KWESST Research Report $4.28 Price Target - Michelle

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September 15, 2021 KWESST Micro Systems Inc. BUY (TSXV: KWE / OTCQB: KWEMF) Current Price: C$2.15 Launching a New Non-Lethal Firing System - Initiating Fair Value: C$4.28 Risk*: 4 Coverage Sector/Industry: Industrial/Defense Click here for more research on the company and to share your views Highlights ➢ KWESST develops and markets proprietary technologies for applications in personal protection, law Sid Rajeev, B.Tech, MBA, CFA enforcement, and the military. Head of Research ➢ In April 2021, the company acquired the Low Energy Cartridge (LEC) technology developed by a company controlled by the Executive Chairman, David Luxton. LEC has potential to be a breakthrough Alexis Cabel, B.A.Econ over existing non-lethal firing systems, which are considered to be dangerous, and are better described Equity Analyst as “less lethal” than non-lethal. ➢ The global non-lethal weapons market is estimated to grow at 4.56% p.a. to US$5.67B by 2026 (reportlinker.com). Demand for non-lethal weapons is growing due to rising instances of armed violence and protests. Governments are looking at arming their military and police with non-lethal weapons to KWESST Price and Volume minimize fatalities and casualties in these events. ➢ Non-lethal weapons are used by law-enforcement, ordinary citizens, and the military. According to 3 1200000 management, LEC is superior to air-powered systems, tasers, and pepper sprays in terms of 2.5 1000000 range, maintenance, resistance to malfunction/damage from heat or cold, number of shots, and a non- 2 800000 lethal projectile velocity of below 400 feet per second (fps) vs 550 to 1,500 fps for its competitors. 1.5 600000 ➢ In addition to sales of its firing systems, KWE can generate recurring revenues from ammo sales. 1 400000 ➢ To keep upfront costs low, KWE plans to outsource production in initial years. Distribution and 0.5 200000 marketing will be primarily done through e-commerce, social media, and influencers. 0 0 ➢ The closest comparable to LEC is the Byrna HD/Home Defense (NASDAQ: BYRN/MCAP of US$627M) air-powered pistol, which generated US$13.40M in revenue in Q2-2021, up from just US$0.91M in FY- Close Volume 2019. ➢ KWE also has other products (targeting military applications) that generated revenue of $0.86M in 2020, and $1.12M in 2021(9M). YTD 12M ➢ Key catalysts include upcoming trade shows, and the official launch of LEC at the SHOT Show in Las KWE 64% 179% Vegas in January 2022. TSXV 2% 22% Risks ➢ Currently generates minimal revenues. Company Data ➢ Potential for share dilution through equity financings. ➢ Technology must be kept up-to-date constantly to remain ahead of the curve. 52-Week Range C$0.65 – $2.68 ➢ There is no guarantee that LEC will gain traction. Shares O/S 48M ➢ The company will have to allocate large marketing budgets to capture market share. BYRNA had spent Market Cap. C$103M US$1M for marketing in 2020. Current Yield N/A P/E (forward) N/A P/B 19x Key Financial Data (C$) YE Sep 30 2020 (9M) 2021E 2022E Cash $ 3,073,760 $ 1,431,632 $ 1,140,493 Working Capital $ 2,840,654 $ 1,709,217 $ 1,762,595 Total Assets $ 5,507,011 $ 6,895,338 $ 6,609,038 Debt $ - $ - $ - Shareholders' Equity $ 3,856,383 $ 4,409,556 $ 4,401,281 Revenue $ 861,917 $ 1,582,033 $ 5,192,882 Net Income $ -3,565,259 $ -7,838,766 $ -5,008,276 EPS $ -0.12 $ -0.16 $ -0.10 *See last page for important disclosures, rating, and risk definitions. All figures in C$ unless otherwise specified. ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 2 of 15 Company Background Went public through a reverse takeover KWESST was incorporated in 2017, and has offices in Ottawa and Stafford, in 2020 Virginia. The company develops and markets proprietary technologies for applications in personal protection, law enforcement, and the military. Three business lines: • Flagship: The non-lethal Low Energy Cartridge (LEC) system is a potential breakthrough technology, with broad applications in law enforcement and personal defence. Tactical and digitization products • Tactical and digitization products - current revenue primarily comes from generated $1.12M in this division’s main product, Tactical Awareness Situational Control System revenue in (TASCS). FY2021(9M) ended June 2021 • Counter-measures against threats such as drones (GreyGhost), lasers, and electronic detection (Phantom). Of the three business lines, LEC is considered to have the quickest path to profitability given its shorter sales cycle, broader target markets, and ability to generate recurring sales. The other products have long sales cycles, as they are currently sold through contracts with the U.S. military. Low Energy Cartridge (LEC) KWESST acquired the LEC technology in April 2021, from DEFSEC Corp., an Ottawa-based private company owned by David Luxton, KWE’s Executive Chairman. LEC was developed by Mr. Luxton. The company will pay a 7% royalty on sales of LEC to DEFSEC. The table below compares LEC with other non-lethal weapons. Comparison of Non-Lethal Weapons LEC has longer range, low maintenance, LEC Air-Powered Tasers Pepper Spray resistant to malfunction/damage Range Short to Long Short to Long Short Close from heat and cold, Maintenance Low High Low Low has more shots and payload options, and Temp-Resist Yes Reliability wanes Yes Yes is less dangerous from cold Shots Multiple Multiple 1 to 2 Multiple Maximum fps <400 550-1,000 NA NA Source: FRC, KWESST and Various ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 3 of 15 Comparison of Long Range Non-Lethal Weapons Byrna and Pepperball’s Company Weapon Shots Projectiles Range (ft) products are air- Bruzer Less Lethal ML12 pistol 2 bean bag (40g fabric 15-35 powered pillow with lead balls) Byrna Technologies, Inc. HD, SD 5 regular round, pepper 60 Bruzer and Defenzia pistols and have limited shots of rifle two and four, Defenzia LLC M09 pistol 4 rubber bullet, pepper 33-90 respectively flash bang (light flash with loud bang sound) LEC is low- Pepperball Technologies, Various multiple regular round, pepper 150 maintenance, allows multiple shots, and Inc. pistols and is less dangerous rifles compared to the rest KWESST LEC single to regular round, pepper not yet multiple disclosed Source: FRC, KWESST and Various Byrna’s own website A key weakness of air-powered systems is that its parts are made of rubber and notes product synthetic sealants, and O-rings. These parts deteriorate over time from hot and limitations from cold weather cold temperatures, giving resulting in faster wear and tear. Also, projectiles of some products have high fps velocity that can be lethal. Existing non-lethal weapons are Other alternatives such as tasers, pepper sprays, and stun guns are only for dangerous to users close encounters, increasing the probability of disarmament by assailants. and assailants LEC has two provisional patents filed and has three main features: 1. An inexpensive dedicated firing platform - The proprietary LEC system has a firing device that fires only LEC cartridges. Although management has not disclosed pricing, they did indicate that their devices will be priced competitively. Competitively priced LEC does not contain any gun power. What propels the projectile is a chemical compound inside an energy actuator (known as a primer cap) at the bottom of the cartridge. LEC firing platforms are offered in various designs that replicate the look of a real firearm, or avoid the appearance of a firearm altogether. LEC provides spin to the projectile when 2. A low energy cartridge case with velocities and muzzle energy far below the fired, minimizing “lethal” threshold - The LEC cartridge generates a lower speed and power far force below the “lethal” threshold of 400 feet per second (fps). 3. Non-lethal polymer projectiles for various applications - LEC's soft frangible projectiles come with various payloads, including coloured marking agents, inert powder, or a safe but powerful irritant powder that temporarily incapacitates subjects. ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 4 of 15 KWE’s projectiles are encased in a soft material In comparison, Bryna’s projectiles have no casing Here is a link to a video on LEC’s first public live demo Source: Company Market According to reportlinker.com, the global non-lethal weapons market will have an estimated CAGR of 4.56% from 2021 to 2026. The market is projected to grow A growing market from US$4.33B in 2020, to US$5.67B by 2026. The U.S. accounted for one-third of the global market in 2020, especially with According to the protests related to Black Lives Matter increasing the purchase of non-lethal FBI, U.S. gun sales weapons. Global demand for non-lethal weapons is also growing due to rising surged 40% YoY to 39.7M in 2020 instances of armed violence and protests. Governments are looking at arming their military and police with non-lethal weapons to minimize fatalities and casualties in Sales were just these events. 25M in 2016, and 10M in 2006 Unlike guns, purchasing non-lethal weapons does not require permits, licenses, waiting periods, and background checks. We note that Canada and some states in the U.S. require permits/registrations/background checks to purchase guns. Air- powered non-lethal weapons, like the Pepperball TCP and Byrna HD, can be directly purchased, and are available in physical and online stores, such as Amazon (NASDAQ: AMZN). LEC expected to be LEC’s classification will be determined by the Bureau of Alcohol, Tobacco, classified as a non- Firearms, and Explosives (ATF) before the end of the year. KWE expects its lethal weapon products to be classified as a non-lethal device, similar to the Byrna HD and before the year-end paintball devices. ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 5 of 15 Consumers will be able to pre-order LEC firing platforms and ammo on the KWESST website towards the end of the year. Following the official commercial launch at the SHOT Show in Las Vegas in January 2022, LEC will be available for sale on the company’s website. SHOT Show is considered to be one of the biggest firearms-related tradeshows in the world. Upcoming Tradeshow Location Tradeshows lined up Defence & Security Equipment International (DSEI) London Association of the United States Army (AUSA) Washington DC SHOT Show Las Vegas Source: KWESST Competitors KWESST’s competition for LEC comes from OEMs that manufacture and sell training munitions, less lethal munitions, and high-action gaming equipment (paintball). KWE is trading significantly below its competitors Source: FRC / S&P Capital IQ The closest precedent to LEC is Byrna HD. Byrna’s devices are priced at US$359. Projectiles are priced at US$29.99 - US$34.99 (30c/round). Byrna launched Byrna HD on February 10, 2019, in the U.S. The company reported revenues of US$0.92M for the FY-ended November 2019, increasing to US$16.57M in FY-2020, and US$13.40M in Q2-2021 ended May 2021. They sold 2,640 units in 2019, 46,145 in 2020, and 37,329 in Q2-2021, reflecting the strong demand for non-lethal weapons. Byrna primarily uses e-commerce platforms (accounting for 85% of sales) to sell Byrna HD, and initiated its marketing campaign by launching the product in tradeshows in 2019. KWE is a planning to adopt a similar strategy. ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 6 of 15 Business Model and Action Plan As mentioned, KWE will use e-commerce platforms and social media campaigns to market LEC. The company has already partnered with a former police officer and now an influencer, Brandon Tatum, who runs the YouTube channel "The Officer Tatum" with over 1.6M subscribers. He also has more than 3M followers across multiple social media platforms. Mr. Tatum has agreed to act as an advisor, and be an advocate for LEC for law enforcement and personal defense in the U.S. Partnering with influencers Source: ‘The Officer Tatum’ in Youtube KWE recently hired an engineer with a 17-year track record with Colt (a leading firearms manufacturer), where he held positions such as R&D Manager and Product Support Engineering Manager. To keep upfront costs low, the company plans to outsource production to firearms manufacturers within North America. KWESST will also be negotiating with distributors in favorable locations. Launching in January 2022 Source: KWESST July Presentation ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 7 of 15 While KWE views the LEC system as its primary driver of revenue in the short- term, the company will continue to pursue contracts with the U.S. and Canadian militaries for its other products. Management and Board Name Position/(s) # Shares Outstanding % of Total Jeffrey Macleod President & CEO 9,895,244 20.66% The CEO and the David Luxton Executive Chairman 4,640,021 9.69% Chairman hold 31% Paul Mangano Independent Director 321,720 0.67% John McCoach Independent Director 107,413 0.22% Elisabeth Preston Corporate Secretary 20,000 0.04% and Director Paul Fortin Independent Director 5,000 0.01% Total Shares Owned by Directors 14,989,398 31.30% Total Shares Outstanding 47,885,013 Source: Company Filings Brief biographies of the senior management and board members, as provided by the company, follow: Jeffrey MacLeod, Founder, President, CEO & Director Jeff is a former Canadian RCEME officer and served as System Engineer for three major Army Crown Projects before moving to the private sector. For almost twenty years he was General Manager of Diemaco/Colt Canada. He is an expert in the Small Arms and Soldier Systems field as well as all aspects of manufacturing. He formed KWESST in 2017 to pursue opportunities in the networking and digitization of legacy and future weapons systems. David E. Luxton, Executive Chairman David is a recognized entrepreneur in the defence and security industry. He was formerly an infantry officer and senior official with the Canadian and British governments before leading the global build-out of successive defence and security companies, including Simunition, the world leader in simulated munitions for close- quarters combat training. He led the build-out of Allen- Vanguard, which became a world leader in Counter-IED solutions, where he remains Chairman. He is also former Chairman of United Tactical Systems, a world leader in non-lethal munitions systems. Steven Archambault, CFO Mr. Archambault began his career as a CPA, CA, with Ernst & Young LLP, followed by senior finance positions at AXIS Capital, a global insurer and reinsurer, and more recently had CFO roles with small-cap public Canadian companies listed on the TSX Venture Exchange and Canadian Securities Exchange in media broadcasting technology and health and wellness industries. ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 8 of 15 Rick Bowes, VP of Operations Prior to his various senior roles with defence contractors such as General Dynamics Canada, DRS Technologies Canada (now Leonardo DRS), ATCO Frontec and ADGA Group Inc., Rick had a distinguished career as a senior officer in the Canadian Army, retiring in 2003 as a Lieutenant Colonel. He is a graduate of Royal Military College of Canada and served in various operational and staff roles in the Canadian military and on secondment to the British Army. As an armour officer, Rick served with various units such as Lord Strathcona’s Horse (Royal Canadians) and the Canadian Airborne Regiment Battle Group across Canada and in deployed operations in Bosnia-Herzegovina with the UN Protection Force and the NATO Stabilization Force (SFOR). Rick was also part of the planning team for Canada’s participation in the NATO Kosovo Force (KFOR) mission in 1999. Jeff Dunn, U.S. Market Development Jeff is former COO of ARTEMIS, Inc., the Naval Service Lead for Rapid Prototyping at Booz Allen Hamilton, and Director Strategic Development at General Atomics Aeronautical Systems. Military service awards include a Bronze Star, a Meritorious Service Medal, a Navy & Marine Corps Commendation Medal and several Navy & Marine Corps Achievement Medals. Jeff spent 20 years as a U.S. Marine AV-8B Harrier pilot & mission commander. John McCoach, Independent Director John McCoach retired from full time employment in 2016. At that time he was President, TSX Venture Exchange; a role he held for seven years. John is a director of the Capital Markets Authority Implementation Organization. CMAIO is tasked by The Government of Canada, six provinces and one territory to create a pan Canadian securities commission. He is also the Lead Director, Liberty Defense Holding Ltd. John was a director, and Interim CEO, of Nautilus Minerals Inc. John is also a director of the Royal Canadian Marine Search and Rescue. Paul Mangano, Independent Director Paul is a thirty-four-year veteran of the high-tech sector. He has an MBA in High Technology from Northeastern University and a BA in Economics from Harvard. In 2015, he established Surculus Advisors, a management advisory firm providing strategic advice and leadership to SME companies in the high-tech sector including aerospace and defense. Prior to forming Surculus Advisors, Paul was a Division President at L-3 Communications (NYSE: LLL). He is former President and Chief Operating Officer of Proterion Corporation. Paul Fortin, Independent Director Paul has held senior business development positions within two of Canada’s largest law firms - Gowlings WLG and more recently Borden Ladner Gervais LLP where he was responsible for the firm’s defense and security as well as international expansion strategies which encompassed Asia Pacific, United Kingdom, and the United States. His network includes exceptionally strong ties to the defense community and diplomatic defense attaché network, notably with the ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 9 of 15 USA (Air Force, Army, Navy, USMC) , 5 Eyes, Korean, Ukrainian, Israeli and NATO and Middle Eastern (Gulf States). Elisabeth Preston, Director & Corporate Secretary Elisabeth Preston is Chief Legal Counsel for a top tier international defence company with widespread global operations. She is an international business and trade lawyer, with significant transactional experience in many jurisdictions. Her experience spans more than thirty years advising companies as an executive in areas relating to governance, cross-border marketing, strategic relationships, major commercial transactions and financings to fund growth. Financials $1.12M in revenue and $6.43M in net losses (EPS: -$0.15) in FY2021 (9M); historical revenue came from tactical and digitization products Spent $1.43M on ads and promotion in FY2021 (9M) Healthy balance sheet Source: Company Filings, FRC Stock Options and Warrants 3.67M options (weighted average price $1.09), and 15.73M warrants ($0.90) outstanding. 3.42M options and all of the warrants are in-the-money, implying potential to raise up to $16M if exercised. ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 10 of 15 FRC Projections and Valuation Assuming sales of 7,500 units in 2022, increasing to 346k units by 2030 (2.25% of the global non-lethal weapons market) DCF valuation of $3.84 per share Source: FRC ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 11 of 15 KWE is trading at a 55% discount Source: S&P Capital IQ and FRC Weighted average fair value of $4.28 per share Source: FRC We are initiating coverage with a BUY rating, and a fair value estimate of $4.28 per share. The success of KWE relies on its ability to gain traction for LEC units. On paper, we believe KWE’s products have advantages over its competitors. The upcoming tradeshows will give us an indication on whether LEC can generate interest from potential customers. Byrna’s track record indicates that KWE will be able to quickly grow revenue if LEC is able to attract customers. We believe KWE will likely have to pursue an equity financing next year to pursue an aggressive marketing campaign. Risks We believe the company is exposed to the following risks (list is non-exhaustive): Assigning a risk rating of 4 ➢ Currently generates minimal revenues. (Speculative) ➢ Potential for share dilution through equity financings. ➢ Technology must be kept up-to-date constantly to remain ahead of the curve. ➢ There is no guarantee that LEC will gain traction. ➢ The company will have to allocate large marketing budgets to capture market share. ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 12 of 15 Appendix ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 13 of 15 ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 14 of 15 ©2021 Fundamental Research Corp. “18+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com Equity Research Page 15 of 15 Fundamental Research Corp. Equity Rating Scale: Buy – Annual expected rate of return exceeds 12% or the expected return is commensurate with risk Hold – Annual expected rate of return is between 5% and 12% Sell – Annual expected rate of return is below 5% or the expected return is not commensurate with risk Suspended or Rating N/A— Coverage and ratings suspended until more information can be obtained from the company regarding recent events. Fundamental Research Corp. Risk Rating Scale: 1 (Low Risk) - The company operates in an industry where it has a strong position (for example a monopoly, high market share etc.) or operates in a regulated industry. The future outlook is stable or positive for the industry. The company generates positive free cash flow and has a history of profitability. The capital structure is conservative with little or no debt. 2 (Below Average Risk) - The company operates in an industry where the fundamentals and outlook are positive. The industry and company are relatively less sensitive to systematic risk than companies with a Risk Rating of 3. The company has a history of profitability and has demonstrated its ability to generate positive free cash flows (though current free cash flow may be negative due to capital investment). The company’s capital structure is conservative with little to modest use of debt. 3 (Average Risk) - The company operates in an industry that has average sensitivity to systematic risk. The industry may be cyclical. Profits and cash flow are sensitive to economic factors although the company has demonstrated its ability to generate positive earnings and cash flow. Debt use is in line with industry averages, and coverage ratios are sufficient. 4 (Speculative) - The company has little or no history of generating earnings or cash flow. Debt use is higher. These companies may be in start-up mode or in a turnaround situation. These companies should be considered speculative. 5 (Highly Speculative) - The company has no history of generating earnings or cash flow. They may operate in a new industry with new, and unproven products. Products may be at the development stage, testing, or seeking regulatory approval. These companies may run into liquidity issues and may rely on external funding. These stocks are considered highly speculative. Disclaimers and Disclosure The opinions expressed in this report are the true opinions of the analyst about this company and industry. Any “forward looking statements” are our best estimates and opinions based upon information that is publicly available and that we believe to be correct, but we have not independently verified with respect to truth or correctness. There is no guarantee that our forecasts will materialize. Actual results will likely vary. A company with related management to FRC owns shares of the subject company, but does not make a market or offer shares for sale of the subject company, and does not have any investment banking business with the subject company. The Analyst does not own shares of KWESST. Fees were paid by KWESST to FRC. The purpose of the fee is to subsidize the high costs of research and monitoring. FRC takes steps to ensure independence including setting fees in advance and utilizing analysts who must abide by CFA Institute Code of Ethics and Standards of Professional Conduct. Additionally, analysts may not trade in any security under coverage. Our full editorial control of all research, timing of release of the reports, and release of liability for negative reports are protected contractually. To further ensure independence, KWESST has agreed to a minimum coverage term including an initial report and three updates. Coverage cannot be unilaterally terminated. Distribution procedure: our reports are distributed first to our web-based subscribers on the date shown on this report then made available to delayed access users through various other channels for a limited time. The distribution of FRC’s ratings are as follows: BUY (68%), HOLD (7%), SELL / SUSPEND (25%). To subscribe for real-time access to research, visit https://www.researchfrc.com/website/subscribe/ for subscription options. This report contains "forward looking" statements. Forward-looking statements regarding the Company and/or stock’s performance inherently involve risks and uncertainties that could cause actual results to differ from such forward-looking statements. Factors that would cause or contribute to such differences include, but are not limited to, continued acceptance of the Company's products/services in the marketplace; acceptance in the marketplace of the Company's new product lines/services; competitive factors; new product/service introductions by others; technological changes; dependence on suppliers; systematic market risks and other risks discussed in the Company's periodic report filings, including interim reports, annual reports, and annual information forms filed with the various securities regulators. By making these forward-looking statements, Fundamental Research Corp. and the analyst/author of this report undertakes no obligation to update these statements for revisions or changes after the date of this report. 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