Meaningful Progress At Duos Technologies (NASDAQ:DUOT)

Railway wheels

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It has been some time since we looked at Duos Technologies (NASDAQ:DUOT). The company suffered from the pandemic, but as that headwind is receding it is now benefiting from new management that seems to have a better grip on the company and is making a number of moves that we feel are likely to bring considerable benefits over the coming years.

DUOT Chart

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Reasons to buy

  • Generic capability, multiple applications
  • Rail car inspection order of magnitude efficiency improvement over manual inspections
  • Rise in revenue
  • Rise in the recurring part of the revenue
  • The new CEO has shaken things up with a clear plan, improve organization, talent, supply chain, core capabilities
  • There are risks, inflation, supply-chain

The company is most known for its rip (railcar inspection portal):

rip

DUOT IR presentation

These can check railcars from all sides at speed in order to detect problems before they become serious. This is an order of magnitude more efficient compared to current practice, which relies still mostly on manual inspections.

AI

At the core, these inspections are based on algorithms, so it’s good to know that this is an area that the new management has given priority, getting new people on board and extending the company’s capabilities here. From the Q4CC:

For context, as recently as six months ago, we could install a new railcar inspection portal and it might take 12 to 18 months to deliver the first 10 to 15 algorithms. Now I can confidently say that we can deliver a railcar inspection portal and within 15 days, deliver the first 15 highly accurate algorithms.

It’s not only the speed of implementation, it’s also the accuracy of the algorithms that have been significantly enhanced to 95%+. There are several significant benefits:

  • Strengthening the company’s competitive position
  • Increasing recurring revenues
  • The AI capabilities can be applied in additional markets

These improvements in the company’s AI capabilities are directly responsible for a host of new orders. The company has already racked up $19M of contract commitments (and a $40M-$50M pipeline), much of which will be delivered this year which is why management guidance ($16.5M-$18M) is for revenues to double in FY2022.

The company doesn’t need new customers or orders in order to achieve this, this is all based on signed contracts already, like a $9M contract with Amtrak. Management believes it now has the best-in-class railcar inspection AI of anyone out there.

Recurring revenue

Another advantage of the renewed focus on improving the algorithms is that these generate recurring revenues and another focus of the new management is to increase these, which come from services, maintenance, and AI offerings.

Recurring revenue is 15%-20% of revenue and will get above 20% from the end of Q2 onwards, according to management.

Additional markets

While the company has only scratched the surface of the rip market, there are a host of additional opportunities where solutions are based on the same principles, with AI capabilities at the core:

Strategy

DUOT IR presentation

The most notable of these is one where the company has already generated some revenues, from alis (automated logistics information system) solutions which (Q4CC):

automates and reduces personnel from gatehouse operations where transport trucks enter and exit large logistics and intermodal facilities. This solution incorporates a similar set of sensors, data processing and artificial intelligence to streamline logistics transactions and tracking while offer offering security and safety automation services. We have already deployed the system with one large North American retailer, and we are currently responding to requests for proposals from several large retailers railroad intermodal operators and select government agencies that manage logistics and border crossing points.

Big retailers as potential customers and this can go beyond trucks to other moving vehicles like aircraft. So watch this space.

In addition to the alis and rip, the company already has already developed a series of additional solutions like:

Of these, apis and icas have sold, but incidentally as the focus is firmly on rip, and to some extent also on alis at the moment.

Q4 and FY2021 figures

Operations

DUOT 10-K

  • FY2021 revenue was up 3% to $8.26M.
  • Q4 revenue was $3.72M or 45% of FY2021 revenue.
  • There is $19M in signed contracts and a $40M-$50M pipeline.
  • Gross margin was lower as a result of additional work needed on some complex installations.
  • Gross profit was $618K in Q4 (down from $951K in Q4 2020)
  • Gross profit for FH2021 was a loss of $2.56M compared to a profit of $236K in 2020.
  • OpEx in Q4 decreased 33% to $858K, while R&D was up marginally, G&A and S&M were down 37% and 26% respectively.
  • Operational cash outflow was $6.58M in FY2021, despite a $1.5M cancellation of the PPP loan.
  • Net loss was $6M for FY2021.
  • FY2022 guidance $16.5M to $18M
  • Q1 will be sequentially lower but will pick up in the rest of the year.

Risk

While the company was buffeted by the pandemic until recently, new risks are manifesting themselves in the form of inflation and supply chain issues. The company suffers from inflation in components and contracted services and supply chain issues that cause some delays.

Management has taken several actions to deal with these problems:

  • Standardization of solutions, components, and subcomponents to increase the supplier base.
  • Negotiating price increases with new and existing customers.
  • Shifting towards a domestic supply chain for better speed and quality (through more intensive cooperation). About 90% of the company’s suppliers are from the US.

Management also admitted that in today’s labor market it has become a little more difficult getting the talent they want, as they’re expanding from 68 employees now to 74-75 next year.

On the other hand, there was a big reduction in customer concentration from 80% dependency on a single customer to 20%-30%.

The company also moved to a single location in Jacksonville that is large enough to accommodate the expected growth.

Cash

The company raised $5.5M in February by issuing 1.52M shares at $4 and should have enough cash to last into Q2 2023.

Chart
Data by YCharts

Valuation

For the company to break even it will have to produce in the order of $4M in gross profit over a 12 month period, but one problem is figuring out how gross margin varies with revenues. Here are both on a TTM basis (not yet including Q4):

Chart
Data by YCharts

This is both reassuring as well as somewhat alarming. The deterioration in gross margin occurred almost entirely last year while revenues held steady. Here is why:

Gross margin

DUOT 10-K

So overall, cost of revenue rose 39% while revenues were up just 3% and most of this comes from overhead, which has risen 125%. If we take technology systems as a fairly stable percentage of revenue we get a $1.11M or a 13.4% margin.

On $18M of revenue this rises to $2.4M but that’s not even enough to cover the overhead and services and consulting, let alone OpEx ($4.9M). There might be two saving graces:

  • Scaling up is likely to expand gross margin
  • Management argued that the main reason for the disappointing gross margin last year was additional work on some complex systems. If these were a one off, there is room for additional gross margin expansion.
  • There was also increased cost of materials and parts, but management is trying to negotiate price increases with new and existing customers.

Searching for more detail, here is the 10-K on the issue:

Cost of revenues on technology systems increased during the period compared to the equivalent period in 2020 by a greater amount than the increase in revenues. The main reason for the continuing high level of cost is the result of additional work being necessary on certain of the Company’s installations to resolve newly identified quality issues which are now mostly resolved as well as higher costs of materials due to supply chain disruptions. There was also a significant increase in cost related to the new deployment of an undercarriage technology. Many of these costs were not envisioned by the original scope of work. However, the costs are expected to be much lower going forward as a percentage of the overall system price.

There was also an organizational realignment that shifted cost from OpEx (most notably R&D) to COGS so we might not get back fully to the historical gross margin levels (35%-45%), which would be more than enough to reach breakeven on the FY2022 guided revenue.

We have little visibility on this issue apart from management arguing gross margin will be positive and improve especially in H2. So things will likely improve, but by how much remains to be seen. Here is the 10-K again:

The Company is expecting improvements in operating margins in 2022 although it does not expect to breakeven on an operating basis until 2023 or thereafter depending upon the impacts of supply chain and inflation.

With 6.1M shares out and $5.7M in cash, but there are also some other items:

  • 2500 Series C convertible stock (4500 were sold in February 2021 for the proceeds of $4.5M and 2000 have already been converted in June). The Series C have a value of $1000, so they roughly convert to 180 common shares, adding roughly 450K shares to the count upon conversion (unless the share price rises significantly by then).
  • 15K of $1000 Series B convertible stock, with a conversion price of $7 could add another 2.14M shares
  • There are 312K options from performance pay outstanding and 1.37M warrants.

So fully diluted there could be 10.35M shares out, which renders a market cap of $56M and an EV of $50M, but even on the current share count of 6.1M we have a market cap of $33M and an EV of $28M, which isn’t an inconsiderable valuation metric (basically 2x FY2022 sales).

Conclusion

The company is undoubtedly making progress on several important fronts:

  • It has improved its organization
  • It has improved its core AI capabilities which underlie all its applications
  • It is gaining a significant amount of new orders
  • It is improving the proportion of recurring revenue

But it remains to be seen to what extent margins recover as production scales and hence whether the cash bleed can reduce enough for the company to avoid another dilutive financing.

Given the mostly one-off nature of their revenue and the uncertainty about that we don’t regard the shares as a compelling buy, given the shares aren’t all that cheap, certainly not on a fully diluted basis.

We do see the longer-term potential though, the company could very well become dominant in the rapidly growing rip market (with plenty of overseas opportunities) and successfully enter a number of additional markets based on its core capabilities.

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