Red Cat Holdings, Inc.

Ladies and gentlemen, thank you for standing by. Good afternoon and welcome to the REDCAT Holdings Fiscal 2024 Third Quarter Financial Results and Corporate Update Conference Call. At this time, all participants are in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star and then two. 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 other actual results to differ materially from those statements. For more information about these risks, please refer to the risk factors described in REDCAT's most recently filed periodic reports on Form 10-K and Form 10-Q, and in REDCAT'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, REDCAT 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.

Thank you. Welcome, everyone, to our Fiscal Year 2024 Third Quarter Earnings Conference Conference. 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 percent, achieving our best quarter ever, and look forward to finishing the year with another record quarter of organic revenue growth. We believe the TL2 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 TL2 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 TL2 airframe, similar to an iPhone with the apps. Let's talk about our current announced software partners. We are integrating Teledyne Clear'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%. are also integrating radio software features that allow the teal 2 drone and the next generation teal drone to fly in ew environments for electronic warfare environments this feature will also increase margins by approximately 20 percent we recently announced our partnership with premortal labs which will bring ai driven voice control technology onto our platform premortal labs Anora interface will be incorporated into REDCAT's TL2 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 the TL2 four-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 Technologies 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 and near real-time 3D mapping and artificial intelligence insight. We have fully integrated with our partner, Athena AI. They have 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 spatio-temporal data. We believe that our gross margins with any purchase of one of these software solutions could be approximately 65% plus if the above customer chooses two or more software features mentioned above, we believe could approach 85% gross margins. In a previous call, I discussed three revenue opportunities driving our growth. They are organic, the replicator initiative, and SRR program of record. Let's start with organic revenue growth. We launched the TL2 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 record such as SRR, we can get to cash flow break even as we continue to get 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, quote, unquote, 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, equitable, 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 REDCAT and TEAL. We have stayed connected to the folks at the DOD and the DIU, and we believe our TEAL-2 and the new SRR drone are perfect solution for the replicator mission goals. And last but not least, let's talk about the Short-Range Reconnaissance Program of Record, otherwise known as SRR. But let me start with our newest addition to our board of directors. General Paul Funk II has joined and is an honor to have General Funk on our board, and we believe he knows what the warfighter requires. As he mentioned in our press release, Small man-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 REDCAT is the only company of the two finalists for SRR that will use lethality to enhance operational success. So, 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 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 that 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 and with the capabilities to complete their mission goals. Which leads to our factory. The production facility in Salt Lake City is in full mass production mode. We are now running one and a half 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 TL2 revenue for a product that did not exist last fiscal year to 18.5 million in the TL2's first year. With that, I will hand the call over to Leah.

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. Growth 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 growth margin will steadily improve over time, despite fluctuations from quarter to quarter. This variability occurs for several reasons. First, 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 warranty, which can cause variations in gross margin as well. Because of this emphasis on customer service, we're 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. 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's 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, 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 this study 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 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 very pleased to have finalized 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 a billion-dollar budget across several tranches, is focused on fielding thousands of attributable 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.

We will now begin the question-and-answer session. If you wish to ask a question on today's call, you will need to press the star key followed by the number one on your telephone. If your question has been addressed and you wish to withdraw your question, you may do so by pressing the star key followed by two. If you're using a speakerphone, please pick up your handset before pressing the keys. Our first question comes from Ashok Kumar with Think Equity. Please go ahead.

Thank you. First, congratulations on the operational results and the appointment of the four-star General Paul Funk to 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, as you mentioned, Replicator, that's been a common theme on your last three calls. Can you expand on why you're well-positioned for this opportunity? And the third and last question is the international opportunity. You had commented on that in your prepared remarks. When can we expect to get some contract announcements? Thank you.

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

Sounds good. Thank you, Jeff. So as I mentioned in the call, I do expect margins to improve over the next 12 months, although we expect there will be some variability by quarter, especially as we complete our engineering effort for the Army. But there are a handful of early manufacturing aspects that we're working on we expect to improve margins. We've had some one-time scrap items, and we're working toward a 1% scrap rate, which would improve margins. We're also working on improving our yields, which would improve margins because of the related labor costs. And as we grow revenues, production volumes naturally increase, which would improve margins as well due to the overhead allocation. Plus, we believe that we'll receive better pricing on materials as we're able to increase our order volumes with increased production volumes. We've also historically had a very robust warranty program so far that we expect to, you know, steadily.

Yeah, let me jump in on the warranties because I'm the one that's dealing with it mostly, and it kind of upsets Leah when we do this. But just to be very frank, folks, as she mentioned, we have a very generous warranty program. And the reason that we have a generous warranty program at the beginning is we're trying to gain market share on large programs that that are converting from our competitors. And lots of times these programs go on for five years. So we've made the decision to make sure that these people get their drones fixed immediately if they can't be fixed in the field. And basically sometimes we get stuff sent back to us and we find out it was actually pilot and operator error, not our issue, but we still support the warranty as we're building market share and it's worked very well. We expect that the warranty, generosity is what I'll say, will continue to go down with all the other items that Leah mentioned. And, you know, we've also been pretty aggressive with non-recurring engineering for the SRR program, which some of that does seep into gap margin. So we have a lot of levers that we'll be pushing over the next couple quarters to increase our margins and hopefully get to that 50% mark and Uh, then we, you know, the next thing is we start selling software on top of everything and that can also increase the margins dramatically. And I think your second question was a replicator. Um, yeah, so yeah. So replicator, uh, you know, that is, uh, you know, the problem with replicator is that no one's going to be making announcements. So it's probably going to frustrate the street, not only for red cap, but other companies that are supplying drones. But, you know, we continue to demonstrate products that the DOD and the DIU want, you know, the capabilities. They're big on Swarm. And we're the first company with a commercial Swarm product called the Foreship. We came out with that first. And, you know, our, you know, having that product and recently with our Swarm capability, we demonstrated eight hours of perch and stare. using our, you know, overcoming the small drone battery limitations, utilizing our swarm. So the way I believe that we're well positioned is we have swarm capabilities. We have small, incredible drone swarms. It's a perfect fit for the replicator initiative. And I really can't say more than that.

And I think your third question is on the international.

Yeah. Yeah. So the, our biz dev team has been, working on more than 10 large RFPs for more than 18 months. And to be frank, a lot of them are larger than SRR. 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, you know, later this spring. So we're, We've tested well. The TL2 is doing fantastic. So we do expect to make some announcements later this year for international.

Thank you, and best wishes to your team.

The next question comes from Scott Michael.

Thank you for taking my call. Can you hear me? Hello? We can hear you. Oh, thank you. What's the status on the chips, chip production, or chip acquisition?

Do you mean as in supply chain? Yes. We've been fine with supply chain for, gosh, over nine months. We are, yeah, so I mean supply chain is something that I'm always concerned about, but it's not on my daily thought sheet anymore.

Okay, that's good to know. Thank you. You said production is at one and a half shifts right now. Currently we have a backlog. Are we able to accommodate the hopeful anticipated awards with the current shifts we have, or will we have to employ more shifts? How are we looking at in that realm?

No, we have plenty of the core chips. I think is what you're talking about that we bought almost two years ago and they were close to 5,000. We are, We are not going to shift in terms of our production. You have, you said we have 1.5. So basically we've got a shift and a half. We've got, we started around nine and we, we end around nine. So we've, we've just increased our shifts to handle the increased production needs by our customers, but we can expand to a full second shift. We're just not there yet. We're going to, adjust our factory capabilities according to our demand.

Okay, so you anticipate being able to knock out the backlog quickly, is that correct?

Well, the good news is we have been doing that with these huge increases in revenue every quarter, and we continue to sell more. So we kind of have the best of both worlds, but we will continue to increase our production to not get the backlog too high and to meet the timeframes that our customers want. So if our customers need 90 days, we're going to make sure they get it in 90 days. If they need it in 120, we'll make sure they get it in 120. If they need it in 60, we'll increase production and get it in 60. So we have to adjust to our customers.

This concludes our question and answer session. I would like to turn the conference back over to Jeff Thompson for pre-submitted questions and closing remarks.

Great. Thank you. Hold on. Let me correct. There's been more coming in. I'm sorry. They're not on the course call here. Leah, do you have them?

Yes, I do. Listen, would you like me to read the first one?

Jeff, the first question is, when do you think we could get to profitability? What revenue or what margin or combination?

Okay, great. Well, Leah, you're going to keep being in the hot seat today. I'll hand that one to you.

That's great. Um, yeah, so based on our current quarterly operating expenses of about 5.5 million, if we reach 50% gross margins, as we hope to, then we we'd expect to reach profitability at approximately 11 million in quarterly revenue.

Okay. Great. Uh, the next question.

is uh you you've mentioned several partnerships do you expect to continue to look at acquisitions yeah that's another good question and we get asked that quite a bit as you see we've done a lot of partnerships in the past you've seen us do partnerships and then you do acquisitions but uh right now we are fine with uh partnering uh with a lot of our our software friends um we would definitely not do acquisitions down here where it would be so dilutive but we are continuing to build relationships with all of our partners, and we think maybe next year we start looking at acquisitions again, but right now our revenue is growing so rapidly, and we're right on the cusp of getting some basically game-changing large contracts. So we're going to stay focused on making the TL2 great, and then when we finalize the SRR, the next generation bird, which will be the new SRR bird. So we're going to hold tight for a little bit.

The final question is, now that you've closed the sale to unusual machines, does this mean you will not be going back to the market?

That's a great question. That's a new one. So, yeah, actually, I'll let Leah review some of that, and then I'll give some final comments on that after that.

Yeah, for sure. So the sale to unusual machines, As I mentioned previously, we received a $1 million cash payment after the closing of the sale, as well as a $2 million note payable to Red Cat. The note is interest-bearing at 8%, and the interest is payable monthly in cash, with the principal payment due in full on the maturity date after two and a half years. However, if UMAC completes an offering of over $5 million, the note becomes payable in full, which would be just another good opportunity for funding for us. And we are working on finalizing the closing working capital, usually with these types of types of deals that we have, we expect to complete that within six to nine months of the closing date. And the closing working capital, which we currently expect to be around $3 million, will be either payable in cash or added to the note. And that determination is up to REDCAT. Jeff, do you want to comment on the stock that we own in UMEC?

Yeah, we also own 4.25 million shares. We are probably going to do some sort of a dividend. We haven't made that decision yet as a board to existing Redcat shareholders. But any other remaining shares that we keep, you know, we would never sell and hurt UMAX stock. But if they had a block buyer or things of that nature, there's ways for us to raise, you know, continue to raise non-dilutive money. As you can see with the revenue ramp, and, you know, we've started proving that we beat guidance three times in a row now. With our revenue ramp and our costs continuing to come down, we believe that we're not going back to the market at all. And to be very frank, if we get an SRR award or a replicator award, all of those give you a chunk of money up front. So our thought process and our modeling is we are out of the market. So we're pretty excited about that.

This concludes our question and answer session. I would like to turn back over to Jeff Thompson for any closing remarks.

Great. Thanks, Dave. Well, thanks, everybody. We have mentioned we believe that we are in a great position to supply drones to the United States military, and we are proud and honored to have them as a customer. We are also ready and willing to help our allies and expect to start getting traction in NATO soon. Field drones are incredible tools that give asymmetric capabilities to the warfighter. Our full-stack technology, including what's being developed for SRR, enables data link resilience in EW environments, GPS-denied navigation using visual-based navigation, battlefield decision-making with artificial intelligence, natural language operation with AI, object detection and recognition with AI, and will ultimately be able to deliver kinetic effects with human assist to fully close the kill chain. Small drones have changed warfare forever. the Ukraine has demonstrated what small drones can do to expensive military assets. The Wall Street Journal's recent headline reads, Drone Swarms Are About to Change the Balance of Military Power, basically describing what Teal Drones has developed. The second half of calendar 2024 is going to be pivotal for REDCAT, and we are set up for success. Thanks again, and good night.

The conference is now concluded. Thank you for attending today's presentation.