Coda Octopus Group, Inc.

Good morning and welcome to Coda Octopus Group's first quarter fiscal year 2023 earnings conference call. My name is Zico and I will be your operator today. Before this call, Coda Octopus issued its financial results for the fiscal first quarter ended January 31st, 2023, including a press release, a copy of which will be furnished in a report filed with the SEC and will be available in the investor relations section of the company's website. Joining us on today's call from Coda Octopus are its chair and CEO, Anne-Marie Geer, and its CFO, Nathan Parker. Following their remarks, we will open the call for questions. Before we begin, Jackie Keschner from Gateway Group will make a brief introductory statement. Ms. Keschner, please proceed.

Thank you, Zico. Good morning, everyone, and welcome to COTA Octopus's first quarter fiscal year 2023 earnings conference call. Before management begins their formal remarks, we would like to remind everyone that some statements we're making today may be considered forward-looking statements under securities law and involve a number of risks and uncertainties. As a result, we caution you that there are a number of factors, many of which are beyond our control, which would cause actual results and events to differ materially from those described in the forward-looking statements. For more detailed risks, uncertainties, and assumptions relating to our forward-looking statements, we see the disclosures in our earnings release and public filings made with the Securities and Exchange Commission. We disclaim any obligation or undertaking to update forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made, except as required by law. We refer you due to our filings with the Securities and Exchange Commission for detailed disclosures and descriptions of our business, as well as uncertainties and other variable circumstances, including, but not limited to, risks and uncertainties identified in our Form 10-K. You may get Coda Octopus's Securities and Exchange Commission filings for free by visiting the SEC website at www.sec.gov. I would also like to remind everyone that this call is being recorded and will be made available for replay via a link in the investor relations section of Coda Octopus's website. Now, I will turn the call over to the company's chair and CEO, Anne-Marie Gale. Anne-Marie?

Thanks, Jackie, and good morning, everyone. Thank you for joining us for our first quarter 2023 earnings call. Last quarter, I walked through an overview of our business and key growth pillars for those that may have been new to our company. While I won't repeat myself today, I will reference some of the growth accelerators discussed and highlight some of the attributes of our company that we believe positions CODA to succeed. I'd now like to summarize our first quarter 2023 performance. We had strong product sales and operational momentum for our Ecoscope pipe and GAPD system, even as we navigated supply chain and foreign currency headwinds. We continued to pivot from R&D focus to sales and marketing and brand building, and the first quarter 2023 saw us taking a number of actions in this direction. participating in several industrial trade shows for the promotion of our products and services, also holding key DAV demonstrations for foreign navies and Tier 1 offshore service providers. We also had DAVD demonstrations with the U.S. Navy and Naval Surface Warfare Center Panama City, which incorporated the DAVD in the new deep sea expeditionary with no compression diving suit. That's a diving suit called Descent. We continue to believe that our most promising pillars of growth are our Ecoscope and Ecoscope Pi products as well as our diver augmented vision display system or the DAVD system. I would like to provide some updates on our progress on each of these pillars in the first quarter of 2023. Turning to the Ecoscope, but giving some short remarks about what is the Ecoscope. With our company being a first mover in innovating and commercializing real-time 3D sonar technology, as well as shifting the market requirements to real-time 3D imaging in the subsidy market, we have positioned CODA to be the market leader in real-time 3D underwater imaging. Ecoscope technology is currently the only real-time 3D imaging sonar. It is the only sonar that can generate a real-time 3D image of moving objects underwater in zero visibility conditions. Almost all activities underwater involve imaging moving objects. Typical examples of our Ecoscope applications are offshore renewables where cables are being laid or repaired, breakwater construction or remediation work involving the breakwater, bridge inspection, or placing or removing something from the seabed, or more broadly, real-time inspection and monitoring on the water in 3D. The Ecoscope is the only choice for customers where there is poor or zero visibility conditions prevailing or imaging moving objects in 3D. This progress made by our technology business over the last four years, both in expanding the range of available Ecoscope models and configuration, and getting into some new underwater vehicle programs in the defense and commercial sector, we believe paves the way for us to increase our share of the imaging sonar market over the next two to three years, and that certainly is our goal. Turning to the first quarter, within the first quarter 2023, although our results were broadly in line with our first quarter 2022, We are pleased with the progress against our growth pillars. The technology business, which is our product business, generated in the first quarter 2023, 3.8 million in sales. At the constant exchange rate, this is 4.1 million in sales versus 3.8 million in the first quarter of 2022. Notable, however, is that within the mix of sales of this segment, that's the product business, equipment sales were 2.15 million in the first quarter 2023 compared to 1.9 million in the quarter 2022, representing a 31% increase in equipment sales. This is good progress in respect of our strategy of increasing the Ecoscope sonars we are selling quarter by quarter and year on year. We continue to pursue our goals to cement the Ecoscope in as many of the new programs for underwater vehicles and at the same time continuing to expand our market share of the addressable commercial market. Now turning to the DAVD, To recap first, how did the DAPD come about and what it is, a short recap. The DAPD emanates from a requirement of the Office of Naval Research, referred to as ONR, under its Future Naval Requirements Program. CODA, working with ONR and NAVSEA and Naval Surface Warfare Center Panama City, developed the DAPD. The DAVD embeds the pair of transparent glasses in the diver's heads-up display, and this is used underwater as the data hub for the diver. The DAVD is a fully integrated suite of sensors which provide real-time data to the diver underwater and to the dive supervisor on the surface simultaneously. This means that both the diver and the dive supervisor can share the same subsea view and data, including life support data in real time. This is the first time in diving operation. The diver and the dive supervisor sharing the same subsea view and a raft of data in real time. We have also transformed the analog communications, the digital communications on the water thus making voice communication significantly clearer and more effective on the water. The DAVD is transformational for the diving market, both in the defense and commercial sectors because it provides a fully integrated suite of sensor data on the water, which is accessible in real time by all parties involved in the dive operation. Now turning to our progress on the DAVD in the first quarter 2023, first, our key customer, the U.S. Navy, has now transferred the DAVD from their research and development phase to their field operations and command phase. This is an important milestone for the product as it means that the TEVIT system is now available for appropriate commands to purchase. This customer has now established a budget line for the acquisition of DAVD systems for new commands, and we expect to receive firm orders in our second quarter 2023. In the quarter also, customization work scope was completed for a DAVD on Tethered prototype system for a major US military command evaluation. The evaluation will be evaluation DAB units to be purchased following the field trials. This is a significant leap forward for the DAPD product as this now is an untethered system allowing teams of divers to communicate among the team without any surface-based participation. And we believe this deployment presents the biggest opportunity for this product in the military sector. In addition, a major Tier 1 European offshore service provider adopted the DABD system on a rental basis for a critical European underwater construction project. If the field project is successful, we believe this will be the precursor to full-scale adoption of the DABD by this world's leading service provider. We will be assisting this service provider on this project in April 23rd. We have also completed adaptation work for a second major tier one European offshore service provider who is now changing their diving workflow to incorporate the DAVD as part of their standard operations. Further, we have completed successful trials of the DAVD in Dunoon, Scotland in February As a result of these trials, two key foreign navies are now working with us on a DAVD adoption plan, including discussions on purchasing evaluation systems in this financial year. We have a number of initiatives around the adoption of the DAVD, encompassing both foreign navies mentioned earlier, and European offshore providers. We are laser focused on getting these opportunities to the point where the DAVD is adopted within their diving operation, thus bringing scale and volume to this product. I now want to talk about the adoption curve. DAVD is an important part of our strategy and we think it is important to update the market on the likely adoption curve for this recently launched technology. The customer adoption curve for nearly all such opportunities is the same. Stage one consists of trials that are unspecific to that customer's workflow. This is designed to establish a certain level of interest in the product. Stage two consists of evaluation designed to incorporate the DABD in the customer's specific diving operation workflow. And we are intimately involved with the customer in this evaluation phase. This then culminates in a decision to move to stage three, adoption. At that point, assuming a favorable review the customer decides that this technology should be adopted in its workflow and sets up a purchase plan. Based on the initiatives we are engaged in, we believe that the likely inflection point for the DAVD, therefore, is in financial year where we hope to have acquisition budget lines established with other customers outside of the U.S. Navy. and importantly, where the U.S. military command has started purchasing systems following completion of their evaluation of the ONTEBA system we have recently customized and for which we are in trial in March and April this year. To conclude, therefore, we remain comfortable targeting approximately $25 million in revenue for the technology, that's the product business, on a standalone basis in the financial year 2024. To put some context on this, in the financial year 2022, the product business had revenue of approximately $15 million, and this year we're targeting $18 million for this business on a standalone basis. and at the same time maintaining our profitability. Now turning to our marine engineering business, this segment is important for our group as it has strong pedigree in defense engineering with stellar relationships with prime defense contractors spanning decades. These are important relationships for our group strategy. There is a strong crossover of engineering skills, which is vital for us to maintain our competitive lead in real-time 3D imaging and our diving technology. This business, that is the marine engineering business, supplies subassemblies into broader mission-critical programs under subcontracts with prime defense contractors. This gives them the opportunity to have repeat orders for these sub-assemblies for the life of the program. Within this business segment, that's the marine engineering business, we are navigating headwinds from supply chain issues across various defense programs. The supply chain difficulties apply not only to our own sourcing of components, but also crucially to our customers' own supply chain issues, resulting in the broader program design requirements being slower to lock in due to the unavailability of components. This has led to many instances of multiple iterations of the design proposals being submitted for the same work package, which in turn has resulted in much slower order take in the first quarter for the marine engineering business. As we work to mitigate these issues, we also remain focused on growing the number of programs where we supply engineering sub-assemblies to support the broader growth of this segment. It is critical to return the services segment to a $10 million plus revenue profile and therefore achieve our overall growth plan for the next two years. Let me now turn over the call to our CFO, Nathan Parker, to walk you through our financials before I provide my closing remarks. Nathan?

Thanks, Anne-Marie, and good morning, everyone. Let me take you through our fiscal first quarter financial results. First, looking at our revenue. In the first quarter of 2023, we recorded total revenue of $5.6 million compared to $5.8 million in the first quarter of last year. The slight decline was due to a 12% sales decrease in our marine engineering business as a result of supply chain issues with certain defense programs. The marine technology business generated revenue of $3.8 million compared to $3.8 million in the prior quarter. However, applying the constant rate, the marine technology business revenue would have been $4.1 million. We're excited about the mix of our sales, as in the first quarter we saw an increase in our Ecoscope sales. Now turning to our gross profit. In the first quarter, we generated a gross profit of $3.8 million, compared to $4.2 million in fiscal first quarter of 2022. Gross margin in the first quarter of 2023 was 67.1% versus 71.3% in the same year-ago period. The reduction in gross profit was primarily due to higher product sales through COTA's network of sales agents, which carry higher commission costs. Our marine technology business gross margin decreased to 72% in fiscal first quarter 2023 compared to 85% in the prior year quarter. This was due to a disproportionate percentage of our product business being made through our sales agents network, and thus incurring significantly higher commission payments. Our marine engineering business gross margin was 56% versus 45% in the prior year, as a greater percentage of revenue was generated from our engineering services contracts. Now moving on to our operating expenses. Whole operating expenses for the first quarter of 2023 decreased 14% to $2.4 million, compared to $2.8 million in the first quarter of 2022, driven by a 34% reduction in R&D expenses due to the conclusion of several multi-year R&D programs. Personnel and general administrative costs in the first quarter of 2023 totaled $2 million, reduced from $2.1 million in the prior year quarter. As a percentage of revenue, our selling general and administrative costs for the first quarter of 2023 decreased to 35% of total revenue compared to 36% in the first quarter of 2022. Looking forward on our cost structure, given the significant progress we have made in R&D in the last four years, we remain focused on aligning a significant portion of our resources and strategy from research and development to global business development, brand building, and investor relations. We believe we have developed world-class products and solutions that will provide market-leading positions for COTA and that can make meaningful progress in our markets through these investments to create shareholder value. Now looking at our overall income and earnings. Our operating income in the first quarter of 2023 was $1.3 million compared to $1.4 million in the year-ago quarter. Our operating margin was 24.1% compared to 23.6% in the first quarter of last year. Net income before taxes in the first quarter of 2023 remained flat at $1.4 million compared to the year-ago quarter. Net income after taxes in the first quarter was $1.4 million, or $0.12 per diluted share, compared to $1.2 million, or $0.11 per diluted share in the same year-ago quarter. Now moving on to our balance sheet. As of January 31st, 2023, we had $24.5 million in cash on hand and no debt. This represents a $1.6 million cash billed in the quarter. That completes my financial summary. Now I'll turn the call over to Anne-Marie for closing remarks.

Thank you, Nathan. As we look to the remainder of the fiscal 2023, we will continue to support the momentum of our products business through further solidifying our current programs and identifying new opportunities. As we grow our product deployment, we will remain focused on increasing the number of programs we're supplying in our engineer business. We remain pleased with the traction we have generated for our EcoScope pipe and DABD solution, and we're optimistic about their future prospects as the main pillars of our growth for our company. We have demonstrated track record of generating high margins and solid profitability, and we have had very healthy balance sheet with cash on hand and no debt, which gives us confidence in our outlook for Coda. We're now happy to take your questions. Operator?

Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we poll for questions. Our first question will come from the line of Brian Kinslinger with Alliance Global Partners. Please proceed.

Hi, thanks for taking my questions guys. I wanted to start first with component shortages that are driving delays for your services and engineering business. What's your visibility into receiving shipments of these components And can you approximate how much revenue you've been not able to generate as a result of these shortages, either in a one-quarter or 12-month kind of perspective?

Well, thank you very much, Brian. So let's start with orders on hand. So if I give you an example, we have a contract for UK services business, and we've had that contract since November. And that contract is a manufacturing contract for a major European industrialist manufacturer. And that order is 2.3 million for the business. Since November last year, we're waiting on a single component to convert this to revenues for the business. And we've had several full starts on the components required. So it's very difficult because then we get what we call a lot of decommits. You have a firm commitment from the component supplier to supply the item on a particular date. And right at that point, we get a decommit. So it's very difficult to say with any confidence, given what's happening in the market, if you think of the FPGA market, it's really supply scans. So we don't have a lot of, although we might have commitments, the risk is that we get decommitted at the last minute by the component supplier. And there's not a lot of reason to explain from this component supplier why they've decommitted this. It's simply the data's moved. So we see this a lot. Nevertheless, I mean, we are really, really working to mitigate some of these. The problem is when a design is locked in, you are fixed with that component, and then you have to go through a qualification process to get a substitute component within the project.

And just to be sure, one more question, then we'll move to more important pieces of your business. Are customers generally understanding? Have there been cancellations of orders? Just talk about what the customer is communicating as a result.

No, no. Because then, for example, this contract that I talk about, this customer also waited in and tried to get the component because they are a sizable manufacturer. it's the same outcome. So we're working really closely with the customer, and everybody, they're in the same position. This is not just a CODA problem. This is a global problem with the supply chain shortages that we see. The customers are understanding, and cancellation is not an option. These are programs that we work on year in, year out. These are our proprietary parts. So there's no risk of that. And also just to say within the chain, it is a domino effect because it's not just CODA that's suffering that problem.

Got it. Thank you. And then with your comments regarding the targets for fiscal 24, we can back into at least a rough expectation for the DAB next year. Are you able to quantify the total addressable market for tethered and untethered DAB? And does a pending untethered DAB have a different target audience, or might some navies wait for this untethered product before ramping their purchases?

No, there are two different markets, actually. You have the surface and the deep diving. The deep diving is really the untethered version. So we've been focused then on the U.S. market for the time being because then the product started as a U.S. project. And if I think about, it's a difficult question, but if I think about how many seals there are, there are 2,500 seals. There are in the U.S. Navy Experimental Diving Unit, there's 120. And then for others, like Combatant Divers Amphibious Support, there's 1,225. So in total, in terms of diving personnel, you have about 3,845. Now, when I look at this, Brian, and say, okay, for us, what we have modeled as, because then when we think of how a technology is adopted, it's always going to be a phased adoption of the product. So because there's, you know, management risk, all of these for the customer. So we've kind of modeled something like 15% of that market over five years. And it might be conservative, but for just the way the adoption curve is, and as I said, when you phase in new technology, it will take time. And so 15% of that addressable market in the U.S. would be about $47 million. And, you know, we think that, and that's just 15% we have targeted. The 47 million is 15% or the 47 is the 15% is what you're saying?

Yes, 15% is 47 million. And that's just U.S.? And that's just U.S.? That's just the U.S. based on those numbers that I gave you, 3,845 diving personnel.

And I also want to clarify that 43 million is, excludes complementary exoscope sales. This is pure DAVD. So I've not included within 47 million the pairing of the exoscope with the DAVD. And the way we think that will go down for command is it won't be a one-for-one, but certainly there will be a number of exoscopes that will introduce with the DAVD because as I mentioned before what the sonar data there in that environment why it's important divers are diving in zero visibility conditions and that that's really the echo scope that's going to provide insurance or from that that was really helpful last question I have and I'll get back in the queue is there any predictability as to the mix of agent sales versus direct sales and

which clearly have a little bit of a different margin profile. And then in addition, can you talk, are DAB sales direct or indirect? And what is their impact on gross margin as they become a bigger piece of your business?

Yes. So just to say, Brian, one of the things we have emphasized as we pivot from R&D to into real hardcore sales and marketing. That necessarily means that we're agnostic where sales come from, and we are expanding our agents' network globally, including in Asia. So what we really want is more sales, although what that means, then there will be commissions paid on those sales. But then at the same time, if we expand our direct workforce, there's also that cost. It will not hit margins, but it certainly will be our operating costs. So we think, I mean, I can't give you a projection of what percentage will come, but we're certainly pushing the boot out to capture all corners of the market globally for our technology. The DAB is different. Right at this moment, we do not see the DAB being via agents just because of the process of adopting the DABD. But having said that, for example, helmet suppliers might be good distributors of the technology. And that's discussions we have ongoing. And in that context, we would pay a commission, but we're not at that point yet.

Great, thank you so much Anne-Marie. Thank you.

At this time, this concludes our question and answer session. I'd now like to turn the call back over to Anne-Marie Gale.

Thank you very much everyone for joining today and we look forward to speaking to you again. Thank you very much for your time today.

Thank you for joining us today for CODA Octopus' conference call. You may now disconnect.