Kustom Entertainment, Inc. (KUST) Q2 2019 Earnings Report, Transcript and Summary

Good morning and welcome to the Digital Ally 2019 Second Quarter Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]. Thank you I will now turn the call over to Stan Ross, CEO. Please go ahead, sir.

Thanks everybody for joining us. I have with me today Tom Heckman, the Company’s CFO which will do a little recap of last quarter's numbers and then I will touch on some of the highlights we had last quarter and also give a little insight to that we see as a remainder of 2019 for the future. Tom.

Thank you Stan and welcome everyone for joining us. I do wanted to let you know that we filed our Form 10-Q yesterday evening and hopefully you have had a chance to look at it. It will be a more detailed analysis of the quarterly operating results and then I will go through here. I will discuss a few of the major events and initiatives that happened during the second quarter, which we believe will also our continue for the rest of 2019 and beyond in a good way. So, let's look at some of those major events. First of all, in a litigation aspect, we had two major events. Number one, the WatchGuard settlement, which has been out there and we have done press releases, so hopefully everyone is in tune with what happened there. We did receive $6 million cash in settlement of that litigation. And more importantly, they have until December 2023 to design and workaround and implement and workaround where we can reinstitute a law suit at that time. So, it is a $6 million settlement that we received during the second quarter and obviously had a big impact to our financials. The second area and not so good impact was a summary judgment motion was granted by the judge in the Axon case. I would tell you that number one, that is unexpected, and number two, is unfortunate, but number three is reversed on appeal. We have appealed it and we fully, fully believe that will be reversed as an area in judgment by the judge on granting that. So, we are very optimistic on the results of that, the problem is that has delayed the lawsuit and us getting in front of judge and jury with Axon for a number of months. I can't give you exact timeline, but we are looking to at least six to eight, maybe nine-months delay in what we had anticipated in a trial date with Axon. The other thing that impacted us in a indirect way was the increase in the BTI obligations. BTI is a litigation financing and if you recall, they were paid out the proceeds of our litigation with both WatchGuard and Axon. So, obviously we received $6 million in WatchGuard settlement, so that went against the obligation. And then the delay in the Axon case due to this unfortunate decision by the judge, also has increased the valuation of the obligation. So, we do fair values that in our financial statements and unfortunately, the valuation experts viewed that as a very positive developments during the quarter and increase the obligation by $3 million, which is a non-cash charge in the non-operating expenses, non-cash charge during the quarter. So, on a macro level, we settled for $6 million for WatchGuard, but we gave back $3 million of it an increase, non-cash increase in the expected obligation to the litigation financier. So kind of an offset to the overall good settlement with WatchGuard. Late matter, the settlement on WatchGuard stop the legal spend on the WatchGuard case and appeal has also slowed the march towards the trial date. So it slowed our legal spend in the second quarter and in fact, we were $200,000 less in legal spend than in the prior year. We do expect that the lower spending and litigation costs will continue through the end of the year, until the appeal was heard and hopefully reversed and then probably next year it will pick back up as we march toward trial with Axon. The second major area is the new product that we announced and launched late in the second quarter, the EVO-HD which is law enforcement style in-car video systems. Really a leapfrog in technology, we believe that is the only 5G offering on the market right now. So we have definitely caught and surpassed our competitors in terms of features and technology. We launched that and began delivering late, late in the June 30 quarter. So it really didn’t have a lot of direct effect on our revenues. We did get some revenue units out, but we did see that customers delayed their purchasing decisions for that launch so that they had time to review the features and how it worked and we hope that we will renewed spending and increase market share in the second half of 2019 because of the EVO-HD launch. In reality, it is a high technology leader in our long list of markets, especially compared to our competitors, but what it does for us also since its fully connected all the time 5G, it will substantially reduce our support costs. So whenever there are troubleshooting needed or new firmware that come out we can push that centrally and remotely to all the deployed units. So it will really help us in terms of the cost of supporting that new products. So we are happy with the EVO-HD and we look forward to seeing that take on some new market share for us in the second half of the year. Another area that we have gone into and we have talked about for sometime is moving more aggressively to our service line, especially in the commercial area and what we launched is an advance solutions category for us, and really what - if you step back and look at it at a macro level there is a lot of single regular events may be infrequent, but regular events take for instance football teams. NFL teams played 16 regular season games at a minimum and then probably only half of them at home. So they are huge market for us, but they have infrequent needs for our services. So what we designed is a full turnkey solution that these teams and the bet organizers do not have to actually buy or body cameras, what they are doing is buying our service. So we would provide the body camera, the server, the pipe up to the cloud, storage, management, batteries all that stuff for each one of the events. And it seems they have been taking off. Now, we did announce a multiyear agreement with Kansas City Chiefs here in our hometown which we are very proud of and obviously with the football season upon us, we expect some good revenues to be generated by that. We also announced that we were awarded a very prestigious award for a similar product offering that we featured at MetLife Stadium, which is in East Rutherford, New Jersey and which is a home of New York Giants and Jets. So we believe that this is a growing area for us and it is a innovated use of our technology and more importantly it will generate a lot of service revenues for us on a go forward basis. We also announced that, we entered into a two year agreement with Rahal Letterman Lanigan Racing team, which for you racing fans, you probably know who they are for those that are not, they are very well known Indy Series racing team and the Letterman in there is a David Letterman from the late-night show. But, anyway, it is a two year agreement, where we are providing the first ever live streaming video from their garages. And I think they have got three to four cars in most of the Indy Series races. So, we are live streaming from the garages and this past Indy 500 was our first time doing that and initial results were encouraging. The number of hit and the people who tuned in on the streaming broadcasts was higher than our expectations and again this is two year agreement, so let's see how it goes next year and potentially that could develop into some more areas of service revenue scores. We also just recently, in fact last week announced a partnership with KMC Brands. KMC Brand is a very well known company here in the Kansas City area and for those who don't know, the City of Kansas approved or is now allowing industrial hemp to be grown in the state and process and sold. So, we are working with KMC Brands to develop a video documentation validation program in addition to security obviously for the industrial hemp that is grown in the state. In other words, what we want to do is provide security for hemp growers within Kansas and other state that have approved hemp and then also be able to validate where it was grown, how it was processed and how it got to the dispensaries. So from start to finish, we would be able to provide video documentation validation for that. And with a number of states that are now allowing marijuana as well as industrial hemp to be grow and processed, we really view this as a growth industry for us, because there is an obvious need for video documentation and our solutions, especially our body cameras. So we believe that will be a good area of growth for us. So, as you can tell, I'm very excited and we are moving very aggressively into the commercial markets and especially the service revenues, anything that will generate recurring service revenues for us and no reason why obviously - if you look at our financials, service revenues generate roughly 80% margins, gross margins, very high gross margin for us and its grown substantially pretty much every year. It is now up to 25% of our total revenues, as compared to 16% in the prior year and we believe that percentage of total revenues will continue to increase, especially with our event solutions and in our industrial hemp offerings. Needless to say, we are going to continue to be aggressive, we are looking for new commercial areas to grow our business. During the quarter, you know our SG&A expenses, excluding the $6 million litigation settlement, which showed up in our operating expenses as a negative expense or income item was up significantly. And if you look at it, really there is two areas that generated that increase in SG&A expense. Number one, we had increased R&D, research and development spend as we finalize the development of launch of EVO-HD, I will that we will see a reduction in the coming quarters to more historical levels on the R&D basis, because we have now actually launched the EVO-HD. Our selling and advertising expense were up significantly primarily due to our NASCAR sponsorship. So the NASCAR race was in the second quarter or hit us in the second quarter. So we don't see that happening again for the rest of the year. So on net basis we recorded a net loss of $387,000 for Q2 2019 that is compared to a $3 million loss in the prior year. So quiet an improvements year-over-year, but more importantly our operating cash flows turn positive. We are $1.3 million positive operating cash flow year-to-date and $2.9 million almost $3 million for just the second quarter. So some very good improvement in the operating cash flows. Couple of subsequent events that has recently been occurred, we issued roughly $2.5 million of principle balance in convertible debentures at $1.40 per share to provide us some liquidity that closed about a week or two ago. And then we were just recently notified the pending issuance of our breath analyzers patent, which was announced a year or two ago that we filed for this patent. What we are doing is integrating the breathalyzer if you will into our video systems put documentation for the court obviously. We are looking at ways to take that to market, there are some well known and very established test kit providers out there and that maybe a avenue we go, but we are just now exploring how to take that thing to market, but we believe that is going to be a game changer in how the breathalyzer market is approached. I guess at the end of the day neither Stan or I or Board are really satisfied with operating results year-to-date and in Q2, but we are optimistic that the new commercial service revenues coupled with the new EVO-HD law enforcement product that is out there will improve revenues for the second half of 2019 and beyond. So with that Stan I will turn it back to you.

Yes, thanks a lot Tom. It was a great sort of recap and also a good insight to where we see things developing over the next few months and quarters. I’m very excited to maximize the understanding of the most recent notice that we received in regards to the breathalyzer patent and that begin as the total new market that we will be able to enter into that should enhance our ability to get in front of different law enforcement departments and other areas outside even in the commercial side of things, which did get utilization for breathalyzer outside of law enforcement. So that along with some of the other patents that we are pretty optimistic that are coming down the pipeline that to give us a leg up in numerous areas. I think you will see a couple of new partnerships that will be announced between now and end of the year. So, I agree with Tom and I think the whole Board does that we have a very exciting outlook in regards to the remainder of this year and clearly one into through next year on how these products could really get a lot of traction and continue to grow. So I think what we will do now, is go ahead and open up the floor for some Q&A.

Thank you [Operator Instructions]. And your first question is comes from [Donald DeFilippo] (Ph). And Donald your line is open. [Operator Instructions].

Lets jump to the next one.

Okay. Your next question is from Bryan Lubitz [Aegis Capital Corporation].

Good morning guys.

Good morning Bryan.

Question about the patents that you guys have just referenced, Tom had referenced in terms of breathalyzer patent. Did you guys say you are looking for ways to monetize that into the product or you are already marketing that, what is the end result in terms of what that can do in terms of bringing sales to the actual product?

Yes. So, Bryan this is Stan. The technology and the patents surrounding the breathalyzer, we have got a couple of different options. One is, flat go out and try to reinvent the wheels a little bit and design our own product and announce it. Or we could sit there and which is a much quicker path and partner up with one a half of dozen breathalyzer companies that are out there, that would be able to have sort of the exclusivity in this particular patent. And that way they have got a real and/or large customer base, the video side of it would allow us to come into sort of their market area as well. So, we are either going to - and I have to tell you, we are leaning towards partnering up, with someone more than anything in regards to implement our technology into their breathalyzers and then having that coupled with our video solutions.

Okay. Also this past quarter out of U.S. Patent Office, you guys were granted if I'm remembering correctly a patent on the Stun Gun. Can you elaborate on that?

Yes. So, the wireless TASER basically is what we call it in short. We did receive a patent on it. There is clearly uniqueness about what its capabilities are able to do surrounding the patent. Again, it is a quite a bit more of a little bit of a challenge for us to implement that versus say the most recent patent that we got on the breathalyzer that is definitely something that is in the queue in regards to our research and development in figuring out how to bring that to market.

When you say challenge, what exactly you are talking about, it is I mean…

Yes, exactly. I mean again you know you got to look at - this is a pretty cool device you know instead of the standard Stunt Guns that are out there now utilizing wires to connect to probes that create the energy that stuns the individual, this would be a wireless device. So, you are actually launching a module that would hit the individual and then be able to deliver the stun. And there’s also a situation that you can regulate the intensity of the stun as well. So, it is little more of a challenge in the development than like I’m saying the other breathalyzer technology.

So, manufacturing part of it is where you think you see a hurdle, is that what you are trying to say?

Yes, all the above. We have got more work to do.

All right. Now, you guys have mentioned that you had a couple of different partnerships that you started this past quarter, KMC Brands, the racecar company and obviously, Kansas City and MetLife. Do we expect to see revenue generated out of these partnerships that should allow us to go profitable in the future?

Yes. I mean, you can definitely see the avenues that we are going down in the situational security side of things in the business, like Tom said, we are up to 25% of our revenues now reoccurring revenue. And so, it continues to grow and we continue to have relationships that we are building up on. These are nice contracts, three-year contracts. And they are filling us out a little bit, what their needs are. But, I think you will see additional - not only partnerships come in to the sectors we have already discussed, but I think you are going to see some new areas where our video solution will come into play that we will be able to announce, that we have not dabbled in, in the past.

So, you are expecting more partnerships to arrive out of, I guess NASCAR and your relationships there?

Absolutely, that NASCAR relationship, the Indy relationship, the B2B that has been developed through those groups, it is priceless. I mean, we are getting in front of the right people to be able to talk to them about how to deliver the right solution for their needs. And as you know, with the engineering capabilities that we have and support, we can adapt to pretty much meet all their needs.

Okay. And that brings me to my last question for you guys. Couple of months ago, right before or a month-ago, right before you guys released EVO, you had a press release saying that the presale orders were well ahead of expectations. If you were to comment, Stan, on your pilot programs right now and the amount of I guess people that you are working with companies, that you are working with one these pilot programs, what would you say in terms of based upon the amount you are working with today as compared to the history of the Company?

The EVO product is absolutely lived up to expectations. I mean, that is the bottom line. And so, now, if we have got a department that has a need, has the capital, and we are able to go in there and show them what all this product is capable of doing, we really, really looked upon very favorably for them to come our direction. And they are not pilots programs anymore. We are looking at orders coming in. I mean, it is starting to happen. I mean, they love the product.

So, you had pilot programs a month or so ago, and now you are actually converting those into contracts is what you are saying?

Correct.

Okay. Well, thank you, boys. I appreciate the time, and good luck in the next quarter.

Thanks, Bryan.

Thank you. [Operator Instructions] And you do have a follow-up from Donald DeFilippo.

Now, I have one question and one comment. My question is, in regard to the appellate court, which it provides a forum for an opportunity to not to try the case again, but to get a type of review of one, de novo, which is new; or two, a clear error of the court, which tries to identify a clear error. It will not substitute its own judgment about what the right decision should have been made. Now, can you tell me what the lawyers have come up with, where the error was made by the original court.

Donald, this is Tom. I will try and answer that. I will preface this by saying I’m not a lawyer, I’m not attorney. But, from what I understand, this is a de novo case where they’ll rehear it and come to their judgment. We believe that the judge misinterpreted the claims in the actual patent. And it was, in our view, a very clear error. So, I guess, what you are asking is that we believe it was a clear error that is reversible and that he did not read the claim correctly. And it is completely reversible. So, number one, it is de novo; it is a new hearing and from the appellate judges on that specific issue. And understand that the judge only ruled on that issue, the summary judgment. He did not say our patent was invalid. What he said was that Axon did not infringe because of that one claim the way he interpreted it. So, we are very optimistic about the outcome of this appeal.

Yes. Donald, this is Stan. I will just chime in quick. And because we actually just met with them yesterday, the attorneys, and we still all are sort of shaking our head because you would have thought that there may be some areas that maybe he could have misinterpreted, but this one in our opinion was so clear. It was the last thing that we thought he would hang his hat on, because we feel very, very confident that he just misinterpreted it.

I see. And now, you say that this new court hearing might take up to nine months. Is it possible to speed things up sort?

So, here is what we know, and this is sort of the format. And like I said, we met with them yesterday, so we would be little more informed on for this call. What will happen is that we will file our brief on the 26th of this month. So, we are right around the corner. So, we will have that filed. And then, we were told that I believe it was 40 days that they have to respond, and then we will have a short period of time to respond after that. Then, they will actually schedule - once we file, they will actually schedule the what will I say, the oral argument, where we will actually be in D.C. in front of the panel. And it won’t be just one, it will be a panel. And we will be able to both talk on this subject. And then they normally rule within 90 days. So, you could say that if everything clicked along pretty nicely, you are looking at probably end of ruling could be as early six months, but realistically, you are looking - probably six to nine is the window.

Okay. Very good. Now, I have one comment concerning the bonuses you paid to the officers and yourself. Is it possible you could rescind those bonuses, based on the current financial condition of the Company?

I don’t know about rescinding. But, I received your letter the other day and I very much appreciated it. It is something that the Board is clearly looking at, what we have to do, what it is going to take for us to get back to profitability. And so, everything is on the table to be looked at, for sure.

Well, that is what everyone is looking for, profitability. Whether it be $0.02 or $0.03 a quarter, whatever, but as long as it is positive.

We totally agree with you.

Okay. Thank you, Mr. Ross.

Thank you.

Thank you. Our next question is from Brian Rockowitz of Madison Global Partners.

How are you, guys?

Hey, Brian. How are you?

I’m doing great. Thank you for asking. Tough quarter for you, guys. I wish you tremendous success in this appeal process and going forward with some new business models that you guys are looking to do regarding your new patents. Over the last eight quarters, six of them have seen declines in revenue. Do you attribute any of those declines over those six quarters to Company’s switching over from using your products, law enforcement agencies that you’ve already had on board that have gone to whether it is VIEVU, whether it is Axon or anybody?

There is obviously a couple of products that we have. But, as far as the in-car systems, I don’t know that that was a dramatic loss on some of - in that area. Obviously, the way that Axon has approached the body camera side of the business and basically buying the business, and given a product away for a year free, that clearly was something that we couldn’t have weathered that storm. And they know. And they took that kind of tactic. And while we think there is a some real issues there, and after they used their product and see the real costs associated with it, I think they may not continue down that path. But, that clearly had an impact on our body camera side of things. The commercial side, again, like Tom mentioned, we are still seeing a good growth there. And you have to realize, Brian, that when we are talking law enforcement, they are making big purchases, okay? And, so you get that upfront flush of money when it comes to the in-car systems and even some of the body cameras to where these contracts that we have on a reoccurring revenue, it is a monthly fee that we are bringing in or even the yearly fee that we are bringing in. So, you don’t see the immediate impact. But, the fact that it is continuing to grow, we are very, very pleased with that.

Okay. And just as a follow-up to the other gentleman’s question about those executive bonuses, of a $1.6 million that you had in SG&A, I guess, last quarter, is that accurate, $1.6 million?

Yes. Brian, the 1.6 is after the $6 million patent litigation settlement, credit, if you will. So real SG&A expense was like $7.6 million.

And of that, how much of that was contributed to executive bonuses?

No, I don’t remember that off the top of my head.

About $450,000.

Okay. Alright, gentlemen. Listen, I wish you guys the best of luck with this appeal and certainly look forward to next quarterly call.

Thank you, Brian. I would like to thank everybody for calling in today, listening in today. And again, we are very optimistic and excited about the remainder of the year and going into next year because of the new product launches, the continued increase in reoccurring revenue growth and also the patents, the technology that continues to be innovative in the industry. And stay tuned. I’m sure you guys will see some new and exciting partnerships that we have to announce. So, thank you everybody for attending today.

Thank you. This does conclude today’s conference call. You may now disconnect.