Earnings Call Transcript - VTSI Q2 2022

Operator, Operator

Good afternoon, and welcome to VirTra's Second Quarter 2022 Earnings Conference Call. My name is Laura, and I will be the operator for today's call. Joining us for today's presentation are the company's Chairman and Co-CEO, Bob Ferris; Co-CEO, John Givens; and Chief Accounting Officer, Marsha Foxx. Following their remarks, we will open the call for questions for VirTra's institutional analysts and investors. Before we begin the call, I would like to provide VirTra's safe harbor statements that include cautions regarding forward-looking statements made during this call. During this presentation, management may discuss financial projections, information or expectations about the company's products and services or markets or otherwise make statements about the future, which are forward-looking and subject to a number of risks and uncertainties that could cause actual results to differ materially from the statements made. The company does not undertake any obligation to update them as required by law. Finally, I would like to remind everyone that this call will be made available for replay via a link in the Investor Relations section of the company's website at www.virtra.com. Now I would like to turn the call over to VirTra's Chairman and Co-CEO, Mr. Bob Ferris. Sir, please proceed.

Bob Ferris, Chairman and Co-CEO

Thank you, Laura, and thank you, everyone, for joining us this morning. Before the market opened today, we issued a press release that provided our financial results for the second quarter and six months ended June 30, 2022, along with highlighted business accomplishments. We also filed our 10-Q with the SEC, which is available for review at your discretion. The first half of 2022 has been a strong start for VirTra, putting us on track for another year of record revenues as total revenue in the first half of 2022 was up over 50% from the comparable period in 2021, which was our highest revenue period in our history. The operational momentum we are capturing is noteworthy as we continue to penetrate our key growth markets in commercial, government, and international. Additionally, this growth has been achieved while generating profits as adjusted EBITDA grew 33% in the first half of the year, and we remained profitable on a GAAP net income basis. The strong growth is being largely driven by the international commercial markets. You might notice that our government sales are down slightly, but keep in mind that normally the high season for us to receive new government orders is during the third quarter, and our sales pipeline is strong. Internationally, revenue in the first half of 2022 increased 125% from the prior year's comparable period, but this was due to an unusual circumstance. As we have discussed on past calls, the international business was negatively impacted in 2020 and 2021 due to COVID-related travel restrictions. With travel restrictions now largely removed and international business travel resuming, we have been better able to sell our products and services internationally, which is manifesting itself in our 2022 results. With this momentum now reestablished, we are optimistic about our continued international growth, which was recently highlighted by another order in Canada under the standing offer we have with their government that provides a streamlined and standardized process for multiple federal, provincial, and municipal agencies in the country, with VirTra as the sole provider. In our commercial segment, which includes military sales through a prime contractor, revenue grew over fivefold in the first half of the year to $5.2 million as we continue to penetrate key markets where VirTra has a competitive solution. Importantly, commercial revenue in the second quarter of $3.6 million exceeded the $3.2 million of commercial revenue we generated for all of 2021. Additionally, while we do not disclose margins by revenue segment, I think it is clear that we are generating healthier margins in the commercial market, given it represented 45% of revenue in the second quarter and we generated almost 60% gross margins as a company in the quarter. What also gets me excited about this market is this growth is essentially achieved all before Co-CEO, John Givens, took his current position earlier this year. So with his addition, we think we are only in the very early stages of fully capturing this larger military market opportunity for VirTra. So with that, I'm going to pass it over to John to discuss his thoughts on his work at VirTra so far.

John Givens, Co-CEO

Thanks, Bob. Thank you. I'd like to focus my remarks today on the first 100 days or so at VirTra, and tell you that we've been very busy, day and night, weekends. As discussed on our last conference call, which was my first since joining the company, I felt we needed a presence in Orlando, Florida if we wanted to significantly expand our ability to capture the opportunities within the military market. Orlando is known as a worldwide epicenter for the modeling and simulation industry for the military. There are 4 major military branches. All have procurement centralized out of Orlando, where they manage multibillion-dollar portfolios, including PEO STRI for the U.S. Army, PM TRASYS for the U.S. Marines, AFAMS for the U.S. Air Force and NAVAIR for the U.S. Navy. So in my experience, if you don't have a physical presence in Orlando to easily demonstrate your products and conduct on-site meetings, you're going to have a real hard time penetrating those markets. As you might guess, all the major defense contractors have offices in Orlando for this very reason. Since I've joined, we have leased a building right in the heart of this action. It's already up and operational, and we have a respected and seasoned program manager based in Orlando, and expect to add business development and other personnel in the coming months. We have virtual equipment on-site. We've already completed demos and expect to be actively conducting regular demonstrations with military personnel over the remainder of the year. To succeed in the military space in the military market, I believe we need three key ingredients. First and foremost, you need a great product offering, which VirTra clearly possesses. The other two are presence in Orlando and relationships to facilitate buying support for your product within the military. The two latter, VirTra has historically lacked, but I'm confident that the company is now well-positioned to begin capturing more opportunities in the military market. The other item I've been intensely focused on during my first 100 days is ensuring VirTra has the right corporate structure in place to ensure efficient operations and scalability. As is often the case with a rapid growth company, there can be some inefficiencies unintentionally created as a result of operations racing to keep up with record sales being recorded year-after-year. With fresh eyes from an outsider's perspective and my experience scaling up operations at Bohemia to $200 million, it became evident to me that there were some areas of optimization. Accordingly, we effected a reorganization at VirTra on August 16, which will reduce our staff by about 10%. Now I want to be clear. This is not an adjustment merely to cut costs. I expect this improvement to greatly enhance the operational efficiency of VirTra staff by eliminating redundancies and streamlining the org chart based on functionality and focusing on facilitating significant scaling for VirTra employees to increase the potential for our business. I'm excited about the direction we're taking, and I'm now going to turn it over to our Chief Accounting Officer, Marsha Foxx, to provide a financial update.

Marsha Foxx, Chief Accounting Officer

Thank you, John, and good afternoon, everyone. It’s a pleasure to speak with you today to discuss our financial results for the second quarter and the six months ended June 30, 2022. Our total revenue for the second quarter of 2022 was $8 million, reflecting a 52% increase from the $5.3 million in revenue during the same quarter last year. For the six months ending in 2022, total revenue rose by 52% to $14.8 million, up from $9.7 million in 2021. This revenue growth resulted from an increase in the number of simulators and accessories completed and delivered, leading to higher revenue recognized compared to 2021. Our gross profit for the second quarter of 2022 was $4.7 million, which is a 51% increase from $3.1 million during the same quarter last year. The gross profit margin for this quarter was 59%, slightly down from 60% in the same quarter last year. For the six months ending in 2022, gross profit increased by 48% to $8.4 million, up from $5.7 million in the same period of 2021. The growth in gross profit was driven by more simulators and accessories being completed, delivered, and recognized as revenue. The gross profit margin for the first half of 2022 was 57%, a slight decrease from 59% for the same period in 2021. Our net operating expense for the second quarter of 2022 was $3.7 million, up from $2.3 million in the same quarter last year. For the six months ending in 2022, net operating expense rose to $6.7 million from $4.3 million in the same period of 2021. The increase was mainly due to costs related to our relocation to a new building, higher research and development costs, and increased payroll expenses. As we move from our old headquarters to the new one, we are currently paying more in overhead than necessary. Once fully transitioned, we anticipate realizing some cost savings. Regarding our profitability metrics, we recorded an operating income of $1 million in the second quarter of 2022, compared to $821,000 in the same quarter of 2021. For the six months ending in 2022, our income from operations reached $1.8 million, up from $1.4 million in the same period of 2021. Our net income for the second quarter of 2022 was $787,000, or $0.07 per diluted share, compared to net income of $529,000, or $0.05 per diluted share, in the same quarter of 2021. For the six months ending in 2022, net income was $1.4 million, or $0.13 per basic and diluted share, compared to net income of $1.2 million, or $0.13 per basic and diluted share, for the same period in 2021. Adjusted EBITDA for the second quarter of 2022 was $1.3 million, up from $1 million in the second quarter of 2021. For the six months ending in 2022, adjusted EBITDA totaled $2.3 million, compared to $1.8 million in the same period of 2021. Now turning to our bookings and backlog, we define bookings as the total of newly signed contracts and purchase orders received within a specific period. In the second quarter and first half of 2022, we received bookings of $3.5 million and $9.9 million, respectively. Furthermore, we define backlog as the total of bookings from signed contracts and purchase orders that are not yet started or completed and cannot be recognized as revenue until delivered in the future. Backlog also includes extended warranty agreements and step agreements treated as deferred revenue recognized over the life of each respective agreement. As of June 30, 2022, our backlog was $16.5 million, compared to $21 million at March 31, 2022, and $17 million at June 30, 2021. Lastly, regarding our balance sheet, as of June 30, 2022, we had unrestricted cash and cash equivalents of $15 million, down from $15.7 million at the end of the prior quarter. In terms of working capital, we had $27 million at the end of the second quarter, slightly up from $25.9 million at the end of Q1. For more detailed financial results, please refer to our 10-Q filing. That concludes my prepared remarks, and I will now turn it back to Bob.

Bob Ferris, Chairman and Co-CEO

Thanks, Marsha. Before I dive into my closing remarks, I want to spend a moment to discuss the departure of our Chief Operating Officer and Director, Matt Burlend, which we announced in our earnings release. Matt departed VirTra earlier this week after more than 20 years with the company, working his way up from an engineer to COO. Matt is credited with a long list of major accomplishments at VirTra and for the market. Matt was a key contributor to the growth and success of VirTra over the years, and we wish him all the best as he pursues new opportunities. To be clear, his departure was not the result of any disagreement with the company or any matters relating to its operations, policies, or practices. We will not seek an immediate replacement for Matt at the company level, but we will plan to fill his Board vacancy in due course. I'd next like to spend a minute to recap our gross margin progression thus far in 2022. If you recall, gross margins in 2021 and the second half of 2021, in particular, were negatively impacted short term by our pursuit of a strategically important military contract that we believe will situate us well for certain future military business going forward. We thought of this as pay R&D and a short-term dynamic as we progress through that contract. Additionally, inflation through higher labor, materials, and travel costs further impacted margins in 2021. So as we adjusted our business to deal with the inflation and move past that strategic military contract, we have seen gross margins return closer to our historical range. While margins will continue to fluctuate quarter-to-quarter, we are encouraged by the fact that gross margins in the first half of 2022 were 57%, very close to last year's 59% despite the inflationary headwinds everyone's familiar with. This is also a significant improvement from the 47% gross margin we recorded for the full year 2021. Now looking ahead for VirTra, I think we are in the best shape we have ever been. Our growth opportunities remain extremely robust, bolstered by our co-CEO, John Givens', proven abilities in the military market. Our balance sheet remains robust, and our internal operations are being streamlined to facilitate maximum scale and operational efficiencies. In Arizona, our move to our new headquarters in Chandler continues to be on track for a full move-in by the end of the year. As we have stated before, the state-of-the-art facility provides us with a larger and more centralized footprint and greater operational efficiencies. Coupled with our recently established Orlando presence, we have a growing capability to demonstrate our advanced training simulation offerings to the industry. And with that, I'm going to wrap up my prepared remarks, and we'll open the call up for your questions. Operator, please provide the appropriate instructions.

Operator, Operator

Our first question comes from Richard Baldry with ROTH.

Richard Baldry, Analyst

Maybe a question for John. In the military market, can you talk about the cadence of seasonal bookings that you saw maybe at Bohemia prior? Is there a distinct seasonality to it? And what kind of scale do you think the company has to get up to before that seasonality would impact? I assume when you're early in something, maybe you can outgrow seasonality for a year or two.

John Givens, Co-CEO

Yes, that's a two-part question. Regarding seasonality, military contracts are typically issued with a four-year option on a five-year base contract. It's quite uncommon for option years to be canceled once the contract is awarded, generally to protect against underperformance. September 30 marks the end of the fiscal year for the military, so there is a rush to allocate funds and establish contracts to avoid losing funding from various sources. You can expect to see this seasonal trend in September, although it can vary depending on when contracts are awarded and when they conclude their five-year cycles. A significant opportunity arises from the government’s decision to initiate 7- and 10-year contracts, often with a three- or four-year base, due to staffing shortages. As for scalability, VirTra has made remarkable strides in developing smaller R&D solutions. We haven’t adopted a cookie-cutter approach, meaning we build specific equipment or software for one customer but can sell it repeatedly. However, VirTra's organizational structure wasn't designed for this type of production pace, which prompted the recent reorganization. I hope that clarifies your question.

Richard Baldry, Analyst

Okay. And maybe in the regular police market, the traditional market. Can you talk about what you're seeing in the backdrop there? Bookings were off a bit year-over-year. Is there something happening in budgets? Or is it just timing? Just so we can kind of get a better grasp of what maybe the second half has for that.

John Givens, Co-CEO

Bob, I can give a quick response. Please go ahead, Bob.

Bob Ferris, Chairman and Co-CEO

Yes. The bookings have been impacted by COVID, which affected our ability to schedule installations and led to a significant backlog of products. However, as COVID-19 restrictions have eased, we've successfully transitioned many of those orders into delivered products, which allowed us to recognize an increase in revenue. This, however, did reduce our backlog. It's important to maintain a healthy balance between the backlog and the ability to convert that backlog into revenue each quarter, and I believe we have made improvements in this area. Additionally, it's important to remember that we are the primary supplier for federal law enforcement in the United States. They operate on a federal budget cycle, as mentioned by John. Typically, our revenue from the police sector peaks in the third quarter when they allocate their funds and initiate new sales orders. We always keep a close eye on this and strive for continuous improvement. I want to clarify that while John is recognized for his expertise in the military market, he is also deeply involved at the highest level in VirTra, working with both law enforcement and military sales efforts and operations. Therefore, it's not a matter of John focusing solely on military and me solely on law enforcement; we both contribute across different areas of VirTra.

Richard Baldry, Analyst

Okay. And then in terms of sort of operational steadiness, can you maybe talk about are the ERP systems in a steady state that you feel like keeping up with filings should be pretty easy essentially going forward? And then inventories have stepped up to a much higher level. I assume a lot of that is to do with increasing orders and some safety stocks for COVID lagging reasons. So overall, do you feel like you're in a more smooth execution positioning now?

Bob Ferris, Chairman and Co-CEO

We are doing our best to transition and set up our main facility. Our goal is to achieve full integration at our new headquarters by the end of this year. John Givens has been physically present to assist with the move, and he is surprisingly involved given his background. The ERP system is still developing and is not fully complete at this time. Regarding scalability, we are committed to ensuring that our company can scale effectively, and we are taking measures to prevent any future delinquencies. We believe past issues were caused by implementing too many changes at once, which could have been handled more efficiently. John's changes are being put in place to help avoid filing delays. We intend to continue being timely filers, as we have been for many years prior to the ERP implementation.

John Givens, Co-CEO

Bob, I would like to add one thing to that. So while the ERP is not perfect, we have identified all of the misgivings of the system and have implemented manual processes that are being integrated into the ERP as we speak. So we're not skipping a beat at all. Finance reports to me. We're going to make every single filing going forward because we have a higher visibility now that those processes are in place.

Richard Baldry, Analyst

And last for me is if we look to the first half of last year, military is pretty negligible. If you look in the past 9 months, you're 1/3 to at times over 40% of revenues, and I assume that's basically the U.S. market. If you think about 18 months out from now, I mean, is that a larger market, a larger component inside the business now than the police side is? Have you had some early wins that were sort of backed up that maybe make it run rate higher than you would expect on a long-term basis? How do we think about the mix longer term?

John Givens, Co-CEO

In the long term, this will become a significant part of the company's business. In the short term, we are preparing for the necessary requirements that each product must meet, including drop tests. There are many requirements involved. A project that Bob has mentioned in previous calls has assisted us in this process. Looking at the cyclical nature of the market, it's quite large and presents numerous opportunities where VirTra acts as a subcontractor for larger companies, and we already have established relationships in that space. In the past, we lacked those relationships and a presence in Orlando, which were critical factors in why VirTra has not tapped into that market. It is essential to engage with those buyers, especially since the acquisition processes occur in Orlando. The key players in the business come to Orlando to interact with and inform the acquisition officers. We believe having a dedicated program manager in Orlando, combined with the market size and aging equipment that aligns with what VirTra offers, will significantly boost our business. Securing just one or two contracts could represent a third of VirTra's annual earnings, which is our target.

Operator, Operator

Our next question comes from the line of Allen Klee with Maxim Group.

Allen Klee, Analyst

Yes. The question is on your operating expenses and the G&A jump in the quarter. Can you give us some color on how much of that you would say is growth initiatives or one-time related? And following up on that also, the 10% cut of staff, can you quantify what that means too?

Bob Ferris, Chairman and Co-CEO

I'll address the latter part of your question first, Allen, and I appreciate you bringing it up. The 10% reduction in staff is part of our restructuring efforts. We will likely introduce a QA department that we currently lack, which will help balance out the cost savings. As John mentioned, this reorganization is not solely a cost-cutting measure but rather an optimization strategy to prepare for scaling. Any cost savings that arise from this are merely an ancillary benefit of our primary focus on optimization, increasing efficiencies, and eliminating redundancies. We strongly oppose waste and aim to avoid redundant functions. While this is a significant aspect of our efforts, preparing for scale and establishing a world-class QA department is even more crucial, especially as we enter the military market more aggressively. Regarding your other question, it's challenging for us to provide a definitive answer at this moment since we lack complete visibility into the future. However, we believe our SG&A expenses are suitable for our current situation. We are also increasing our R&D investments, although we can't share much detail due to our policy on R&D. We see potential opportunities in various markets and thus have ramped up our R&D spending and initiatives. We consider our SG&A to be appropriate, although parts of it may reflect one-time expenses related to our relocation and the costs involved with our Orlando facility, our mortgaged Phoenix facility, and leased properties, including a currently vacant lease that we are working on subleasing. Our goal is to centralize these facilities, which should create a more efficient and streamlined ongoing presence for the company, ultimately optimizing our SG&A moving forward.

Allen Klee, Analyst

My last question is, as we're approaching the September budget fiscal year-end for the government and for law enforcement and the military, can you give us some qualitative comments on how conversations are going on in deals in the pipeline and how you feel about opportunities?

Bob Ferris, Chairman and Co-CEO

Yes, we're very excited with our sales pipeline. I wish I could get into greater detail than that. We are very excited about it. But as somebody who's been in this for 29 years, until it crosses the finish line, it's not done. So while we are optimistic and excited, we still are paranoid and hard-working. So that might be the best way to explain it.

Operator, Operator

Our next question comes from the line of Jaeson Schmidt with Lake Street Capital.

Jaeson Schmidt, Analyst

I just want to follow up on some of the previous questions. And I mean, we're halfway through the September quarter here. And obviously, everyone sort of alluded to potential from seasonality in the government space. Can you just talk about how order patterns have tracked so far this quarter?

Bob Ferris, Chairman and Co-CEO

Thank you, Jaeson. We continually monitor the situation closely. Factors like sequestration and budget impasses are concerning, but currently, we're not facing any significant issues in our government business, which makes up the majority of our operations. Police budgets can vary, and there was a time when calls for defunding the police were prevalent. That was a less common view, and those sentiments seem to have diminished, giving way to a focus on increasing funding and improving police training. VirTra has benefitted from this shift in attitude, and we hope it continues. We are firm believers that police departments are making wise decisions when investing in the most effective training tools for critical scenarios, allowing them to make mistakes in a simulator rather than in real life where the stakes are high. This approach is logical regardless of public discourse about police training needs. We believe that cutting corners on training methods, such as using non-professional VR games that trainees often dismiss, can lead to poor outcomes that government agencies should avoid. During head-to-head demonstrations, our mature and professional training products usually stand out when compared to less developed technologies, making it clear to clients that our offerings are worth the investment. We often hear from industry professionals who have faced life-or-death decisions, and many credit our simulator training with having made a positive impact. This reinforces our mission's importance. Our dedicated staff, many of whom could earn more elsewhere, choose to work at VirTra because they believe in our mission, which resonates with police departments. I am confident that government agencies have available funds from quarter to quarter, regardless of seasonal trends. For VirTra, the focus remains on educating the market about the necessity for high-quality training in critical situations. Although this seems obvious, we actively engage with stakeholders to highlight why such training matters. A key opportunity for us in law enforcement lies in raising awareness among those who currently don't engage in simulation training and stressing its importance. I apologize for the lengthy response, but it addresses the essence of our work. If we can effectively communicate the value of our simulator and offer potential clients a chance to experience it against other options, we believe they will find the budget to invest in our training solutions. This may happen in a month or six months, but we are likely to succeed, somewhat independent of the timing of budget cycles.

Jaeson Schmidt, Analyst

Okay. I really appreciate that color. And just want to make sure I fully understand if I heard correctly. So the 10% headcount reduction, you don't anticipate that to lead to any sort of significant savings given that it's going to be sort of backfilled with this new department. Is that how we should think about it?

Bob Ferris, Chairman and Co-CEO

Generally, yes. While there may be some decreases, our main focus is maintaining our reputation in the market. It's important for us to achieve success for each and every client, which means ensuring quality installations and high standards. We are investing more in components to enhance the quality of our products and to stand out in the industry. Although there might be some savings, we should not approach the modeling of VirTra by significantly cutting SG&A if it risks harming our reputation, performance, or ability to grow. Any potential savings will likely be offset by hiring new staff for the new department, which is essential for our future plans.

Jaeson Schmidt, Analyst

Okay. Got it. And I know you mentioned or some of the funded R&D that hurt gross margins earlier. But can you just sort of discuss some of the dynamics that are driving the better gross margins in the commercial space?

Bob Ferris, Chairman and Co-CEO

Yes, it feels like a return to normal rather than initiating something new. This return to normal is linked to the strategic military contract. We understand that VirTra has not historically been the top company for military simulation contracts over the past two decades. However, we excel in law enforcement and federal law enforcement training, which have significant overlap with military needs. We believe that our product development aligns well with military requirements in the future. We're optimistic that we will see positive outcomes from undertaking a military project at a lower cost than usual, enabling us to gain entry and tailor our product to military standards. This aligns with our past, as we often start with limited resources and focus on creating profitable products. While we have raised some funds, our approach has always been to design in-demand products that yield profit. Our most successful innovative products typically fill unique market needs and become essential to our customers. This focus drives our decision to accept the military contract, despite a lower profit margin than our historical standards.

Operator, Operator

At this time, this concludes our question-and-answer session. I would now like to turn the call over to Mr. Ferris for closing remarks.

Bob Ferris, Chairman and Co-CEO

Thank you, Laura. Well, we really appreciate everyone for taking time to join us today. Please know we are dedicated more than ever to building shareholder value and building the world's most effective simulation training products so that the warfighter and the law officer can serve their country, accomplish their mission, and make it home safely. I firmly believe the best days for VirTra are ahead of us. Be safe, take care, and God bless.

Operator, Operator

Thank you for joining us today for VirTra's Second Quarter 2022 Earnings Conference Call. You may now disconnect your lines at this time. Thank you for your participation. Enjoy the rest of your day.