Unusual Machines, Inc.: Form 10-Q for the period ended Jun 30, 2024

The following discussion and analysis should be read in conjunction with the unaudited condensed financial statements and related notes included elsewhere in this Quarterly Report and our audited financial statements and related notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2023, which was filed with the SEC on March 22, 2024. The following discussion contains forward-looking statements that are subject to risks and uncertainties. See “Special Note Regarding Forward-Looking Statements” for a discussion of the uncertainties, risks, and assumptions associated with those statements. Actual results could differ materially from those discussed in or implied by forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Quarterly Report and of our Annual Report on Form 10-K for the year ended December 31, 2023, particularly in the section entitled “Risk Factors.” Unless we state otherwise or the context otherwise requires, the terms “we,” “us,” “our” and the “Company” refer to Unusual Machines, Inc. and its subsidiaries. All amounts presented in tables, other than per share amounts, are in thousands unless otherwise noted.

Recent Developments

Initial Public Offering

On February 16, 2024, we closed our initial public offering (“IPO”) for the sale of 1,250,000 shares of common stock, at a public offering price of $4.00 per share. The IPO generated gross proceeds of $5.0 million and net proceeds of approximately $4.5 million. We incurred and paid additional direct offering costs prior to the close of the IPO of $0.1 million during the six months ended June 30, 2024, and $0.5 million during the year ended December 31, 2023. We used $1.0 million of proceeds to pay for the acquisition of Fat Shark and Rotor Riot as discussed below.

Acquisition of Fat Shark and Rotor Riot

On November 21, 2022, we entered into the Purchase Agreement with Red Cat Holdings, Inc. (“Red Cat”) and Jeffrey Thompson, the founder and Chief Executive Officer of Red Cat and also director of our Company, pursuant to which we agreed to purchase Red Cat’s consumer business consisting of Fat Shark Holdings Ltd. (“Fat Shark”) and Rotor Riot LLC (“Rotor Riot”). Fat Shark and Rotor Riot are in the business of designing and marketing consumer drones and FPV goggles. Rotor Riot is also a licensed authorized reseller of consumer drones manufactured by third-parties.

Under the terms of the Purchase Agreement, as amended, the Company purchased from Red Cat its Rotor Riot and Fat Shark subsidiaries for $20.1 million comprised of (i) $1.1 million in cash, (ii) a $2.0 million promissory note issued by the Company to Red Cat, and (iii) $17.0 million of the Company’s common stock or 4,250,000 shares of common stock.

Simultaneous with the closing of our IPO, on February 16, 2024, we closed the acquisitions of Fat Shark and Rotor Riot.

Nevada Reincorporation

On April 22, 2024, we completed the change of incorporation from a Puerto Rico Corporation to a Nevada Corporation.

Finalization of Working Capital Adjustment

On July 22, 2024, we finalized the working capital adjustment as stipulated in the Purchase Agreement, which resulted in an increase in the overall purchase price by an additional $2.0 million. We agreed to increase the principal amount of the original note for the working capital adjustment, which increased the total Note Payable to $4.0 million. In addition, we agreed to extend the maturity date of the promissory note to November 30, 2025.

Results of Operations – Three Months Ended June 30, 2024 compared to the Three Months Ended June 30, 2023

Revenue

During the three months ended June 30, 2024 we generated revenues totaling $1,411,124 compared to $0 during the three months ended June 30, 2023, representing an increase of $1,411,124 or 100%. We did not generate any revenues until the closing of the acquisitions of Fat Shark and Rotor Riot on February 16, 2024. The majority of our revenue during the quarter relates to completed and fulfilled product sales during the period through our Rotor Riot retail channel and from our B2B wholesale through Fat Shark. We also generated $112,500 related to our Rampage event, which is an annual event held in May.

Cost of Goods Sold

During the three months ended June 30, 2024, we incurred cost of goods sold of $1,022,684 compared to $0 during the three months ended June 30, 2023, resulting in an increase of $1,022,684 or 100%. Similar to revenues, we did not incur any cost of goods sold until the closing of the acquisitions on February 16, 2024. Cost of goods sold primarily relate to product costs from our sales, but also include certain shipping and other direct product costs.

Gross Margin

During the three months ended June 30, 2024, our gross margin was $388,440 compared to $0 during the three months ended June 30, 2023, resulting in an increase of $388,440 or 100%. Our gross margin, as a percentage of sales, totaled 28% during the three months ended June 30, 2024, compared to 0% during the three months ended June 30, 2023. We anticipate our gross margin to fluctuate period to period depending on certain promotions and products that are sold during the period and the margins we generated during the quarter are in line with our expectations and normal operating margins.

Operating Expenses

During the three months ended June 30, 2024, operations expenses totaled $213,772 compared to $0 during the three months ended June 30, 2023, resulting in an increase of $213,772 or 100%. Prior to the closing of the acquisitions in February 2024, we did not have any operations expenses. Operations expenses primarily relate to our direct operations including our warehouse personnel and warehouse expenses.

During the three months ended June 30, 2024, research and development expenses totaled $10,282 compared to $0 for the three months ended June 30, 2023, resulting in an increase of $10,282 or 100%. Prior to the closing of the acquisitions in February 2024, we did not have any research and development expenses during 2023. Research and development expense primarily relates to new product development as we continue to partner with manufacturers to bring drone component manufacturing to the United States.

During the three months ended June 30, 2024, sales and marketing expenses totaled $386,332 compared to $0 for the three months ended June 30, 2023, resulting in an increase of $386,332 or 100%. Prior to the closing of the acquisitions in February 2024, we did not have any sales and marketing expenses. Sales and marketing expenses primarily relate to advertising spend related to Rotor Riot and payroll expenses. In addition, we incurred approximately $143,000 in expenses related to our Rampage event, which is an annual event held in May.

During the three months ended June 30, 2024, general and administrative expenses totaling $1,349,587 compared to $434,917 for the three months ended June 30, 2023, resulting in an increase of $914,670 or 210%. The increase relates to stock compensation expense during quarter that we did not have in the previous year, increase in expenses related to closing the IPO including legal and accounting fees, additional transition and integration related expenses, and the costs related to operating Fat Shark and Rotor Riot.

Net Loss

Our net loss for the three months ended June 30, 2024, totaled $1,612,238 compared to $435,298 for the three months ended June 30, 2023, resulting in an increase in net loss of $1,176,940 or 270%. The increase in net loss primarily relates to stock compensation expense taken during the period, in addition to the increase in general and administrative expenses related to closing the IPO and the increased operations and sales and marketing expenses we incurred since the acquisition from Fat Shark and Rotor Riot. This was partially offset by generating gross margin related to the revenue and cost of goods sold from sales for Fat Shark and Rotor Riot. In the third quarter of 2024, we expect that we may begin to amortize our intangibles, which will result in a non-cash charge going forward. Until we do a valuation, the amount is uncertain and the future charge may or may not be material.

Results of Operations – Six Months Ended June 30, 2024 compared to the Six Months Ended June 30, 2023

Revenue

During the six months ended June 30, 2024 we generated revenues totaling $2,030,039 compared to $0 during the six months ended June 30, 2023, representing an increase of $2,030,039 or 100%. We did not generate any revenues until the closing of the acquisitions of Fat Shark and Rotor Riot on February 16, 2024. Revenues relate to completed and fulfilled product sales during the period through our Rotor Riot retail channel and from our B2B wholesale through Fat Shark. We also generated $112,500 related to our Rampage event, which is an annual event held in May.

Cost of Goods Sold

During the six months ended June 30, 2024, we incurred cost of goods sold of $1,437,432 compared to $0 during the six months ended June 30, 2023, resulting in an increase of $1,437,432 or 100%. Similar to revenues, we did not incur any cost of goods sold until the closing of the acquisitions on February 16, 2024. Cost of goods sold primarily relate to product costs from our sales, but also include certain shipping and other direct product costs.

Gross Margin

During the six months ended June 30, 2024, our gross margin was $592,607 compared to $0 during the six months ended June 30, 2023, resulting in an increase of $592,607 or 100%. Our gross margin, as a percentage of sales, totaled 29% during the six months ended June 30, 2024, compared to 0% during the six months ended June 30, 2023. We anticipate our gross margin to fluctuate period to period depending on certain promotions and products that are sold during the period and the margins we generated during the quarter are in line with our expectations and normal operating margins.

Operating Expenses

During the six months ended June 30, 2024, operations expenses totaled $326,094 compared to $0 during the six months ended June 30, 2023, resulting in an increase of $326,094 or 100%. Prior to the closing of the acquisitions in February 2024, we did not have any operations expenses. Operations expenses primarily relate to our direct operations including our warehouse personnel and warehouse expenses.

During the six months ended June 30, 2024, research and development expenses totaled $27,078 compared to $0 for the six months ended June 30, 2023, resulting in an increase of $27,078 or 100%. Prior to the closing of the acquisitions in February 2024, we did not have any research and development expenses during 2023. Research and development expense primarily relates to new product development as we continue to partner with manufacturers to bring drone component manufacturing to the United States.

During the six months ended June 30, 2024, sales and marketing expenses totaled $543,390 compared to $0 for the six months ended June 30, 2023, resulting in an increase of $543,390 or 100%. Prior to the closing of the acquisitions in February 2024, we did not have any sales and marketing expenses. Sales and marketing expenses primarily relate to advertising spend related to Rotor Riot and payroll expenses. In addition, we incurred approximately $143,000 in expenses related to our Rampage event, which is an annual event held in May.

During the six months ended June 30, 2024, general and administrative expenses totaling $2,353,761 compared to $1,612,440 for the six months ended June 30, 2023, resulting in an increase of $741,321 or 46%. The increase relates to increased expenses related to closing the IPO including legal and accounting fees, additional transition and integration related expenses, and the costs related to operating Fat Shark and Rotor Riot.

Net Loss

Our net loss for the six months ended June 30, 2024, totaled $2,718,240 compared to $1,613,202 for the six months ended June 30, 2023, resulting in an increase in net loss of $1,105,038 or 69%. The increase in net loss primarily relates the increase in general and administrative expenses related to closing the IPO with additional increase in expenses for operations and sales and marketing expenses we incurred since the acquisition from Fat Shark and Rotor Riot. This was partially offset by generating gross margin related to the revenue and cost of goods sold from sales for Fat Shark and Rotor Riot. In the third quarter of 2024, we expect that we may begin to amortize our intangibles, which will result in a non-cash charge going forward. Until we do a valuation, the amount is uncertain and the future charge may or may not be material.

Cash Flow Analysis

Prior to the closing of our IPO and the acquisitions of Fat Shark and Rotor Riot, we did not have any cash inflows from operations and all cash outflows related to our activities related to our IPO. Our future cash flows from operating activities will be significantly impacted by revenues received, our investment in sales and marketing to drive growth, and general and administrative expenses related to operating a public company. Our ability to meet future liquidity needs will be driven by our operating performance and the extent of continued investment in our operations. Failure to generate sufficient revenues and related cash flows could have a material adverse effect on our ability to meet our liquidity needs and achieve our business objectives.

Operating Activities

Net cash used in operating activities was $2,181,840 during the six months ended June 30, 2024, compared to net cash used in operating activities of $1,022,861 during the six months ended June 30, 2023, representing an increase of $1,158,979 or 113%. This increase in net cash used primarily resulted from our increase in net loss of $1,105,038 and an increase in prepaid expenses of $253,424, other assets of $173,054 and non-cash expenses of $158,206, offset by a decrease in inventory of $152,566 and an increase in accounts payable and accrued expenses of $417,478.

Investing Activities

Net cash used in investing activities was $852,801 during the six months ended June 30, 2024 compared to net cash used in investing activities of $4,837 during the six months ended June 30, 2023, representing an increase of $847,964 or 100%. This increase in net cash used related to the $1,000,000 of cash used in the Purchase Agreement related to Fat Shark and Rotor Riot, offset by $147,199 in cash acquired as compared to $4,837 used for purchase of computer equipment during 2023.

Financing Activities

Net cash provided by financing activities totaled $4,362,313 during the six months ended June 30, 2024, compared to net cash used in financing activities of $223,579 during the six months ended June 30, 2023, resulting in an increase in net cash provided by financing activities of $4,585,892. The increase primarily relates to proceeds received from our IPO of $5,000,000, offset by change in deferred offering costs and other IPO related expenses of $414,108.

Liquidity and Capital Resources

As of June 30, 2024, we had current assets totaling $5,116,963 primarily consisting of cash balances of $2,222,445, inventory of $1,638,038 and prepaid expenses and deposits for inventory of $1,074,403. Our current liabilities as of June 30, 2024 totaled $931,200, primarily consisting of accounts payable and accrued expenses of $786,598 and customer deposits and other current liabilities of $144,602. Our net working capital as of June 30, 2024 was $4,185,763.

On February 16, 2024, we completed our IPO for the sale of 1,250,000 shares of common stock at a public offering price of $4.00 per share for gross proceeds of $5.0 million. After paying certain underwriting discounts and commissions, business combination cash payment and other expenses related to the IPO, we retained approximately $2.9 million in net proceeds.

As of August 14, 2024, we have approximately $1.8 million in cash. We believe that the net proceeds from our February 2024 IPO and existing cash balances will be sufficient to fund our current operating plans through at least the next 12 months. We have based these estimates, however, on assumptions that may prove to be wrong, and we could spend our available financial resources much faster than we currently expect and need to raise additional funds sooner than we anticipate. We do not anticipate any significant cost increases post the Fat Shark and Rotor Riot and with consideration of the combined companies’ net low and cash position, we expect we will have sufficient working capital to support our operations for at least 12 months.

As described in Note 14 of our financial statements, we issued the New Notes following our agreement with Red Cat on the Working Capital Adjustment. We will need to either (a) raise additional capital, (b) refinance the New Notes, (c) seek an extension of the maturity date of the Notes, or (d) explore the conversion or exchange of the New Notes into equity, which will result in dilution to our shareholders. If we are unable to raise capital or explore such other options when needed or on acceptable terms, we may default under the obligation pursuant to the New Notes, or be forced to delay, reduce or eliminate certain operational efforts.

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, on 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.

Fair value of assets acquired and liabilities assumed in business combination

The Fat Shark and Rotor Riot acquisitions are accounted for as a business combination under ASC 805. We recognized the assets acquired and liabilities assumed at fair value as of the date of acquisition. We have not yet completed our evaluation of the fair value for determining the unallocated purchase price between goodwill and other intangible assets. Such amounts are subject to adjustment during the one-year measurement period. The fair value will be determined based on assumptions used in valuations and estimates determined by management, which are subjective.

Impairment of 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. Goodwill represents costs in excess of fair values assigned to the underlying identifiable net assets of acquired businesses. Intangible assets from acquired business are recognized at fair value on the acquisition date. We are continuing our evaluation of the fair value of the assets acquired and liabilities assumed from the Fat Shark and Rotor Riot acquisition, and we have not yet determined the unallocated purchase price between goodwill and other intangible assets. 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.

Valuation of Inventory

Our policy for valuation of inventory requires us to evaluate the net realizable value of our inventory using various reference measures including current product selling prices, as well as evaluating for excess quantities and obsolescence. We may be required to record inventory write-downs if actual inventory values are less favorable than those estimates by management.

Stock Based Compensation

Certain employees have received grants of common shares in our company. These awards are accounted for in accordance with guidance prescribed for accounting for equity-based compensation. Based on this guidance and the terms of the awards, the awards are equity classified.

The fair value of each award is determined using the Black-Scholes option-pricing model which values options based on the stock price at the grant date, the expected life of the option, the estimated volatility of the stock, and the risk-free interest rate over the expected life of the option. The expected volatility was determined considering comparable companies historical stock prices as a peer group for the fiscal year the grant occurred and prior fiscal years for a period equal to the expected life of the option. The risk-free interest rate was the rate available from the St. Louis Federal Reserve Bank with a term equal to the expected life of the option. The expected life of the option was estimated based on a mid-point method calculation.

In addition, the Company issued shares of our common stock in 2023 to consultants for services performed. Prior to our IPO in February 2024, we were a private company with no active public market for our common stock. Therefore, we have periodically determined the overall value of our company and the estimated per share fair value of our common equity at their various dates and valuations based on a per share valuation using the private funding transactions as an estimate. These values and estimates are subjective.

Recently Issued Accounting Pronouncements

The Company has 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 the Company does not believe that there are any other new accounting pronouncements that have been issued that might have a material impact on its financial position or results of operations.

We are a smaller reporting company as defined by Rule 12b-2 of the Exchange Act and are not required to provide the information required under this item.

Evaluation of Disclosure Controls and Procedures

We carried out an evaluation, under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial Officer, of the effectiveness of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”) as of the end of the period covered by this report. Based on that evaluation, our Principal Executive Officer and Principal Financial Officer have concluded that our disclosure controls and procedures as of June 30, 2024, were not effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms because of a material weakness in the Company’s internal control over financial reporting. Specifically, the Company did not maintain effective controls, segregation of duties, and procedures to support the identification of, accounting for, and the evaluation and disclosure of certain transactions, as limited individuals, either the Principal Executive Officer or Principal Financial Officer, initiates all transactions and they also review, evaluate, and approve these same transactions.

Changes in Internal Control Over Financial Reporting

During the six months ended June 30, 2024, we have:

• Continued to strengthen our internal policies, processes, and reviews, including drafting of related documentation thereof;
• Engaged outside consultants to ensure that appropriate level of knowledge and experience is applied based on the risk and complexity of the transactions and tasks under review;
• Hired additional accounting staff to provide additional segregation of duties within accounting functions;
• Started internal control documentation along with the engagement of outside consultants to assist in the design, implementation, and documentation of internal controls to address relevant risks;
• Implemented the initial phase of an ERP and financial accounting system and added additional systematic internal controls and timely recording of transactions. We will continue to build out and expand the functionality of our ERP system and build in additional automation and controls.

The process of implementing an effective financial reporting system is a continuous effort that requires us to anticipate and react to changes in our business and the economic and regulatory environments and to expend significant resources to maintain a financial reporting system that is adequate to satisfy our reporting obligations. As we continue to evaluate and take actions to improve our internal control over financial reporting, we may take additional actions to address control deficiencies or modify certain of the remediation measures described above.

While progress has been made to enhance our internal control over financial reporting, we are still in the process of implementing these processes, procedures and controls. Additional time is required to complete implementation and to assess and ensure the sustainability of these procedures. There have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during the six months ended June 30, 2024 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting, other than the activities described above.

In addition to the information set forth in this Form 10-Q, you should carefully consider the risk factors disclosed under the heading “Risk Factors” in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2023.