Red Cat Holdings, Inc.: Form 10-Q for the period ended Jul 31, 2024

You should read the following discussion and analysis of our financial condition and results of operations together with our financial statements and the related notes appearing elsewhere in this Quarterly Report on Form 10-Q. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below, and those discussed in the section titled “Risk Factors” included in our Annual Report on Form 10-K for the fiscal year ended April 30, 2024 as may be amended, supplemented or superseded from time to time by other reports we file with the SEC. All amounts in this report are in U.S. dollars, unless otherwise noted.

Overview

We are a technology company focused on developing products, services, and solutions to the drone industry. We were originally incorporated under the laws of the State of Colorado in 1984 under the name “Oravest International, Inc.” In November 2016, we changed our name to “TimefireVR, Inc.” and re-incorporated in Nevada. In May 2019, we completed a share exchange agreement with Propware which resulted in the Propware shareholders acquiring an 83% ownership interest, and management control, of the Company. In connection with the share exchange agreement, we changed our name to “Red Cat Holdings, Inc.”, and our operating focus to the drone industry.

Prior to the share exchange agreement, Propware was focused on the research and development of software solutions that could provide secure cloud-based analytics, storage and services for the drone industry. Following the share exchange agreement and name change, we have completed a series of acquisitions and financings which have broadened the scope of our activities in the drone industry.

Recent Developments

On September 4, 2024, the Company, Teal, FW Acquisition, Inc. (“Buyer”), and FlightWave Aerospace Systems Corporation (“Seller”) entered into and closed on the transactions set forth in an Asset Purchase Agreement (the “APA” and the transactions set forth therein, the “Transactions”), pursuant to which Buyer purchased and Seller sold certain assets used in designing, developing, manufacturing, and selling long range, AI-powered UAVs for commercial use.

As a condition to the closing of the Transactions, each of the shareholders of the Seller entered into a Joinder Agreement with the Company, Teal and Buyer pursuant to which such shareholder agreed to the terms of the APA and agreed to be bound by the provisions thereof applicable to the Seller’s shareholders, including without limit, the indemnification provisions in the APA.

The purchase price under the APA is equal to $14 million worth of shares of the Company’s common stock which are payable as follows:

• $7 million worth of the Company’s common stock to be issued on September 30, 2024, at a price per share equal to the VWAP on such date, which shall be payable to the preferred shareholders of the Seller as set forth in the APA.
• $7 million worth of the Company’s common stock to be issued on December 31, 2024, at a price per share equal to the VWAP on such date, of which (i) $2 million will be payable to preferred shareholders of the Seller, and (ii) $5 million will be payable to common shareholders and option-holders of the Seller as set forth the APA.

On September 23, 2024, we entered into a Securities Purchase Agreement (the “SPA”) with Lind Global Asset Management X LLC (“Lind”). Under the SPA, within days of closing, we will receive $8 million in funding from Lind in exchange for our issuance to Lind of a Senior Secured Convertible Promissory Note in the amount of $9,600,000 (the “Note”) and a Common Stock Purchase Warrant for the purchase of 750,000 shares of our common stock at a price of $6.50 per share, exercisable for 5 years (the “Warrant”). As addition consideration to Lind, we have agreed to pay a commitment fee in the amount of $280,000, which may be paid by deduction from the funding to be received. The Note, which does not accrue interest, shall be repaid in eighteen (18) consecutive monthly installments in the amount of $533,334 beginning six months from the issuance date.

Plan of Operations

Since April 2016, our primary business has been to provide products, services, and solutions to the drone industry which we presently do through our three wholly owned subsidiaries Skypersonic, Teal, and Propware. Beginning in January 2020, we expanded the scope of our drone products and services through four acquisitions, including:

A. In January 2020, we acquired Rotor Riot, a provider of First Person View (FPV) drones and equipment, primarily to the consumer marketplace. The purchase price was $1,995,114.

B. In November 2020, we acquired Fat Shark Holdings, a provider of FPV video goggles to the drone industry. The purchase price was $8,354,076.

C. In May 2021, we acquired Skypersonic which provides hardware and software solutions that enable drones to complete inspection services in locations where GPS is not available, yet still record and transmit data even while being operated from thousands of miles away. The purchase price was $2,791,012.

D. In August 2021, we acquired Teal, a leader in commercial and government UAV technology, primarily drones, to government and commercial enterprises, most notably, the military. Teal manufactures drones approved by the U.S. Department of Defense for reconnaissance, public safety, and inspection applications. The purchase price was $10,011,279.

Following the Teal acquisition in August 2021, we concentrated on integrating and organizing these businesses. Effective May 1, 2022, we established the Enterprise segment (“Enterprise”) and the Consumer segment (“Consumer”) to focus on the unique opportunities in each sector. Enterprise's initial strategy was to provide UAVs to commercial enterprises, and the military, to navigate dangerous military environments and confined industrial and commercial interior spaces. Subsequently, Enterprise narrowed its near-term attention on the military and other government agencies. Skypersonic's technology has been redirected to military applications and its operations consolidated into Teal.

The Enterprise segment’s current business strategy is focused on providing integrated robotic hardware and software for use across a variety of applications. Its solutions provide critical situational awareness and actionable intelligence to on-the-ground warfighters and battlefield commanders as well as firefighters and public safety officials. Our Enterprise segment’s efforts are centered on developing and scaling an American made family of systems. We have since completed construction of a manufacturing facility in Salt Lake City, Utah and believe that an increased focus by the United States government and American businesses on purchasing products that are “Made in America” provide our Enterprise segment with a competitive advantage.

On February 16, 2024, we closed the sale of our Consumer segment, consisting of Rotor Riot and Fat Shark, to Unusual Machines. The sale reflects our decision to focus our efforts and capital on defense where we believe there are more opportunities to create long term shareholder value.

On September 4, 2024, we entered into and closed on the transactions set forth in an Asset Purchase Agreement with FlightWave pursuant to which we purchased certain assets for designing, developing, manufacturing, and selling long range, AI-powered UAVs for commercial use. Please refer to the Recent Developments section above for further information regarding the APA and related transactions.

Results of Operations

The analysis of our results of operations for the three months ended July 31, 2024 compared to the three months ended July 31, 2023 includes only our Enterprise segment as our Consumer segment was divested in February 2024.

Discussion and Analysis of Three Months Ended July 31, 2024 compared to Three Months Ended July 31, 2023

Revenues

Consolidated revenues totaled $2,776,535 during the three months ended July 31, 2024 (or the “2024 period”) compared to $1,748,129 during the three months ended July 31, 2023 (or the “2023 period”) representing an increase of $1,028,406, or 59%. The increase related to higher product revenue and higher contract revenue. Product revenue totaled $1,890,095 during the quarter ended July 31, 2024 compared to $1,437,248 during the quarter ended July 31, 2023 representing an increase of $452,847, or 32%. Contract revenues totaled $886,440 during the 2024 period compared to $310,881 during the 2023 period, representing an increase of $575,559, or 185%. Contract revenues are primarily sourced through government agencies and can fluctuate from period to period based on the timing of award deliverables and amendments.

Gross Profit

Consolidated gross loss totaled $483,391 during the 2024 period compared to a gross profit of $174,665 during the 2023 period representing a decrease of $658,056, or 377%. On a percentage basis, gross loss was 17% during the 2024 period compared to a gross profit of 10% during the 2023 period. The gross loss in the 2024 period was due to the delivery of final prototypes under the Short Range Reconnaissance Tranche 2 contract with the U.S. Army and did not pertain to product sales.

Operating Expenses

Research and development expenses totaled $1,626,440 during the 2024 period compared to $1,353,551 during the 2023 period, representing an increase of $272,889, or 20%. Professional fees totaled $483,129 in the 2024 period compared to $211,883 in the 2023 period. This increase of $271,246, or 128%, primarily related to outsourced software development expenses and represented substantially all of the total increase in research and development costs.

Sales and marketing costs totaled $2,041,511 during the 2024 period compared to $1,288,760 during the 2023 period, representing an increase of $752,751 or 58%. The increase was driven by higher payroll expenses and an increase in tradeshow attendance to support increased sales efforts of our Teal 2 drone.

General and administrative expenses totaled $3,483,095 during the 2024 period compared to $2,863,758 during the 2023 period, representing an increase of $619,337 or 22%. The increase primarily related to higher stock compensation expense.

During the 2024 period, we incurred stock-based compensation costs of $1,446,038 compared to $911,606 in the 2023 period, resulting in an increase of $534,432 or 59%.

Other Income

Other expense totaled $4,688,889 during the 2024 period compared to $262,891 during the 2023 period, representing an increase of $4,425,998 or more than 16 times. During the 2024 period, we incurred a loss on the sale of our equity method investment of $4,008,357.

Net Loss from Continuing Operations

Net loss from continuing operations totaled $12,416,376 for the 2024 period compared to $5,594,295 for the 2023 period, resulting in an increase of $6,822,081 or 122%. Total operating expenses totaled $6,407,513 for the 2024 period compared to $5,187,700 for the 2023 period. This increase of $1,219,813 or 24%, primarily to the increase in sales and marketing expenses.

Cash Flows

Operating Activities

Net cash used in operating activities was $2,348,412 during the 2024 period compared to net cash used in operating activities of $6,926,069 during the 2023 period, representing a decrease of $4,577,657 or 66%. The decreased use of cash primarily related to timing of accounts receivable receipts for government customers. Net cash used in operations, net of non-cash expenses, totaled $6,755,639 during the 2024 period, compared to $1,522,611 during the 2023 period, resulting in an increase of $5,233,028, or 344%. Net cash used related to changes in operating assets and liabilities totaled $3,312,325 during the 2024 period, compared to negative $2,854,385 during the 2023 period, representing an increase of $6,166,710 or 216%. Changes in operating assets and liabilities can fluctuate significantly from period to period depending upon the timing and level of multiple factors, including inventory purchases, vendor payments, and customer collections.

Investing Activities

Net cash provided by investing activities was $4,300,043 during the 2024 period compared to net cash provided by investing activities of $4,883,345 during the 2023 period, resulting in a decrease of $583,302 or 12%. Proceeds of $4,400,000 from the sale of equity method investment were used to fund operations during the 2024 period.

Financing Activities

Net cash used in financing activities totaled $286,037 during the 2024 period compared to net cash used in financing activities of $146,509 during the 2023 period. Financing activities can vary from period to period depending upon market conditions, both at a macro-level and specific to the Company.

Liquidity and Capital Resources

At July 31, 2024, we reported current assets totaling $21,470,151, current liabilities totaling $4,230,512 and net working capital of $17,239,639. Cash totaled $7,732,763 at July 31, 2024. Inventory related balances, including pre-paid inventory, totaled $10,667,676.

Going Concern

We have never been profitable and have incurred net losses related to acquisitions, as well as costs incurred to pursue our long-term growth strategy. During the three months ended July 31, 2024, we incurred a net loss of approximately $12,000,000 and used cash in operating activities of approximately $2,300,000. As of July 31, 2024, working capital totaled approximately $17,200,000. These financial results and our financial position at July 31, 2024 raise substantial doubt about our ability to continue as a going concern. However, we have recently taken actions to strengthen our liquidity.

On December 11, 2023, we completed a public offering of 18,400,000 shares of common stock which generated net proceeds of approximately $8,400,000 as further described in Note 1 and Note 12. In addition, our operating plan for the next twelve months has been updated to reflect recent operating improvements. Revenues have accelerated and are expected to continue growing. Our manufacturing facility is scaling production and gross profits are projected to increase. If necessary, we will seek to obtain additional debt financing for which there can be no guarantee. As described in Note 7, we sold our equity method investment for $4,400,000 in July 2024. As described in Note 18, the Company closed a financing with proceeds of $8 million to be received in late September 2024. Management has concluded that these recent positive developments alleviate any substantial doubt about our ability to continue our operations, and meet our financial obligations, for twelve months from the date these consolidated financial statements are issued.

Critical Accounting Policies and Estimates

Our financial statements and accompanying notes have been prepared in accordance with GAAP applied on a consistent basis. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods.

We regularly evaluate the accounting policies and estimates that we use to prepare our financial statements. A complete summary of these policies is included in the notes to our financial statements. In general, management's estimates are based on historical experience, information from third party professionals, and on various other assumptions that are believed to be reasonable under the facts and circumstances. Actual results could differ from those estimates made by management.

Significant estimates reflected in these financial statements include those used to (i) complete purchase price accounting for acquisitions, (ii) the evaluation of long-term assets, including goodwill, for impairment, and (iii) the evaluation of other-than-temporary-impairment of equity method investments.

Goodwill and Long-lived Assets – Goodwill represents the future economic benefit arising from other assets acquired in an acquisition that are not individually identified and separately recognized. We test goodwill for impairment in accordance with the provisions of *ASC 350, Intangibles – Goodwill and Other, (“*ASC 350”). Goodwill is tested for impairment at least annually at the reporting unit level or whenever events or changes in circumstances indicate that goodwill might be impaired. ASC 350 provides that an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then additional impairment testing is not required. However, if an entity concludes otherwise, then it is required to perform an impairment test. The impairment test involves comparing the estimated fair value of a reporting unit with its book value, including goodwill. If the estimated fair value exceeds book value, goodwill is considered not to be impaired. If, however, the fair value of the reporting unit is less than book value, then an impairment loss is recognized in an amount equal to the amount that the book value of the reporting unit exceeds its fair value, not to exceed the total amount of goodwill allocated to the reporting unit.

The estimate of fair value of a reporting unit is computed using either an income approach, a market approach, or a combination of both. Under the income approach, we utilize the discounted cash flow method to estimate the fair value of a reporting unit. Significant assumptions inherent in estimating the fair values include the estimated future cash flows, growth assumptions for future revenues (including gross profit, operating expenses, and capital expenditures), and a rate used to discount estimated future cash flow projections to their present value based on estimated weighted average cost of capital (i.e., the selected discount rate). Our assumptions are based on historical data, supplemented by current and anticipated market conditions, estimated growth rates, and management’s plans. Under the market approach, fair value is derived from metrics of publicly traded companies or historically completed transactions of comparable businesses. The selection of comparable businesses is based on the markets in which the reporting units operate and consider risk profiles, size, geography, and diversity of products and services.

Fair Values, Inputs and Valuation Techniques for Financial Assets and Liabilities and Related Disclosures – The fair value measurements and disclosure guidance defines fair value and establishes a framework for measuring fair value. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. In accordance with this guidance, we have categorized our recurring basis financial assets and liabilities into a three-level fair value hierarchy based on the priority of the inputs to the valuation technique.

The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). The inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment and considers factors specific to the asset or liability.

The guidance establishes three levels of the fair value hierarchy as follows:

Level 1: Inputs are unadjusted, quoted prices in active markets for identical assets or liabilities at the measurement date;

Level 2: Inputs are observable, unadjusted quoted prices in active markets for similar assets or liabilities, unadjusted quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related assets or liabilities; and

Level 3: Unobservable inputs that are significant to the measurement of the fair value of the assets or liabilities that are supported by little or no market data.

Financial Instruments

Our financial instruments mainly consist of cash, receivables, current assets, accounts payable, accrued expenses and debt. The carrying amounts of cash, receivables, current assets, accounts payable, accrued expenses and current debt approximates fair value due to the short-term nature of these instruments.

Recently Issued Accounting Pronouncements

We have implemented all new accounting pronouncements that are in effect. These pronouncements did not have any material impact on the financial statements unless otherwise disclosed, and we do not believe that there are any other new accounting pronouncements that have been issued that might have a material impact on our financial position or results of operations.

We are not required to provide the information required by this Item as we are a “smaller reporting company,” as defined in Rule 12b-2 of the Exchange Act.

Evaluation of Disclosure Controls and Procedures

Our principal executive officer and principal financial officer evaluated the effectiveness of our “disclosure controls and procedures” as of July 31, 2024, the end of the period covered by this Quarterly Report on Form 10-Q. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files under the Exchange Act is accumulated and communicated to a company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Based on the evaluation of our disclosure controls and procedures as of July 31, 2024, our Chief Executive Officer and our Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were not effective, specifically pertaining to the quarter ended July 31, 2023 for which we restated items related to the removal of the derivative liabilities.

Management's quarterly report on internal control over financial reporting.

Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Our internal control over financial reporting is designed to provide reasonable assurances regarding the reliability of financial reporting and the preparation of our consolidated financial statements in accordance with GAAP. Our accounting policies and internal controls over financial reporting, established and maintained by management, are under the general oversight of the Board’s audit committee.

Our internal control over financial reporting includes those policies and procedures that:

• pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets;
• provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
• provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree or compliance with the policies or procedures may deteriorate.

Management assessed our internal control over financial reporting as of July 31, 2024. The standard measures adopted by management in making its evaluation are the measures in the Internal-Control Integrated Framework published by the Committee of Sponsoring Organizations (“COSO”) of the Treadway Commission.

Based on management’s assessment using the COSO criteria, our CEO and CFO concluded that our internal control over financial reporting was not effective, specifically pertaining to the quarter ended July 31, 2023 for which we restated items related to the removal of the derivative liabilities. The Company is currently in the process of formalizing narratives and processes which are expected to mitigate these weaknesses, and has hired additional personnel to strengthen the internal control environment.

Changes In Controls Over Financial Reporting

There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) of the Exchange Act) that occurred during the three months ended July 31, 2024, that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

Limitations on Effectiveness of Controls and Procedures

In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply judgment in evaluating the benefits of possible controls and procedures relative to their costs.

Risk factors that affect our business and financial results are discussed in Part I, Item 1A “Risk Factors,” in our Annual Report on Form 10-K for the year ended April 30, 2024, as filed with the SEC on August 8, 2024 (“Annual Report”). There have been no material changes in our risk factors from those previously disclosed in our Annual Report. You should carefully consider the risks described in our Annual Report which could materially affect our business, financial condition or future results. The risks described in our Annual Report are not the only risks we face. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition, and/or operating results. If any of the risks actually occur, our business, financial condition, and/or results of operations could be negatively affected.