Kopin Corp Q3 FY2020 Earnings Call

Good day, and welcome to the Kopin Corporation Third Quarter 2020 Earnings Call. As a reminder, today’s conference is being recorded. At this time, I would like to turn the conference over to Richard Sneider, Chief Financial Officer. Please go ahead.

Thank you, operator. Welcome, everyone, and thank you for joining us this morning. John will begin today’s call with a discussion about the market environment that we see and our progress in executing our strategy, including the sales activity and technology development. I will go through the third quarter results at a high level. John will conclude our prepared remarks, and then we will be happy to take your questions. I would like to remind everyone that during today’s call, which is taking place on Tuesday, November 3, 2020, we will be making forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are based on our expectations, projections, beliefs, and estimates and are subject to a number of risks and uncertainties that could cause actual results to materially differ from those forward-looking statements. Potential risks include, but are not limited to, demand for our products, operating results for our subsidiaries, market conditions, and other factors discussed in our most recent annual report on Form 10-K and other documents filed with the Securities and Exchange Commission. The company undertakes no obligation to update the forward-looking statements. And with that, I will turn it over to John.

Good morning. Thank you for joining us to discuss our third quarter results. I want to start by expressing our hope that you and your families continue to stay well and safe during this unprecedented time. Looking into the next quarter, we are very pleased with many aspects of our business. Our current product sales are increasing, and our development programs are advancing strongly. We continue to make major improvements in our product cost and yields while maintaining tight expense control. In addition, we are making great strides in our next-generation EVAS display development. Our total revenue increased 55% compared to the third quarter of 2019, which represents the fifth straight quarter with double-digit year-on-year top-line growth, excluding our one-time asset sales in the third quarter of 2019. It has been a very good year for us so far, and we look forward to continuing strong momentum through the fourth quarter and into 2021. Leading our third quarter revenue growth were product revenues in defense, which grew 140% year-over-year. Our two primary production programs are the F-355 fighter jet helmet and the FWS-I program. In September, we announced that we were awarded a $22.9 million follow-on contract for the FWS-I Family of Weapon Sight program, with deliveries through the third quarter of 2021. Including this recent contract, we have received total orders to date of approximately $33 million for this program. As discussed in the news release announcing that contract win, the FWS-I program is a clip-on thermal weapon sight that provides users with the ability to identify targets in the most extreme circumstances. Kopin is the sole source supplier for that contract as it is for the F-35. We expect both programs to continue for many years into the future. Our funded development program revenues grew over 100% year-over-year, which clearly indicates our future growth potential. These programs are funded by our customers, including both product-specific development as well as new advanced micro-display technology development. In fact, much of the new funding for R&D growth is for advanced micro-display development. We expect these development programs will further build on our current production business in the coming years. We currently have over 10 different programs in various stages of development, which is the strongest sign-up in our history. These development programs include the use of our products in vehicles, systems, rotary wing aircraft helmets, and more. Three of these defense development programs are expected to start production next year, adding to our two current production programs. We are also very excited to see growth from our enterprise customers who have incorporated orchestration modules into their AR products. The remote work approach driven by COVID-19 has highlighted the power of our technology, as we are seeing solid adoption and rollout of our devices to enterprise workforces. We expect the enterprise market in AR to gain traction, and infrastructure elements necessary for this market, such as 5G, will help accelerate consumer AR and VR adoption. Kopin is already benefiting from defense enterprise adoption, and we are ideally positioned to meet the demands of this market with a broad lineup of micro-display products and module solutions, including both LCD and OLED micro-displays. It is important to emphasize the significance of a larger solution; the micro-display must be offered with a superior margin, which includes sophisticated optics and electronics within a sealed housing. Kopin has extensive experience in this area, which is why many customers choose us for their micro-display solutions. We are also excited about the technical benefits of light-emitting diode, or OLED, micro-displays. We recently highlighted these OLED developments in a webinar where we shared results of our patent assets in achieving industry-leading high brightness OLED micro-displays. Achieving high brightness with low power consumption while maintaining color fidelity is critical for AR/VR development. In the webinar, we demonstrated our color 720p OLED micro-display, which reaches 7,000 nits of brightness with significantly lower power consumption than previous models. We also outlined our technical path to achieve even greater brightness levels, potentially up to 30,000 nits for color OLED micro-displays in the coming years. It's important to note that color mixing among the OLED micro-displays can lead to poor color performance due to the impracticality of color mixing individual RGB duo-stack structures. We tackled this challenge and introduced our ColorMax Technology, which controls color mixing among components in our duo-stack OLED architecture. ColorMax Technology now enables a much wider color gamut of up to 115%, which is considered a significant breakthrough. We believe our innovative approach is manufacturable and cost-competitive. This is a major achievement for OLED micro-displays and a crucial step in expanding the market for AR/VR applications. We see the long-awaited adoption of AR/VR systems starting to take off. As we've stated, these systems are first being adopted in defense, then industrial enterprise, and later consumer applications. Almost all of our defense programs relate to AR/VR applications. As VR and AR continue to grow in this new remote environment, we feel we are very well positioned to meet the increasing demand. Our technology and products are designed for these AR/VR applications and solutions. In summary, we are making great progress in executing our strategy, and it is reflected in our performance. The market conditions are favorable, and we are well positioned to capitalize in the fourth quarter and beyond.

Thank you, John. Turning to our financial results, product revenues for the third quarter ended September 26, 2020, were $6.5 million, compared with $5 million for the third quarter ended September 28, 2019, a 31% increase year-over-year. Funded research, development, and other tax revenue were $3 million for the third quarter ended September 26, 2020, compared with $1.2 million for the third quarter ended September 28, 2019, an increase of over 100%. Total revenues for Q3 2020 were $9.5 million versus $6.1 million the prior year. Cost of goods sold for the third quarter of 2020 was $4.8 million or 74% of product revenues, compared with $4.7 million or 95% for the third quarter of last year. The significant decrease in cost of product revenues as a percentage of net product revenue for the three months ended September 26, 2020, compared to the three months ended September 28, 2019, was primarily due to lower material costs, along with improved manufacturing yields and efficiencies gained due to higher sales, which reduced fixed cost per unit at our U.S. plants. Additionally, we are commencing production of certain products and we had fared higher than normal scrap for the first three and nine months of 2019 as compared to the same period of 2020. Combined, internal and externally funded R&D expenses in the third quarter of 2020 were $2.7 million compared with $2.4 million for the third quarter of 2019. The higher R&D costs for the third quarter of 2020 compared to the prior year were a result of an increase in customer-funded R&D expenses of approximately $500,000 in support of several development programs. SG&A expenses were $3.1 million in the third quarter of 2020 compared to $5.1 million in the third quarter of 2019. The decrease was primarily due to lower compensation expenses, including stock-based compensation, bad debt expenses, professional fees, information technology, and travel expenses. Other income and expense was income of approximately $158,000 for the third quarter of 2020 compared with a loss of $78,000 for the third quarter of 2019. During the three months ended September 26, 2020, we recorded $184,000 of foreign currency gains as compared to $88,000 of foreign currency losses for the three months ended September 28, 2019. Turning to the bottom line, our net loss attributable to controlling interest for the quarter was approximately $1 million or $0.01 per share compared with a loss of $6.6 million or $0.08 per share in the third quarter of 2019, an 87% improvement. Kopin’s cash and marketable securities were approximately $15.6 million at September 26, 2020, compared to $21.8 million at December 28, 2019. Net cash provided by operating activities for the third quarter ended September 26, 2020, was approximately $500,000, which was a result of improving operations and managing working capital. During the third quarter, we had four patents granted. Third quarter amounts for depreciation and stock compensation expense are attached in the tables of the Q3 press release. The amounts discussed above are based on current estimates and listeners should review our Form 10-Q for the third quarter 2020 for any possible changes and additional disclosures. Operator, we will now take questions.

Thank you. We will now take our first question from Glenn Mattson from Ladenburg Thalmann. Please go ahead, your line is open.

Richard, I'm not sure we want to give guidance today on 2021 revenues, but I can tell you over the next several years, we expect these to go into the $80 million to $100 million range of annual revenues.

Yes, I think, Glenn, this is John Fan speaking. Those programs are all defense programs, but we will know when this starts ramping up at the beginning this does slow, and then it ramps, just like the other two programs we have now, but they are part of the programs.

Great. And being that it’s Election Day and obviously no one knows the outcome, but what’s your confidence that under either administration, these programs would continue to advance the way they have been going?

Well, I can tell you right now, for the next three to four months, everything we are doing is for the 2022 budget, 2021 for purposes as well, so not much is going to change. And so literally, by January, most of 2022 budgets have a lot. Yes, I think it is a very good question, Glenn. The defense budgets are usually decided a long time before this election, the second military defense programs have been determined a long time ago and we have established our current system years in advance. So today’s brand-new programs, which may be coming five to ten years from now, can be affected, but weapon systems have been decided many, many years ago.

Great. Thanks for the color. Just last thing for me, Rich, just on the gross margin, it’s been better than expected for two quarters in a row, so is that perhaps a function of the products getting a little more mature and the processes getting a little more advanced? So is that something we should expect kind of these high 40s or so in the total gross margin line?

So I assume you’re talking about the funded R&D revenue, not expense. In any given quarter, who drives revenue changes by program. So some programs that undergo a lot of development, then we send it off to the customer, and we’re kind of doing it for a while as they run through their test; and of course, then we outsource to another program. There’s no one particular program that’s a significantly bigger driver per se than all the rest right now. It just changes month-to-month really based on where they are in the program and where various resources are coming through. So no, there’s no one particular one big driver.

Yes. It’s a very interesting phenomenon going on, all this remote learning, as we now are working from home, we see a lot of traffic in effect, I think an increase toward tech that has never been higher. So it’s come from all sectors, the enterprise sectors and the consumer sectors as well. But I must caution you that when those things get designed into the products, you will take at least a year. Even consumer products will take a year from today to go to market. So those are a little bit further out, but we are now seeing as high-traffic currently as before.

And on the industrial side, in particular, 2019 seems to be like a big year where a lot of people adopted some products and tried to maybe work them into their workflows and things, but 2020 maybe has been a little quieter. So that period of digestion seems to have played itself out? And do you expect that to pick back up a little bit in the medium term?

Yes. It’s been interesting now, everyone is looking at hands-free solutions for industry. And I think many of our customers are recognizing this now. We have more than 10 programs going on and a lot of funded programs coming in from all sectors, enterprise sectors as well as defense sectors. We’re seeing a lot of activity in these areas, and we are proud to be part of it. We provide displays, optics, electronics, assembly—we provide the whole solution.

Great. Okay, thanks for the clarification. Thank you very much.

Thank you. We will now take our next question from Kevin Dede from H.C. Wainwright. Please go ahead. Your line is now open.

Thanks. Hi, John, Rich. Thanks for taking my questions.

Hi, Kevin. Hi, good morning.

So I assume you’re talking about the funded R&D revenue, not expense. In any given quarter, who drives it changes by program. Some programs do a lot of development, then we send it off to the customer, and we’re kind of doing it for a while as they run through their tests, and of course, then we outsource to another program. So there’s no one particular program that’s a significantly bigger driver per se than all the rest right now. It just changes month-to-month really based upon where they are in the program and where various resources are coming through.

As you well know, Kevin, we’ve been waiting for this variable hands-free transformation for years. And what we noticed is that actually, like we thought, it was somewhat predictable. The first wave is actually in the defense world. We have more than 10 programs going on and there are lots of funded programs coming in from all sectors.

Okay, so I guess that’s not a hockey stick, yes, but a mix well.

We expect it not to ramp up significantly for a couple of years from now.

Okay. But I guess it’s a mix of wearables really, is what you’re pointing to in terms of what you’re seeing driving the revenues now?

I think the revenue growth in defense will be substantial. That is very surprising to us.

Okay. John, you referenced ColorMax in your press release. And I was wondering if that references the duo-stack or the fact that you’re just able to, I guess, keep colors from mixing and decreasing that fidelity, what specifically does that refer to in your OLED design?

Yes. See in the AR situation, especially in AR applications, people would like to have the brightness to be much higher than what they have today. So the two ways to solve it: one is in direct happening, which is that for more display is very difficult to manufacture. So we did it as we do double stack, so we say one junction to two junction product. Now we do not go through too much hassle because in a small micro-display, the designs are very specific.

Okay, so a 10-year life program, if you were to compare it against what it’s replacing.

The TWS program that this is replacing went 10 years. And so we think this has a long life to it.

If I understand correctly, I’m sorry, John, go ahead.

Go ahead and finish your question before I make a comment.

Okay, okay. So a 10-year life program, if you were to compare it against what it’s replacing. And if I remember correctly, it went into production about this time last year. Is that true?

Yes.

Okay, I know Glenn asked about gross margin already, Rich, but I’m just I guess what I’m wondering is where you think it can go if product revenues nudge a little bit higher, which is sort of where my estimates have them going given your commentary? Or do you start getting pushback from your customers?

The new military programs will likely have lower initial gross margins that are ultimately sustained, but the sheer volume of having these additional programs will absorb more fixed costs per unit across everything. So we believe this will ultimately increase margins, allowing us to grow toward our goal of 35% to 40%.

Yes, we’re going through this harvesting period right now.

Okay. Do you think there is more beyond that or do you think the army switches to something else?

No. The TWS program that this is replacing went 10 years. And so we think this has a long life to it.

If I understand correctly, I am sorry, John, go ahead.

Go ahead and finish your question before I make a comment.

Okay, okay. Yes. So a 10-year life program, if you were to compare it against what it’s replacing. And if I remember correctly, it went into production about this time last year. Is that true?

Yes.

Okay, I know Glenn asked about gross margin already, Rich, but I’m just I guess what I’m wondering is where you think it can go if product revenues nudge a little bit higher, which is sort of where my estimates have them going given your commentary? Or do you start getting pushback from your customers?

The new military programs will likely have lower initial gross margins but ultimately stabilized. The sheer volume of having these additional programs will absorb more fixed costs per unit across everything. Thus, we believe this will ultimately increase margins toward our goal of 35% to 40%.

Thank you. We will now take our next question from Jeff Bernstein from Cowen. Please go ahead. Your line is now open.

Congratulations. First off on the positive cash flow from operations; it seems like you are on a positive track here. Do we think we are going to be free cash flow positive for 2021?

Correct. We expect to at least break-even by 2021, though I don’t want to say for the whole year right now.

Okay, great. And I apologize I don’t have the best connection, so I think I might have missed a couple of things. I wanted to just make sure you said the FWS-I follow on order, $22.9 million, was that on top of $33 million already awarded? Or did that total $33 million with what was already awarded?

$33 million is a total. It includes the $22 million.

Got it. Okay. So that clarifies that. Alright. And then I want to make sure you were talking about the externally funded R&D and that it’s not just military. So you have some commercial customers who are actually paying money for you to do R&D?

Yes.

Great. And then I wanted you to touch on fourth dimension and what’s going on with 3D machine vision, as I think the Chinese economy seems to be rebounding at the big end market. What are we looking forward to here in the next 12 months?

So, we are working with the three big Chinese foundries and so we really can’t talk about who their customers are.

Yes. I think it’s also clear for the enterprise world, as you will know, the real ways are now on Google Gramaltoe, so there are the usual suspects. It results in a lot of traffic right now. So we are optimistic about the future.

So you are saying you have some additional customers that are customers of the Chinese foundries?

Yes. The situation in China is very interesting. They have recovered much more than other regions, and there are lots of activities. However, I’m cautious about how their sell-through is going to unfold since I haven't visited there in over a year.

Okay. And then ColorMax, is that in those foundries now? Is that being produced on a scale basis, or is it just a prototype? Where are we on that technology?

ColorMax is manufacturable. In fact, we are manufacturing them, and people are using it, and displays are coming out from them, and customers are sampling the technology now.

That’s terrific. That’s just great, guys. And then just to beat up one more time on the gross margin. So the incremental gross margins have been outstanding, up to the 90% this quarter. Are you telling us that new military programs will come in with lower margins that could possibly change that?

Yes. So I think it's a combination of factors that you mentioned. The first couple of quarters of 2019 were artificially low because FWS-I was just getting going, and we had a lot of scrap associated with design changes. Now that it has reached its stride, and we continue to make improvements in how we manufacture, so our yields are going up and we are getting lower pricing for materials by having multiple vendors. Thus, FWS-I has been a solid contributor and is doing well. F-35 is in a nice steady state, and we continue to make improvements on the yield. Next year, as John indicated, some of these new products will come on with lower gross margins, but the sheer volume of these additional programs will absorb more fixed costs per unit over the broader base. This gives us confidence we will grow margins.

That’s great. Okay. And then, Rich, did you say for some of the new programs, it was a total of $80 million of potential revenues or something next year? I missed that.

I was referring to three to four years out.

Good morning, guys. Congratulations on not only a great quarter with positive cash flow but on the military contract you guys announced last quarter that went unrecognized/unappreciated, very thankful for that. And I am just very excited. Secondly, I want to ask you about double stack. John, last quarter, you told, I believe, Jeffrey, last quarter on the conference call that no one will be doing a couple of stacks in a year. That being said, I’ve always viewed you as a competitor to other OLED players. But to me, today, after the white paper and the webinar, you’re almost agnostic to me where you can supply the wafers to as many fabs as you want. Is your architecture similar in nature to Sony, BOE, LG, or Samsung? Can you give me some color on how you see yourself being agnostic or someone as a competitor to these types of players in the marketplace?

Yes. Because the reason why I ask that is, in case COVID has come unexpectedly. We have had AR/VR Tier 1 players in our pipeline. And I am thinking if you have now found double stack where numerous parties have not reached double-stack at the ATA family. Maybe these fabs will come to us quicker because the Tier 1s in COVID want to push these products out the door faster. And Kopin now has a display, double stacked, 5x brighter, and more power-efficient. And I believe you should be able to win business that people don’t even think that you can achieve.

It’s possible. However, there will be a time delay for full production. People begin to recognize it, and so the wearable segment will be significant; you don’t want to carry too much battery on your body. So all these are benefits. We are observing significant interest.

Just to clarify, we do not have an equity stake in MDMD. But we are working with them. Lenovo continues to make progress. We get the financial statements and we mark-to-market the investments as needed. Solos is a new company launching a new product. They’re dealing with COVID challenges over in China. RealWear has been bullish as well.

Okay, alright. Thank you, guys. Good luck. Great quarter. Look forward to talking to you down the road.

Thank you very much, Kevin.

Thank you. We will now take our next question from the queue. This comes from Jeff Bernstein from Cowen. Please go ahead. Your line is now open.

Thank you very much for joining us this morning, and we look forward to talking to you again in the next quarter. Stay safe. Thank you.