Kerrisdale Capital is short shares of Red Cat Holdings Inc (NASDAQ:RCAT), a $1 billion drone manufacturer that’s added more than $900 million in market capitalization over the last 9 months mostly in anticipation of an award for the production of the US Army’s short range reconnaissance (SRR) drone and the supposedly massive market opportunity unlocked by such a high-profile endorsement. But expectations for both the SRR contract size and the potential for follow-on sales bear almost no relationship to reality.
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Army budget documents clearly delineate an SRR budget for 2025 of just under $25 million, and an expectation of about the same in the medium term. The Army also intends to refresh the SRR model every 2-3 years while remaining open to switching contractors. That contrasts sharply with Red Cat management’s crafty portrayal of a sole-source contract worth close to $400 million over 5 years, and $80 million in 2025. Investors should also consider that Red Cat preemptively announced the program win without the Army’s permission, weakening its position in contract negotiations and even, in a worst-case scenario, endangering the award.
Red Cat’s depiction of a huge follow-on market consisting of the other US military services, US government agencies, and US-allied militaries is also a fantasy. The Air Force has little infantry and thus little use for an infantry drone, and the Marines and Coast Guard have preexisting drone programs. The only other relevant government agency is Customs and Border Patrol, and its budget documents indicate near term drone procurement of just $1 million. Meanwhile, management has been talking about massive imminent drone sales to NATO allies for the last 3 years with nothing to show for it, which could be because European militaries are more inclined to modify cheaper and better Chinese drones or because there’s an array of smaller home-grown European drone suppliers already supplying these customers.
Just like those elusive NATO contracts, Red Cat has been setting near-term deadlines for a “mass production” facility since 2022, but having devoted almost no capex to one, still can’t manufacture large quantities of drones. 2025 guidance, though, assumes that Red Cat will produce 3 new drone models, each at triple the speed of the company’s historical best seller. One of those new drones, the Edge 130, comes to Red Cat through a 2024 acquisition and has never been produced as more than a prototype.
Red Cat’s declarations and projections rarely materialize, and we believe the same will be true of both the company’s 2025 guidance and the parameters of the SRR contract. Almost immediately following the SRR win, two key executives – including George Matus, the brains behind the SRR-winning drone – resigned and sold most of their stock. Share sales have also been made by other insiders. Having set almost impossible expectations, Red Cat is set to be blown out of the sky.
I. Investment Highlights
The SRR contract that Red Cat won in November and preemptively announced without the Army’s permission is much smaller and less favorable than management has intimated. Red Cat management has spent years hyping the potential of Tranche 2 of the Army’s Short Range Reconnaissance (SRR) small unmanned aerial system (sUAS) program for which the company was competing. Investors were initially led to believe that the revenue potential of a win would be in the billion dollar range over the course of 5-10 years. Upon winning the contract, management curbed those expectations by quite a bit, though still signaled revenue of $260 million for 5,880 drone systems over the next five years, plus about 30% of that sticker price to be earned in repairs, replacements, and training services. Management called out $80 million in 2025 expected revenue, specifically citing the National Defense Authorization Act (NDAA) text.
But the NDAA says nothing about the SRR funding in particular and the Army’s detailed funding request for 2025 shows that the service expects to procure between 275 and 300 systems annually at a cost of $20-25 million, which is a very far cry from Red Cat’s 2025 SRR guidance. Additionally, the cost for repairs, replacements, and related services are included in that $20-25 million, so Red Cat’s “plus 30%” should be entirely discounted.
The claim that the contract will be a five-year fixed-quantity sole-sourced agreement is also contradicted by the Army’s public disclosures and announcements about the program. The Army has repeatedly emphasized that in order for its small-drone procurement to be flexible and adaptive, it plans to conduct a product refresh every 2-3 years while leaving the door open to new suppliers with potentially superior technology. Several defense procurement specialists with whom we spoke confirmed that the SRR program was indeed designed accordingly. While the contract Red Cat signs might stipulate a 5 year term and specific quantities, those are upper bounds, not hard-coded expected values.
We also discovered in the course of our diligence that Red Cat’s November announcement of the SRR contract win was made improperly without the Army’s approval. While that’s unlikely to scuttle the contract win completely, our sources indicated that it might make negotiating the precise contract terms with the Army contentious and more difficult for Red Cat. It may also result in the Army more strictly enforcing contract terms and more willing to contemplate other suppliers if and when the opportunity presents itself.
Red Cat has been misleading investors about its manufacturing capacity for years. Over the last 3 years, Red Cat has promised investors multiple times that within some clearly definable near-term deadline it will be capable of producing “thousands of drones” per month. First it was “by the fall” in early 2022, then it was “in a few months” in November of 2022, then “now” in March of 2023, then “in a few months” in July of that year, then “now” (again) in early 2024, and most recently (in September) it was to be at some point in 2025. We present the full comical timeline of management’s contradictory and misleading assurances below, but investors shouldn’t find it funny that drone industry sources close to the company don’t think Red Cat has the manufacturing capability for mass production of drones. Getting there would take time and a real capital expenditure commitment. Considering that Red Cat has dedicated a total of just $3 million to capex over the last 3 years (most of it in 2022), it’s going to be a long and expensive slog to the kind of facilities that would enable a respectable drone manufacturing operation. It certainly won’t be ready to meet investor expectations for 2025.
Management has also sent conflicting signals about Red Cat’s ability to manufacture more than one model on the Teal production line. On the one hand, management is guiding to tens of millions of dollars in 2025 revenue from each of the Teal 3 and Black Widow (SRR) models. On the other hand, management blamed the precipitous dip in sales of the Teal 2 model in the second half of 2024 on the need to retool the factory for the SRR. So, can the factory produce two models simultaneously? Realistically, we think Red Cat faces a dual predicament – the company indeed lacks the manufacturing capacity to produce two models concurrently and, at the same time, demand for its $15,000 drones is much weaker than management lets on.
Read the full report here by Kerrisdale Capital
