AITX Analysis – IP and the Effect on Gross Margin Ft. Knightscope

Today’s article, to be broken down into a two posts due to size, are taking a deeper dive into three income statement line items: Net Revenue, COGS, and Gross Profit, and how they can be partially attributable to intangible property, or “IP”.

All throughout AITX’s filings, as well as the CEO’s press, they only name one real direct competitor (to date). That company is the relative enigma called Knightscope Inc. (“KS”). They essentially are developing and trying to sell a similar suite of autonomous security robots to those of AITX. KS currently offers the K3 and K5 which are both essentially ROAMEOs, and the K1 which is more like a stationary ROAMEO.

Knightscope – How are They Doing?

To start us off, see below KS’s most recent financials for the 6 months ended June 30, 2021 and 2020, with AITX for comparison:

All of my info here on KS comes from its most recent Form 1-SA filed on September 28, 2021 for the period ending June 30, 2021. According to the filing, Knightscope manufactures out of its corporate headquarters in Mountainview, California. You can actually look it up on Google Maps, it’s a pretty slick looking facility: 1070 Terra Bella Ave, Mountain View, CA 94043.

However, this is about as good as it gets so far for KS. Let’s get into the hard numbers, which never lie (according to their statutory auditors!)…

If the gross profit and margin line items above didn’t set off alarm bells, it should now. When we look at a technology company, they are supposed to make high margins at the gross level. This is typically due to their high level of IP for which they earn excess returns over just your basic manufacturer.

This IP takes two forms.

Pricing Power and Product IP

First, at the 3^rd party pricing level. KS, as a technology company, should be commanding a superior price for its products well above its cost to manufacture. This should be due to the embedded benefit of the product to the customer above and beyond what’s in the actual physical product makeup. For example, I could sell you an iPhone shell with no OS, programs, etc. loaded onto it. It’s just a manufactured piece with some embedded value from the raw materials, labor, etc. But that’s it.

It’s when the smart folks at Apple drop in their IP that the iPhone 13 costs well over a thousand dollars. Clearly customers are not seeing this benefit, or KS has some serious “foot in the door pricing” syndrome (something $AITX has specifically mentioned they do not do, I’ll get to that later). Either that, or customers legitimately don’t think the product is worth anything more than its manufacturing cost (or even less in this case).

Manufacturing Efficiency and Engineering IP

The second piece of IP is on the manufacturing side. Using that same example of Apple and the iPhone, Apple has spent billions of dollars figuring out the most cost-effective way to manufacture their iPhones. This is IP the same way the iPhone technology and brand is. They operate, what I assume, are state of the art facilities using highly engineering manufacturing processes to keep costs to the bare minimum and efficiency to the maximum. KS has this slick facility in California, but clearly, they are not yet recognizing any manufacturing cost efficiency benefit from it. Something in the supply chain is not working if they cannot even earn a positive gross profit. There are a million reasons for this on the supply side, such as:

• Bloat on the manufacturing floor i.e. too many people, not enough products out the door
• Overpayment due to them manufacturing in one of the most expensive areas in the country
• Under-use of fixed assets
• Poor supplier management

I will paste it below because KS actually spends a huge portion of the filing talking about this, which makes me think they are quite concerned about this. It is also one of the longest sections I’ve ever seen in the Management’s Discussion section dedicated entirely to “Gross Profit/Loss”.

“Gross Loss

The revenue and cost of services described above resulted in a gross loss for the six months ended June 30, 2021 of approximately $0.7 million compared to $0.5 million for the six months ended June 30, 2020.

As our business scales and becomes more streamlined, management expects gross loss to decrease once a critical mass has been achieved. We are focusing our resources on growing the business to be able to generate both a gross profit and overall net income. We are continually evaluating and taking a number of near-term actions to facilitate this result, and expect that as the Company matures, we will obtain expertise, economies of scale and efficiency that should increase revenue and reduce costs over the medium to long-term. For example, we continue to refine our sales strategy for 2021, which is expected to increase and enhance our revenue streams. Our ASR materials sourcing, production, assembly and manufacturing are expected to become more efficient over time, and the costs associated with these processes reduced as we grow. However, with global supply chain constraints resulting from the COVID-19 pandemic, the Company has experienced an increase in minimum order requirements during the first six months of 2021 to secure certain parts for our products. The Company expects this to continue throughout 2021 and 2022. As operations scale, we believe we will be in a better position to negotiate volume-based pricing terms with suppliers as well as to optimize our designs for design-for-assembly and design-for-service. We are also focused on controlling general overhead costs, such as expenditures for real estate leases and optimizing team composition and size. We believe that with the building of new internal tools, the Company will be able to streamline procedures and manage deployments more efficiently, alleviating the need for a dramatic increase in headcount. Additionally, new service cost reduction initiatives are underway to further reduce our ongoing operating costs. Our overall strategy is to try to keep our fixed costs as low as possible while achieving our overall growth objectives.”

I’m going to be honest, reading this does not inspire confidence. They are basically just saying “Trust us, as we sell more products it will get better.” That doesn’t exactly tell us anything. What if they never sell enough product? How much is enough product? How efficient will processes become over time? Are we going to go 10 years before turning a gross profit? What if COVID pressures last longer than we thought? This screams “I can’t control my spend, let’s pray we sell more stuff”. I’ll leave it at that and let you fill in the rest.

Now, I know what you’re going to say and surely someone on Twitter will point this out (or maybe not because I have 2 followers at the time of writing this), “BUT SAM THEY’RE A STARTUP THEY HAVEN’T EVEN BEGUN TO SCALE YET, THIS IS GOING TO GROW EXPONENTIALLY (ROCKET SHIP ROCKET SHIP ROCKET SHIP)”. That is actually a very valid point and a fact in economics and business. So, if you are bullish on KS, feel free to lean on this to justify buying into their IPO. We’ll get into that more later…

For me, what makes me worried is when we flip over to AITX’s financials… which is essentially their only direct competitor to date. To be continued in a second post…

For further reading and AITX analysis, check out all of my articles HERE as well as in the sidebar.

DISCLAIMER – I CURRENTLY HOLD A LONG POSITION IN $AITX AND I DO NOT HAVE A POSITION, LONG OR SHORT, IN KNIGHTSCOPE. THIS ARTICLE IS NOT FINANCIAL ADVICE AND IS INTENDED ONLY FOR EDUCATIONAL PURPOSES.