Earnings Call Transcript - RCAT Q3 2024

Operator, Operator

Ladies and gentlemen, thank you for standing by. Good afternoon, and welcome to the Red Cat Holdings Fiscal 2024 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 18, 2024. Joining us today from Red Cat Holdings are Jeff Thompson, Chief Executive Officer; and Leah Lunger, Interim 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 the 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 as of today, March 18, 2024. 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

Thank you. Welcome, everyone, to our fiscal year 2024 third quarter earnings conference call. I will first review our Q3 performance and recent achievements. After which, Leah Lunger will review our financial results. Next, I will provide information about our outlook for the remainder of fiscal year 2024 and then we will take your questions. I am pleased to report that our third quarter results were exceptional, and we once again exceeded our guidance by 16%, achieving our best quarter ever and look forward to finishing the year with another record quarter of organic revenue growth. We believe the Teal 2 airframe is becoming the small UAS of choice for the DoD and other federal agencies as well as over 10 NATO countries. Bringing the Teal 2 drone to market was a significant milestone and the first drone to focus on nighttime operations. The Teal 2 was built to dominate the night. With this reliable new airframe and the traction, we are getting with customers, software companies felt comfortable integrating onto the Teal 2 airframe. This has allowed us to capitalize on software partnerships that will significantly increase our gross margins. The Teal 2 business model has always been to offer an open-source airframe and to be able to put the software that our customers want on the Teal 2 airframe, similar to an iPhone with the apps. Let's talk about our current announced software partners. We are integrating Teledyne FLIR's Prism artificial intelligence platform onto our next-generation drone under development for the U.S. Army's short-range reconnaissance, SRR program of record. Teledyne Prism AI platform provides classification object detection and autonomous tracking technology in real time during both nighttime and daytime operations. We believe customers who purchase this software feature on our drones will increase our gross margins by approximately 25%. We are also integrating radio software features that allow the Teal 2 drone and the next-generation Teal drone to fly in electronic warfare environments. This feature will also increase margins by approximately 20%. We recently announced our partnership with Primordial Labs, which will bring AI-driven voice control technology onto our platform. Primordial Labs Anura interface will be incorporated into Red Cat's Teal 2 drones and future products where it will enable operators to leverage natural language to command and control autonomous actions for drones and swarms of drones. Aero environment, we are fully integrated with Tomahawk Robotics, now part of Aero environment. This enables multi-ship and multi-domain capabilities. This software powers Teal 2 4-Ship swarm product, allowing a single operator to fly four drones simultaneously to surveil targets with 360-degree situational awareness and/or to protect an asset, which follows the asset capabilities and other formations. We have also fully integrated with Reveal Technology software that delivers intuitive rapid intelligence at the tactical edge, blending state-of-the-art computer vision, artificial intelligence, and edge computing technologies, giving the Warfighter real-time 2D maps in near real-time 3D mapping and artificial intelligence insight. We have fully integrated with our partner, Athena AI. They provide real-time situational awareness through AI-powered soldier readiness, hands-off world space tracking, detecting and identifying entities seamlessly, tactical insights of all detections designed to operate on Soldier Worn AI infrastructure at the tactical edge, advanced visualization of pattern of life, and spatial temporal data. We believe that our gross margins with any purchase of one of these software solutions could be approximately 65% plus, and if the above customer chooses two or more software features mentioned above, we believe it could approach 85% gross margins. In a previous call, I discussed three revenue opportunities driving our growth. They are organic, the Replicator initiative, and the SRR program of record. Let's start with organic revenue growth. We launched the Teal 2 in Q1 2024. Q1 revenue was $1.75 million, a great first quarter for a brand-new drone. Q2 was $3.9 million, 123% sequential quarterly growth. Q3 was $5.85 million, 46% sequential quarterly growth. We believe that even without any large programs of records such as SRR, we can get to cash flow breakeven as we continue to gain market share in the small drone defense category. Traditional feet-on-the-street organic revenue is the most difficult to execute. Our business development team has done a great job. And as they tell me, this will be the year of international. Let's move on to the Replicator initiative. The Replicator initiative is a strategic effort by the United States Department of Defense, aimed at countering China's military buildup. Here are the key points about the initiative: the objective. The Replicator initiative seeks to deliver thousands of relatively low-cost attritable autonomous systems across multiple domains within 18 to 24 months. These systems are designed to help the Pentagon address the growing military capabilities of China. The Replicator initiative has many moving parts and to outsiders, it may look messy. The DoD and the DIU are trying to move very quickly, which is something new to a large bureaucratic process. We applaud their progress; our swarm capability and being able to mount an 80-drone portable hive on a ship is unique to Red Cat and Teal. We have stayed connected with the folks at the DoD and the DIU, and we believe our Teal 2 and the new SRR drone are the perfect solution for the Replicator commission goals. And last but not least, let's talk about the short-range reconnaissance program of record, otherwise known as SRR. Let me start with our newest addition to our Board of Directors. General Funk II has joined, and it is an honor to have General Funk on our Board, and we believe he knows what the Warfighter requires. As we mentioned in our press release, small, manned portable unmanned aircraft systems play an increasingly critical role in close reconnaissance to reduce risk and increase lethality to enhance operational success. Just to remind everyone that Red Cat is the only company of the two finalists for SRR that will use collaboration to enhance operational success. The final winner-take-all selection is expected by September 2024. The contract is for approximately 12,000 drones. The award for the first tranche of production drones two years ago was $100 million for 1,083 drones. The final delivery of prototypes is in May 2024, more on that when we talk about Q4 guidance. We believe we are well positioned with the first drones designed for nighttime operations, a drone that meets the Army's requirements, a drone system that meets the Army's cost requirements, a drone that is open source. It can be continuously upgraded with third-party features, a brand-new factory that can meet the Army's production requests, and a drone that a Warfighter would use, with the capabilities to complete their mission roles. That leads us to our factory. The production facility in Salt Lake City is in full mass production mode. We are now running 1.5 shifts to meet production goals as we continue to invest in facilities, people, and processes. We are now demonstrating that we can build tens of thousands of drones yearly. And to finish up, let's talk about Q4 guidance. Q4 guidance is approximately $7 million, putting us at almost a $30 million annual run rate. This guidance is also very impressive considering we must switch production to the Army prototypes in April to satisfy the SRR final prototype delivery in May. If we meet our Q4 guidance, we will have gone from zero Q2 revenue from a product that did not exist last fiscal year to $18.5 million in the Teal 2's first year. With that, I will hand the call over to Leah.

Leah Lunger, Interim CFO

Thank you, Jeff. We are thrilled to report record revenues again for the third quarter of fiscal 2024, totaling $5.8 million. This represents growth of more than 250% year-over-year and 49% on a sequential basis and exceeded our guidance by approximately 16%, as Jeff mentioned. I want to congratulate our business development and manufacturing teams as we've reached a $20 million annualized run rate this quarter, which is a significant accomplishment. Once again, we have guided to continued growth in our fourth fiscal quarter and remain confident in our long-term revenue outlook. Gross margin for the third quarter totaled $1.1 million or approximately 19% of total revenue. On a percentage basis, this represents a year-over-year increase of more than 24% and a sequential decrease of 12%. We anticipate gross margin will steadily improve over time despite fluctuations from quarter to quarter. This variability occurs for several reasons. First, the material and effort required for the short-range reconnaissance contract with the Army vary by deliverable. Second, since we have prioritized building quality customer relationships, we've been generous with our warranties, which can cause variations in gross margin as well. Because of this emphasis on customer service, we are able to leverage feedback from real-life product applications in order to iterate and ultimately provide the best possible product. Over time, we anticipate warranty costs to gradually lower relative to other components of cost of goods sold. Third, this quarter marks the completion of the first full year of manufacturing the Teal 2 drone. During this time, our primary focus has been on growing revenue to capture market share. However, we are also implementing operational efficiencies expected to drive improvements in gross margin, which will be imperative as we work toward cash flow breakeven. We expect our full year gross margin to end between 25% and 30%. However, we believe that we can reach gross margins of 50% as production capacity scales exclusive of software add-ons discussed previously by Jeff. During the third quarter, the operating loss totaled $4.4 million, and cash used in operations totaled $4.1 million, both of which represent a decrease for the third consecutive quarter. As evidenced by the steady improvement, we are committed to controlling costs as we grow revenues and further research and development in anticipation of winning the SRR program of record award. Our combined cash and accounts receivable balances as of January 31, 2024, totaled over $12.7 million. In December, we completed a capital raise, which has provided the operating runway needed to achieve our strategic objectives during calendar 2024. Last month, we closed the sale of our Consumer segment to Unusual Machines, which included a $1 million cash payment as well as a $2 million interest-bearing note receivable. The completion of this divestiture will enable us to focus even more intently on the success of our enterprise segment. Overall, we remain optimistic about the future of the Company. We are pleased to have secured the latest amendment to our Army contract, securing the funding required to complete engineering and deliver prototypes despite funding delays within the DoD. As one of only two finalists in the Army short-range reconnaissance Tranche 2 program, we believe we are well positioned to receive an award later this calendar year. The Replicator program, which is expected to include over $1 billion budget across several tranches, is focused on fielding thousands of attritable systems, including small UAS. Revenues continue to grow as we expand our customer base domestically as well as internationally. We have now sold our products to customers in over 10 different countries. 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

First, congratulations on the operational results and the appointment of the four-star general Paul Funk onto your board. Three questions. First is, can you give us some color on the margins? And do you expect them to increase over the next 12 months? Second question is you mentioned Replicator has been a common theme on your last three calls. Can you expand on why you're well positioned for this opportunity? And the third, the last question is the international opportunity, you had commented on that in your prepared remarks. When can we expect to get some contract announcements?

Jeff Thompson, CEO

Well, Leah, your first question, you're getting the first hot question. So, I'm going to hand it over to Leah on the margin question.

Leah Lunger, Interim CFO

Thank you, Jeff. As I mentioned during the call, I do expect margins to improve over the next 12 months. There will be some variability by quarter, particularly as we finalize our engineering efforts for the Army. However, we are currently addressing several early manufacturing aspects that we anticipate will enhance margins. We have encountered some one-time scrap issues, and we are aiming for a 1% scrap rate, which would boost margins. Additionally, we are focused on improving our yields, further enhancing margins due to related labor costs. As our revenues increase, production volumes will naturally go up, which will also contribute to margin improvement because of overhead allocation. Moreover, we expect to secure better pricing on materials as we scale our order volumes alongside production increases. Historically, we have maintained a strong warranty program that we believe will continue to support our margins.

Jeff Thompson, CEO

Leah, let me address the warranties since I'm primarily handling that aspect. I understand it can be frustrating for Leah when we discuss it, but to be straightforward, as she noted, we have a very generous warranty program. This approach helps us gain market share, particularly on large programs transitioning from our competitors, which often last five years. Therefore, we've decided to ensure that any drones needing repair are fixed promptly, even when it's found to be pilot or operator error rather than an issue with our product. This support is important as we build our market share, and it has been effective. We anticipate that the extent of our warranty support will gradually decrease, alongside the other factors Leah mentioned. We've also been quite proactive with nonrecurring engineering for the SRR program, which affects our GAAP margin. We have various strategies in place that we will implement over the next few quarters to enhance our margins, aiming for that 50% mark. Additionally, as we start selling software, this could significantly boost our margins. Regarding your second question about Replicator, the challenge there is that no announcements will be made, which might lead to frustration on Wall Street, not only for Red Cat but for other drone suppliers as well. However, we are actively showcasing our products to the DoD, and the DIU is interested in our capabilities, particularly in swarm technology. We were the first to introduce a commercial swarm product called the 4-Ship. Recently, we've also demonstrated our swarm capabilities with eight hours of perch and stare, effectively addressing small drone battery limitations. I believe we are well positioned with our swarm technologies and small attritable drone swarms, making us a strong fit for the Replicator initiative. I can't provide further details at this time. I think your third question pertained to the international opportunity.

Ashok Kumar, Analyst

And the last question is related to the international?

Jeff Thompson, CEO

Yes. Our biz dev team has been working on more than 10 large RFPs for more than 18 months. To be frank, a lot of them are larger than expected. Some of these RFPs are supposed to pop soon and could be our largest contracts yet. So, the work we've done over the last year, almost two years on some of these RFPs are set to be announced winners later this spring. We've tested well. The Teal 2 is doing fantastic. We do expect to make some announcements later this year for international.

Operator, Operator

The next question comes from Scott Michael.