Precision Optics Corporation, Inc. (POCI) Earnings Call Transcript & Summary

Good day, and welcome to the Precision Optics Reports Second Quarter and Fiscal Year 2020 Financial Results Conference Call. [Operator Instruction] Please note that this event is being recorded. I would now like to turn the conference over to Robert Blum with Lytham Partners.

All right. Thanks so much, Chuck. And thank you for joining us today to discuss the financial results of Precision Optics' second quarter fiscal year 2020 ended December 31, 2019. With us on the call representing the company today is Dr. Joe Forkey, Precision Optics' Chief Executive Officer. At the conclusion of today's prepared remarks, we'll open the call for a question-and-answer session. Today's conference call is also being webcast with replay capabilities available both through the webcast as well as through a dial-in instructions. The details of both were included in today's press release. Before we begin with prepared remarks, we submit for the record the following statement: Statements made by the management team of Precision Optics during the course of this conference call may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended. And such forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements describe future expectations, plans, results or strategies and are generally preceded by words such as may, future, plan or planned, will or should, expected, anticipates, draft, eventually or projected. Listeners are cautioned that such statements are subject to a multitude of risks and uncertainties that could cause future circumstances, events or results to differ materially from those projected in the forward-looking statements, including the risk that actual results may differ materially from those projected in the forward-looking statements as a result of various factors and other risks identified in our filings with the Securities and Exchange Commission. All forward-looking statements contained during this conference call speak only as of the date on which they are made and are based on management's assumptions and estimates as of such date. The company does not undertake any obligation to publicly update any forward-looking statements, whether as a result of the receipt of new information, the occurrence of future events or otherwise. With that said, let me turn the call over to Dr. Joe Forkey, Chief Executive Officer of Precision Optics. Joe, please proceed.

Thank you, Robert. Thank you all for joining our call today to discuss our second quarter fiscal 2020 financial results. I am pleased with the strong top line performance during the second quarter, which highlighted the continued traction we are achieving in the operations of Precision Optics as well as our recently acquired Ross Optical division, with both divisions reporting growth in revenues on a quarter-over-quarter and year-over-year basis. Equally encouraging is that this growth in revenue was nicely complemented by advancements and additions to our customer product pipeline as we have received updated reports from customers that 2 pipeline products continue to be targeted for commercial production levels this calendar year. In addition, we received, recently, notice from another customer that their pipeline project will advance to the next stage of engineering development and from yet another customer that we will be awarded a development contract for a new engineering pipeline project. I will expand on these customer developments later in the call, but I want to emphasize that these new project activities are indications of continuing demand for the differentiating product and service offerings we employ in partnership with our customers to conceptualize, develop and manufacture complex optics based products. Our unique vertically integrated capabilities are rooted in the development of innovative and custom endoscopic products based on our proprietary 3D endoscopy technology as well as micro-precision lenses with sizes on the order of 1 millimeter and smaller. Our know-how and optical opto-mechanical and manufacturing engineering, focused on applications and micro-imaging systems, including single-use endoscopes and applications for 3D endoscopes, many for use in robotic surgical systems, has made Precision Optics a valued partner for an increasing number of companies in the medical device and defense industries. In order to maximize the value of these long-developed technical capabilities, our business strategy continues to be focused on driving growth and efficiencies in our currently commercialized products, while simultaneously moving additional products to production by bringing new opportunities into and through our engineering pipeline. We recognize that while we utilize our existing industry-leading technology, we must always remain on the cutting-edge of what is possible by continuing to innovate and to advance our technology and associated intellectual property. All of this requires a dedicated team of employees and supporting infrastructure. To this end, we continue with a disciplined investment strategy to add to our employee base and corporate infrastructure, particularly in the areas of sales and marketing and engineering. Finally, we continued to execute on integration activities with our recently acquired Ross Optical division, capitalizing, particularly on opportunities for cross-divisional operational efficiencies and joint presentations of a broader offering to our customers. As we execute on this business plan, we have made investments in key areas of the business from our development pipeline to the overall infrastructure as well as our portfolio of patented intellectual property. Some of these investments with longer-term horizons have had a short-term negative impact on our gross margins and net profits as reported in our second quarter results. However, as these investments begin to impact our operations particularly those related to moving development projects into production, we believe they will result in increased revenues, along with a return to higher blended gross margins. At a high level, I am pleased with the developments during the quarter and believe they leave us well positioned to achieve our goals for the year of continued revenue growth, advancement of various pipeline projects and improving cash flow performance. I will now review the quarterly figures in more detail, then provide an update on our current commercialized products, give some additional insight into our pipeline and finish with comments on our recent sales and marketing activities, and then of course, answer any questions. Revenue during the second quarter ended December 31 was $2.797 million, an increase of 89% compared to $1.478 million in the second quarter of last year. Revenue generated by the Precision Optics division in the second quarter came in strong at $1.650 million, an increase of 11% and compared to last year's second quarter. Production revenue was up over $150,000 sequentially compared to the most recent first quarter of fiscal year 2020, and includes the 3 commercialized projects in the medical device and defense sectors that we have discussed in previous calls, along with Precision Optics' traditional products such as couplers and various endoscopes many of which we have provided to customers for many years. Our engineering revenue was also up this quarter, both quarter-over-quarter and year-over-year. Custom development projects of complex medical device instruments, by their nature, are subject to fluctuations in engineering activities and related revenue. Our focus is to employ our resources into those projects with the best potential for long-term partnerships with our customers. We believe the quality of the pipeline projects and the personnel additions we have recently made to an all-ready industry-leading collection of engineering talent will continue to drive product opportunities through development and into commercialization, contributing to an increased number of production level products and an elevation of company-wide revenues. Our Ross Optical division contributed $1.150 million or 41% of our total quarterly revenue of $2.8 million in the second quarter ended December 31, 2019. Ross Optical continues to deliver increasing revenues with margins in excess of 47%. Ross' second quarter revenues increased approximately 9% compared to last year's second quarter when they were still a private company, and approximately 6% over sales of the immediately preceding quarter ended September 30, 2019. The Ross Optical division provides technical, thin film, subassembly and material expertise to a large number of diverse customers seeking custom and catalog maintained optical components. As we look forward, on an annualized basis, we expect continued revenue growth from both our Precision Optics and Ross Optical divisions, although there will continue to be choppy quarterly performance as the significant size of some projects, both production and engineering, compared to our overall revenue means timing of deliveries for one significant project or engineering phase can cause peaks and valleys in total quarterly revenues. Overall, we continue to be encouraged by the conversations we are having with our customers regarding the long-term outlook for our 3 commercialized products that we have discussed previously. As you are aware, we must be sensitive to the information we can provide, but at a broad level, I can share the following: for our cardiac product, production is moving forward smoothly as the customer continues to sell-through inventory. Due to timing of shipments, we expect that deliveries for the remainder of fiscal 2020 will continue at the same levels as they have so far. But deliveries for the first half of fiscal 2021 may decline slightly, depending on our customers' inventory levels at that time. Overall, the long-term prospects continue to look very good for this product. The ship hold on the otoscope device that we discussed last quarter is expected to be resolved in the next few weeks. Again, the ship hold was caused by a faulty component supplied by another supplier, and while everyone agreed that POC was not responsible for the problem, they welcomed our assistance in resolving the issue. The technical and supply chain work that was required to resolve this issue was completed before the end of December. Since then, our customer has been documenting and finalizing internal approval of the correction to satisfy their internal quality and regulatory teams. 2 weeks ago, we heard that key steps had recently been completed, and they expected the ship hold to be lifted very soon. Despite the customers hold on end-product to the marketplace, they have continued to accept product shipments from us. The customer is anxious to recover and has told us to expect ongoing production at steady levels throughout the remainder of this calendar year. The defense product that we have discussed in the past is also undergoing some redesign issues related to changes in a component supplied by another supplier. While our customer has shared with us an expectation that the redesign effort will take up to another 6 to 9 months, they have also notified us that despite the need for the redesign their customer has reiterated their strong support of this program and they desired to recover production at an increased run rate as soon as possible. While delays caused by the redesign will have some impact on our production levels, our customer has agreed to continue to accept product from us during this time and has indicated a desire to have us begin to ramp even before their redesign is complete. As we have talked about in the past, for each of these 3 products, we have blanket orders with minimum monthly releases set up with each customer. So while we might work with our customers to smooth out the starts and stops that could be caused by the redesign issues, overall, we continue to supply them with product close to the agreed-upon levels when we average over a few months' time period. As I mentioned at the beginning, our engineering pipeline remains strong. During the second quarter, we made key advances for 2 of these projects, which are slated to move to commercialization later this calendar year. One is for a new colonoscopy product that relies on Precision Optics' micro-camera enabling technology. We have completed prototype units, and our customer is currently pursuing 510(k) clearance with the FDA. In just the last month, we have assisted our customer by performing some key optical measurements to respond to some specific requests from the FDA. As soon as our customer receives clearance, they expect to begin selling product they currently have in inventory and to begin full production orders with us. The second project potentially set for commercialization in calendar 2020 is in the robotic surgery market. As we discussed last quarter, the customer recently started clinical trials overseas for CE mark approval and with our help is now pursuing 510 clearance in the U.S. Due to the uniqueness of this project and the long-term potential for this product and others that use similar technology, we have made certain investments in additional engineering requirements beyond the original scope of this project. These investments have significantly limited the profitability of this project in the near term, negatively impacting our gross margins as we have invested more than originally anticipated in solving some challenging engineering issues. However, the long-term prospects for this product and for the underlying technology remain very good, and we believe continued investment is justified. We recently demonstrated the successful resolution of 2 of the major technical challenges we have been working on for many months and are currently incorporating these solutions into prototypes that we expect to deliver to our customer in the next month. We expect the engineering portion of this program to be completed within fiscal 2020 and commercial production to begin before the end of the calendar year. The other engineering projects in our pipeline are all continuing to advance. One of these customers, a well-funded startup, was recently acquired by a large global medical device company who is very familiar with Precision Optics. We believe this bodes well for the accelerated advancement of this product with an expectation that we will receive a purchase order to move on to the next phase of development any day now. Finally, as I said in the beginning, we recently received word that we will receive another engineering development project that we have been pursuing for several months. There is not much I can elaborate on for this project at this time due to confidentiality with our customer. However, we do know that our customer evaluated various technologies and potential suppliers for this project. We are extremely pleased to be adding to our pipeline as it continues to validate the value of the technology we can bring to next-generation medical devices across a wide range of end-market indications. Our gross margin of 33% for the second quarter was an improvement compared to 24% in the previous year but was down compared to the most recent first quarter gross margin of 39%. Ross Optical margins were in line with their historical averages, and the margins for the 3 production products we have discussed are also in line with expectations. Despite these positive results, our overall margins were particularly low for a few reasons. First, the level of effort and associated labor and overhead costs for the robotic surgery project, I have mentioned in previous calls and earlier on this call, continues to run much higher than our targets. Second, for a couple of engineering projects, including the one I just mentioned, we had unusually high costs associated with outside consultants and services during the second quarter. This is due to the particular phases of these projects and is not expected to continue at the same level. While we always mark up the cost of such outside services, we are not able to achieve the same margin level as we do when using inside resources, which leverage our unique proprietary capabilities. Finally, as we ramp our resources in anticipation of future growth, our overhead absorption is not yet at the level we anticipate in the future. We are confident that all 3 of these causes of our lower gross margin are transient, and that our gross margins will improve over the next few quarters. But the exact timing will remain contingent on various factors including our customers' success in advancing all aspects of their products through development and into production, many aspects of which we do not directly influence or control. While the margins associated with certain specific projects are having a negative impact on the total quarterly gross margin percentage, I am extremely pleased that for the 3 projects that recently went into production, gross margins are holding steady or even improving. In particular, the cardiac product has now been running smoothly for multiple quarters with good efficiency and no issues. This is very encouraging since this project required a significant effort and sometime even after ramping to production levels to work out some of the ramp-up issues and get to a smoothly running production process. It took some time to get there, but it is now going very well. Similarly, I mentioned issues with the otoscope device during a number of earlier calls, while we were ramping production of this product. During our last earnings call, I commented that we had finally deployed some updated tooling fixtures and procedures, and I'm happy to report that after using these for several months now, they are working very well and have contributed to greater efficiency and higher yields for this product. With the contribution of the Ross Optical division, our goal continues to be company-wide margins in the 40%-plus range, and if you were to strip away the impact on gross margin resulting from the isolated engineering projects we just discussed, our margins would be in that range. Operating expenses were $1.470 million during the second quarter of fiscal 2020, which included $263,000 of stock-based compensation and $326,000 of operating expenses incurred by our Ross Optical division. Although operating expenses of the Precision Optics division have increased on a quarterly basis, we have maintained a disciplined investment approach to adding resources to the sales and marketing team and their activities as well as adding engineering capabilities to address the anticipated additional growth in our business. To that end, and subsequent to the end of the second quarter, we made a key addition to our engineering staff by hiring Jon Everett as our new Vice President of Engineering. Jon joined us from BAE Systems, where he oversaw new product development with expertise in optics and electro-optics. The appointment of Jon was a key operational objective for the company as we look to further expand our efforts to develop new technologies, increase our product development pipeline and move existing development projects towards commercialization. Our combined sales and marketing team just finished the Photonics West show last week in San Francisco, and the MD&M show this week in Anaheim, where we showcased our new booth displaying the combined logos of Precision Optics and Ross Optical, both recognized long-standing trademarks in the optics industry, along with merged products and sales messaging of the 2 divisions. The synergies we hoped we would achieve through cross-selling are certainly beginning to be showcased and recognized in the market. One final note, as it relates to our operating expenses is the time and costs associated with ongoing technological development and protection of the associated intellectual property. We have talked about our desire to stay at the leading edge of optical technology development. To that end, we were recently awarded a key patent for an optical lens form that we believe is ideal for single-use endoscopes, which the medical device market greatly values as a deterrent to operating room instrument contamination and is a benefit to surgical procedure outcomes and hospital procedure efficiencies. We have 2 additional patent applications currently at the patent office that also relate to single-use medical endoscopes as well as 4 additional patent applications that are in various stages of drafting with our patent attorneys. Each of these 4 also relate to specific aspects of enabling technology associated with micro-optics or 3D imaging for medical device applications. Many of our investments are directly contributing to the company's collective array of leading-edge, world-class optics development capability that we believe will allow us to remain at the forefront of innovation and product supply for the many markets utilizing micro-optics and 3D endoscopes, principally the minimally invasive medical device industry. All told, on the net income line, we reported a GAAP net loss of $551,000 during the second quarter. Included in this was $275,000 of total stock-based compensation. Backing out the stock-based compensation as well as depreciation, amortization and interest of $23,000, our adjusted EBITDA for the quarter was a loss of $253,000. The previously discussed depressed margins on certain engineering projects and the increased investment in ongoing operating expenses were the primary factors for the second quarter EBITDA loss. We expect that the complex engineering project development stage will be completed by the end of the fiscal year, thereby removing that component of downward pressure on margins, and that the investments made in infrastructure, sales and marketing, and engineering personnel will position us for efficient growth with improving financial results. Turning now to our balance sheet. Our cash balances dropped by more than adjusted EBITDA from September 30 to the end of the second quarter at December 31, due mainly to changes in working capital items, particularly an increase in accounts receivable and a reduction in the balance of customer advances. While we expect both accounts receivable and accounts payable to fluctuate from quarter-to-quarter, we anticipate customer advances to recover over the next couple of quarters, given the terms of existing orders and a couple of new anticipated engineering orders that will require advanced cash payments by our customers. While our cash levels are subject to significant fluctuation during any given quarter and from the end of 1 quarter to another, the change in working capital from the beginning to the end of the second quarter was consistent with the adjusted EBITDA. We intend to continue to actively manage working capital, cash flow and cash balances in response to operational results into the foreseeable future. To summarize, during the second quarter, we achieved strong growth in revenue and good advancements in our pipeline products. Despite the lower overall gross margins, the margins on the commercialized products continued to improve. The integration with Ross continues to proceed smoothly and the investments we outlined making in engineering, sales and marketing, technology development and infrastructure improvements have occurred on schedule as planned. The market for our products continues to be robust as the medical device industry is increasingly moving towards smaller optics enabled devices and 3D endoscopes, our 2 core differentiators with an added emphasis on single-use devices. Our go-forward strategy remains firmly intact with an emphasis on the following items: driving growth and efficiencies in our currently commercialized products; advancing our pipeline projects to commercialization; maintaining competitive advantages in our core micro-optics and 3D imaging capabilities for medical devices, while exploring expanded applications of existing technologies into the defense market; executing a disciplined investment strategy in sales and marketing as well as engineering capabilities; recognizing cross-division operational benefits from the Ross Optical acquisition; and finally, continuing the search for strategic transactions to broaden our existing capabilities and extend our vertically integrated focus on medical- and defense-based products. All told, I am pleased with the pathway we are on to continue building shareholder value. I want to thank all of you for your continued support and interest in the company. And I'd be happy to take any questions now.

[Operator Instruction] Robert, I will turn it over to you for questions while we wait.

All right. Thanks so much, Chuck. Joe, a couple of questions here. First, you've talked about one of the project pipeline -- the pipeline project products. There was an acquisition of one of the companies by a larger company in the space. Is there anything that you can elaborate on with that?

Yes, sure. So of course, I can't go into details because we have confidentiality agreements in place. But what I can tell you is this, we've been working with this customer for over a year now. This is a product that has been in our engineering pipeline for quite some time. We knew that our customer was actively pursuing approval for their new product. And they announced just about a month or so ago that they received PMA approval from the FDA. And those of you who are familiar with the medical device space will know that a PMA approval is a much more difficult and often challenging approval to get from the FDA. But it also indicates that the technology and the procedures are novel in addressing unique issues that other products may not be addressing. So they received their PMA approval a couple of months ago. Not long after that, they told us that they were not ready to give us a purchase order for the next phase of the work that we were working on with them because they were looking at some financial transactions. And lo and behold, about 2 weeks ago, they announced publicly that they had been acquired by a very large global medical device company. Very quickly after that, just last week, we met with them, and met with the principals, and they told us that this is a very positive thing for us. The company that acquired them was familiar with Precision Optics and knew us well and knew our work. And so while it had only been a week since they had been acquired, they are already actively talking with their new owners about continuing with this project that they had started with us sometime ago. So they have told us that they're pushing aggressively, and so we expect a new purchase order from them any time now. The fact that they already have a PMA is a very encouraging aspect of this as well because it means once we get through the engineering pipeline and have a product that's ready to go, that the commercialization rate will likely be very quick because they've already satisfied the regulatory requirements for the PMA. There may be some requirements that we have to satisfy with the specific device, but those will be much easier to satisfy than the requirements for the full PMA. So all in all, this is a very good and positive development for us, and we're quite pleased to have this project moving forward.

All right. Excellent, Joe. One more, and then I'll turn it back over to the operator here. On the 2 new commercial products that you have referred to possibly moving to commercial scale here in 2020, is there anything you can provide as it relates to cadences, how this might play out, timing, things of that nature to give a little bit more color on that?

Yes, sure. So with the caveat first, that we don't have full control over the timing of commercialization. And there are sometimes things that have to do with other parts of the program. We have been in close communication with these 2 customers about their desired time line for getting the products into production. I mentioned both of them during the comments here on this call. But just to reiterate, maybe give a little more color. For the colonoscopy project, our customer has already -- is ready to start selling. They've actually been talking to potential customers, but they're not allowed to officially sell until they have approval from the FDA. Nonetheless, they already have a sales force in place. They've already been going to conferences and to shows and demonstrating the product to lots of doctors with a great level of interest. The customer filed their 510(k) and received the letter from the FDA, which is not unusual, asking for some further clarification and additional information. We were able to help them with that information, and they're going back to the FDA now. So our general thought is that unless there's some other issue that we're unaware of that the approval we would expect would come in the near-term in a matter of weeks or months. And our customer has already told us that once that happens, they'll sell the limited inventory that we've already provided to them, and they'll be placing an order with us pretty quickly. So that one looks like it's quite likely to come in, in the next 3 to 6 months. The second one is the one that we've talked an awful lot about, it's the one that has had some really technical -- significant technical challenges but our customer there, again, is working with us to get their product approved with the 510(k) process. We know that they're working aggressively. They would like to see the product go into commercial availability in the latter half of this calendar year, which fits well with the timing that we see, given the progress we've made with some of these really technical -- really challenging technical aspects, and the fact that we're now moving into the stage where we're actually providing prototypes. So that one we expect in the latter half of the calendar year.

All right. Perfect. Thanks, Joe. Chuck, I will turn it back over to you if there are any additional questions from the audience here?

[Operator Instructions] Our first question will come from [ Weslin Mahaylov ], investor.

So I just want to first ask you about the existing 3 lines that we have. It looks like rapid growth for these lines in the aggregate has plateaued. Revenues were up only 11% year-over-year. And I say only because a couple of years ago, when the initial uptick in production revenues emerged, we had growth of 100% year-over-year, 70% year-over-year and so on. And now we're even talking about one of them having a drop-off in the second half of the year, the cardiac products. So apparently, these are not products with high single digits annually each -- a high single-digit millions, say $8 million, $9 million, $10 million run rate each per year or more. Is that a correct assumption? Or how would you characterize this slowdown in growth?