, Analyst

And is that based on the specifications that you have established through your Tranche 1 development?

Jeff Thompson, CEO

Yes, the Golden Eagle 1 was demonstrated back in September 14 for Tranche 2, and it meets the DoD specifications. We were accepted into Blue UAS 1.0, and the DoD’s acceptance means various NATO countries will not need their separate evaluation processes to procure our drones.

Kevin Dede, Analyst

Okay. The big question revolves around timing and revenue recognition. Can you speak to that a little bit?

Jeff Thompson, CEO

We don’t have anything to announce yet, but once we receive signed purchase orders, we will ensure they are executed accordingly. The demand we are experiencing is significant, and we foresee that from our available capacity, we will fulfill orders quickly and efficiently. The DoD order flow will remain consistent year-round, so we don’t expect a disruptive spike due to any one contract or situation.

Kevin Dede, Analyst

Thanks, Jeff. Appreciate the insight.

Jeff Thompson, CEO

Thanks, Kevin. Thanks for joining the call.

Operator, Operator

The next question comes from Scott Michael, a private investor. Please go ahead.

Scott Michael, Investor

Thank you for taking my call. I have a quick question for clarity. I’m trying to understand how the tranche system works. I know that we have been accepted for Tranche 2; that’s for development. Are we marketing for a contract within Tranche 2, or does that lead us to the third tranche? If so, is there a demonstration of a developed product, and when would that be?

Jeff Thompson, CEO

Yes. You have to demonstrate your drone for Tranche 1 and that was two years ago, leading the way for five prototype contracts awarded alongside one production contract. There are ultimately three tranches. After demonstrating your drone prototype, we competed for the production contract under Tranche 2, and we’re now awaiting further developments. Each contract includes milestones for developing the drone to meet specific criteria laid out in the SRR contracts. The overall capability expected for Tranche 2 surpasses that of the original prototypes from Tranche 1. As we achieve these milestones throughout the year, it will set the stage for potential Tranche 3 awards.

Scott Michael, Investor

Is there an amount for the Tranche 2 production that we are aware of? Is there a timeframe for the Tranche 3 presentation?

Jeff Thompson, CEO

Unfortunately, we do not know the specifics for Tranche 2 production, and there has been no information released regarding Tranche 3 presentations. We suspect the entire program may range around $500 million, but we cannot confirm that. Our estimates for Tranche 2 production contracts are at least $100 million but are purely speculative based on what we observed with Tranche 1.

Scott Michael, Investor

Thank you very much. I appreciate it.

Jeff Thompson, CEO

Thank you. Thanks for joining us.

Operator, Operator

Next question is a follow-up from Ashok Kumar with ThinkEquity. Please go ahead.

Ashok Kumar, Analyst

Thank you. To follow up, Jeff and Joe. To clarify on production, you stated you have a current capacity of 2,000 a month with the potential to double that capacity in the same facility. Additionally, you indicated a good solid source for chips. So to confirm, are these off-the-shelf chips, bespoke products? What functionality does this chip provide?

Jeff Thompson, CEO

Yes, on the chipset front, we currently have about 4,000 chipsets ready for nearly 4,000 Golden Eagles. That puts us in a strong position. However, if we start receiving contracts, we will need to make adjustments. There are many components in a Golden Eagle, totaling 550 items, and while I don’t know the exact breakdown of chips, our primary chip is from Qualcomm. We are particularly aware of one crucial element—the Flora camera—which is in high demand for its thermal capabilities. This has attracted significant interest from police, first responders, and is highly sought after by entities in Ukraine.

Ashok Kumar, Analyst

Are these all fabs that TSMC provides through Qualcomm?

Jeff Thompson, CEO

I don’t have the exact details on that; Dr. Evans could provide you those specifics, but I don’t want to misstate the sources of our components.

Ashok Kumar, Analyst

Last question—concerning the timeline for T2, from the start of the program to becoming one of the two finalists—was that a two-year process? Just wanting to clarify the timeline for that.

Jeff Thompson, CEO

The timeframe for updates isn’t something we have noticed on their public announcements. However, there were significant delays from COVID; for instance, the $100 million production contract award didn’t occur until February, having been garnered nearly two years prior. With COVID no longer hindering operations, we expect acceleration on upcoming Tranche 2 contracts and the demo occurred on September 14. We anticipate expedited timelines now, particularly given the current environment's heightened focus on drone needs. We are actively working to scale.

Ashok Kumar, Analyst

Got it. Thank you once again and best of luck. So on your cloud program, that continues in parallel, right?

Jeff Thompson, CEO

Yes, absolutely.

Operator, Operator

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

Jeff Thompson, CEO

Thanks, everyone, for staying on this call. We’re pleased to have had many questions. There’s a lot of confusion around the different tranches and how it works. We’re working hard to scale our production efforts and believe that not just us, but every drone made in the U.S. must and will be sold. We’re ramping up and focusing on production. Thank you for your support; you’ll be hearing from us soon. Thanks.

Operator, Operator

I would like to thank everyone for taking the time today to join the call and for your ongoing support. You may now disconnect.