Precision Optics Corporation, Inc. Q2 FY2024 Earnings Call

Good afternoon, and welcome to the Precision Optics Second Quarter Fiscal Year 2024 Financial Results conference call. All participants will be in listen-only mode. Please note, this event is being recorded. I would now like to turn the conference over to Robert Blum of Lytham Partners. Please go ahead.

All right. Thank you, Andrea, and to everyone as well for joining the call today. As the operator mentioned, on today's call, we will discuss Precision Optics' second quarter fiscal year 2024 financial results for the period ended December 31, 2023. With us on the call representing the company today are Dr. Joe Forkey, Precision Optics' Chief Executive Officer; and Wayne Coll, the company's Chief Financial Officer. At the conclusion of today's prepared remarks, we will open the call for a question and answer session. Today's conference call is also being webcast with replay capabilities available through both the webcast as well as through the dial-in instructions. The details of both are 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 27 A of the Securities Act of 1933 as amended, and Section 21 E 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 risks 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 the company's 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 were 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, Precision Optics. Joe, please proceed.

Thank you, Robert, and thanks to everyone for joining our call today to review our financial results for the second quarter of fiscal year 2024. Our revenue for this quarter was $4.8 million. As we expected and have discussed in previous calls, this represents a decrease compared to last year due to various factors, including timing differences with reorders, the conclusion of some established customer programs, and the launch of new ones. However, it's encouraging to note a 12% increase in revenue from the first to the second quarter, aligning with our expectations that expanding our engineering pipeline and transitioning new programs into production will enhance our overall revenues and profitability in the latter half of the year, with record quarterly run rates anticipated by the end of the fiscal year. Production revenue for the quarter amounted to $2.6 million, which is a 6% increase compared to the first quarter, largely attributed to introducing a new defense aerospace program into production. Engineering revenue reached $2.3 million, showing a 33% increase year-over-year and a 19% sequential increase. This growth in engineering revenue was partly supported by the hiring of two senior engineers during the second quarter. We’re actively recruiting to expand our technical team to meet the high demand for our engineering services. We did see a decline in gross margins from the first to the second quarter, leading to an adjusted EBITDA loss that was relatively close to Q1, even with the rise in Q2 revenue. As Wayne will elaborate on later, we understand the reasons behind the reduced margin this quarter and are confident that we have implemented the necessary steps to recover gross margin in the latter half of fiscal 2024. Overall, we expect strong engineering revenues and increasing production revenues for the rest of the fiscal year. Our robust engineering pipeline remains a positive indicator for potential future production revenue. I would like to briefly discuss some key programs that have moved or will move into production this year, which will fuel the sequential revenue growth we anticipate for the third and fourth quarters. It is also important to frame these programs within their respective market segments. The otoscopy program, which recently resumed production following a pause due to the pandemic, along with a new complex imaging subassembly for robotic laparoscopy that will begin production in the third quarter, exemplify endoscopes employing our proprietary digital imaging and micro-optics technology. The otoscopy program, which we restarted a few quarters back, faced limitations due to issues arising from a supplier's inability to produce a critical component. After collaborating closely with this supplier over the past six months, we believe these issues have now been addressed. With this supply chain challenge resolved, we project revenue from this customer to grow from a few hundred thousand dollars in the first half of the year to over $600,000 in the second half, mainly in the fourth quarter. We expect this program to stabilize at a run rate of approximately $400,000 to $500,000 per quarter. The second program in this category is a vital subassembly for a robotic laparoscopy system. We announced the receipt of the first production order for this product in November and transitioned it to production during the second quarter. This product is anticipated to start generating production revenue in the third quarter at a run rate of about $200,000 to $250,000 per quarter. These programs exemplify the shift over the past five to ten years toward complex endoscopes that leverage modern technologies as opposed to traditional methods that utilized larger cameras and rod lens relays. Our expertise in optical design at micro and small scales and our ability to design and manufacture digital imaging systems positions us favorably in the medical device market that demands next-generation CMOS-based endoscopes. The overall endoscope market is relatively mature, growing annually by 5% to 10% and is primarily driven by procedures like colonoscopy and traditional laparoscopy. However, POC's digital and micro-optics technology is particularly suited for medical disciplines where traditional endoscopies have faced challenges due to the extremely small sizes required. We are also witnessing significant demand for new engineering programs within this area. Currently, we have more opportunities than we can address with our existing team. Another important segment of the endoscope market requiring advanced CMOS sensors and micro-optics is single-use endoscopy. Two programs set to advance from our engineering pipeline to production this fiscal year fall under this category. Single-use endoscopes offer numerous advantages over their reusable counterparts, such as easier inventory management, always-new image quality, and reduced risk of cross-contamination. The interest we've received from clients for new single-use programs has surged in recent years, which mirrors broader market trends showing single-use endoscopy is expanding at a remarkable 15% to 20% annually. We've previously outlined our two single-use programs, so I will not delve into details, but I want to provide a brief update. The first program pertains to an ophthalmic application, which has now reached a stage where POC is prepared to start production. However, delays in our customer's FDA submission have pushed our expected production start to either the fourth quarter of this fiscal year or the first quarter of fiscal 2025. We anticipate production will continue for a year, after which it may move to our customer's facility, with royalties accruing to us on units they manufacture and sell. The second program involves a single-use cystoscope, which has experienced an accelerated timetable, with our customer urging us to finalize production readiness by the fourth quarter, six months earlier than planned. This project has been the largest in our engineering pipeline, and we expect it will quickly evolve into our largest production program following its launch, given it's a replacement for a reusable device in a larger robotic system. Our sales and engineering teams' experience with these two single-use programs and the rapid market growth gives us certainty that single-use products will be a significant source of growth for years to come. In October, we announced orders for a new defense aerospace program that commenced production in the second quarter. Following this announcement, we've received additional orders to sustain production at least through the fourth quarter of this fiscal year and are in talks for further orders to extend deliveries for another 12 months. This program contributed about $200,000 to our second-quarter production revenue, and we project it will ramp up to approximately $0.5 million per quarter by the end of the fiscal year. Our established defense aerospace program also made a contribution to second-quarter revenue and is anticipated to grow in the third quarter. The customer for this program has indicated that follow-on orders are on the horizon to maintain a sustainable production rate of around $2 million annually. As noted in previous discussions, we've been investing significantly in our sales resources. I’m pleased to report we added two new sales representatives in the second quarter. While our primary focus remains in the medical device market, both new reps bring valuable experience in the defense aerospace sector. Given our successes with ongoing defense aerospace programs, we have initiated efforts to understand the size and growth potential of various market segments and to pinpoint areas where POC's unique technology can deliver significant value. We've engaged an outside consultant and created an internal team to identify the most promising submarkets for consideration. While the general growth rate for traditional optical targeting systems hovers around 5% to 10%, POC's capabilities are best suited to segments that rely on next-generation technology, currently identified as unmanned aerial vehicles, directed energy weapons, and satellite communications, each growing at double-digit annual rates. We are beginning to engage the defense aerospace market more strategically, and it is already clear that there are significant opportunities for POC's unique capabilities. I look forward to giving further updates on this initiative in upcoming calls. With numerous programs expected to transition to production in the next few quarters, we are critically evaluating our manufacturing infrastructure and exploring options to enhance our manufacturing capacity to align with both our short-term and long-term growth goals. We are also assessing the need to replenish the engineering pipeline as programs shift into production. Our experiences in the market confirm our belief that POC's technologies are well-suited to the rapidly growing segments of the medical device market. With our deepening understanding of the defense aerospace sector, we foresee additional opportunities in that domain as well. By continuing to bolster our sales resources and considering the high quality and volume of potential new clients we currently have, we are confident in our capacity to sustain the growth of our engineering pipeline alongside production transitions. Variability in the timing of programs moving in and out of production can cause some fluctuations in quarterly revenues, but the overarching trend is toward increased revenue for the remainder of fiscal 2024 and beyond. I will now turn the call over to Wayne to provide a detailed review of the financial results, followed by a few closing remarks before we open up for questions.

Thank you, Joe. Let me expand on some of Joe's comments on the financial results, starting with revenue. Last year, we recognized $600,000 in one-time revenue pertaining to a technology rights agreement in the second quarter, which makes year-over-year comparisons to this year's second quarter a bit challenging. For the second quarter of fiscal 2024, total revenue was $4.8 million, a decrease of 18% compared to $5.9 million in last year's second quarter. However, net of the technology rights revenue, the year-over-year decline for the quarter was 8.8% or $463,000. Engineering revenue was a record $2.3 million compared to $1.7 million last year, an increase of 33%. However, revenue from optical components was down $600,000 for the quarter compared to the same quarter last year, primarily due to reduced demand at Ross Optical, which, while improving in the second quarter compared to the first, is still down compared to the prior year. Finished products and assemblies was down approximately $400,000 year-over-year due to the elimination of certain products from our customers' portfolios and a pause in the manufacture of one product into the beginning of our next fiscal year while our customer sells through their existing inventory. However, as Joe touched on, we expect this category to be a source of significant revenue growth during the second half of this fiscal year. Compared to the first quarter, revenues grew by $500,000 due primarily to increasing engineering revenues, improvements in order volumes at Ross, and the production start of the new defense aerospace program that Joe mentioned earlier. We have taken proactive measures within our Ross Optical operation to continue revenue growth, including the onboarding of a new technical salesperson in the second quarter, and a revitalized digital marketing program. For the second quarter, our gross margin was 30.1% compared to 44.2% in the same quarter last year. Excluding the technology rights revenue I discussed, gross margin for the second quarter a year ago would have been 37.8%. The biggest driver of the gross margin decrease is reduced overall sales and lower utilization of facilities. Additionally, while engineering revenues continue their trajectory of growing sales, we had 34% of our sales in the second quarter in the materials component of engineering sales, compared to a more typical 24% of sales in the first quarter. Since the margin on materials is only 20%, this factor serves to dampen overall margins. We also recorded a one-time increase to our excess and obsolete inventory reserve in the amount of $75,000 after a thorough analysis, driven by preparations for our new ERP system, which we are excited to say will go live at the end of this month after the lengthy and dedicated efforts of our team. Finally, gross margin was negatively impacted by startup inefficiencies associated with programs transitioning to, or restarting production during the second quarter. We have already addressed these inefficiencies, mainly embodied in low startup yields, and expect margins for these programs to recover nicely in the third quarter and beyond. Total operating expenses in the second quarter were $2.16 million compared to $2.03 million in Q2 of last year, or an increase of about $125,000. Increases in travel expenses, and the allowance for accounts, as well as an increase in stock-based compensation expense during the quarter were the main drivers here. Despite the anticipated increases in revenue for the second half of 2024, we expect quarterly operating expenses to remain substantially constant. As a result of the year-over-year decline in revenue and gross margin, the net loss during the second quarter was $759,000 compared to a net income of $508,000 in last year's second quarter, which of course includes the $600,000 of technology rights revenue. Adjusted EBITDA, which excludes stock-based compensation, interest expense, depreciation, and amortization, was negative $269,000 for the second quarter of fiscal 2024 compared to positive adjusted EBITDA of $866,000 in the second quarter of last year. Again, the key driver here was the decrease in production revenue, and the technology rights agreements included in last year's financials. Our cash balance at December 31, 2023, was nearly $1 million, compared to $1.4 million at September 30, 2023. The change in cash is consistent with our EBITDA loss and normal debt repayments in Q2. As a reminder, we continue to maintain full availability on our $1.25 million working capital line of credit with our bank. As we look to the third quarter of fiscal 2024, we expect to see sequential quarterly revenue growth similar to the growth from the first to second quarter, due to key production deliveries against existing customer orders, and a continuation of strong engineering revenue. We believe these higher revenues, along with improved margins, will result in higher profitability and positive adjusted EBITDA.

Thank you, Wayne. I'd like to summarize a few key points before we take questions. First, our engineering pipeline is as large and robust as it has ever been, with record engineering revenue in the second quarter. We believe this is a key leading indicator of future production revenue increases. While total second quarter revenue was down year-over-year, we grew revenue sequentially from Q1 to Q2, and expect to see continued growth in Q3 and Q4 of this year. With growth in revenue will come increased utilization of our manufacturing capacity, and thus improvement in gross margins and the bottom line. Our technological capabilities are highly sought after. We are one of only a few companies in the world that can deliver the type of micro-optics and digital imaging that are supporting the next generation of medical devices. The segments of the medical device market that we operate in are growing quickly, and we expect to benefit from this surge in new devices that are coming to the market in the coming years. With a number of production orders in hand that support sequential revenue growth in the back half of fiscal 2024, coupled with continued strength in our engineering pipeline, we remain optimistic for a strong finish to fiscal 2024, and look forward to ongoing growth in future years. To all of you on the call, I thank you for your continued support of Precision Optics. We'd be happy to take questions at this time.

We will now begin the question-and-answer session. Our first will come from Chris Vichovski, a Private Investor.

Hello. Thanks for taking my question. You said a lot of engineering revenue this quarter, now is that all going to turn into manufacturing revenue in future quarters, or do you sometimes just do engineering on contract, or is everything for something that you start producing in the future?

Yes. So with very few exceptions, we only take programs into our engineering pipeline that we expect will go to production. Now that doesn't mean that 100% of everything that we do in the engineering pipeline ultimately gets to production, but we do go through a fairly thorough analysis before we accept an engineering program, and evaluate the programs with a high focus on the likelihood that they'll go to production. So the short answer is everything in the engineering pipeline we work on with an expectation that it will go to production.

The significant growth in engineering revenue is crucial for even greater revenues in the production area.

Exactly.

Okay. On that program, you mentioned that you expect it to be the largest program, and I think it will start in the fourth quarter. Could you explain to a non-medical professional what it entails?

So I can tell you briefly, we're constrained a bit by the nondisclosure agreements we have with our customer because they have not announced publicly what it is that we're doing for them. But it's a cystoscopy system, which means that it's used in the urinary tract. And it's a robotic type system. So it's a robotic system that has an endoscope that goes into the urinary tract to do various things.

Okay. And is it one-time use?

It is. Yes.

Okay. So I guess you're going to be making lots of them.

Exactly, yes.

Okay. Alright. This all seems very optimistic. Good luck. And this is all from me. Thanks.

Great. Thanks very much for the questions.

Before we check for any additional questions in the queue, Joe, I have a couple of inquiries on this side. As you mentioned the pursuit of more defense and aerospace projects, can you give us an idea of how long it generally takes to win these opportunities and how they convert into revenue, especially in comparison to the medical device sector?

Yes, it's a great question. We're currently examining different segments of the defense aerospace market, and I can use our two ongoing programs as examples of the range of timelines. Compared to medical devices, I want to remind everyone that medical device programs usually take two to three years to complete the engineering process due to regulatory requirements and because we generally start from the very conception stage. In some instances, it may take longer if a program requires more than a 510(k) approval or if multiple clinical trials are needed. For a medical device program, the typical timeframe is about two to three years, though it can vary slightly. For our defense aerospace programs, the timeline heavily depends on how far the program pushes technological boundaries. The new program I mentioned, which began production this year, started about a year ago when the customer provided us with a well-defined design. It took us about a year to develop the manufacturing process and build the technology we contribute. This included multiple rounds of prototypes to ensure we could meet their requirements, making this the fastest program timeline I would expect, which is about a year. Conversely, we have a historical defense aerospace program that began before the pandemic and took approximately three to four years, as the customer requested something that was on the edge of physical possibility. Although we don't know its exact use, we understand it's related to advanced technology, pushing the limits of what can be achieved with micro-optics. As we explore segments with higher growth rates and technological development, I anticipate that the timeframe we observed for these two programs—one year to four years—will likely be the standard for new programs in the defense aerospace market.

All right. Perfect. That is helpful. Our next question we have here is you mentioned the introduction of a new ERP system. Talk about how you expect the system to improve operations and financial results?

Yes. So I should say, Wayne and our new COO, Mahesh, really have spearheaded this effort, which has required the efforts of a lot of people in the company. They've done a great job of getting this ready to launch in the next month, as Wayne alluded to. So I'm going to let him answer this question, but I would just say, from my standpoint, I expect I'll be able to get more detailed reports more often, which I think from my standpoint will help me to understand what's going on in the company on a more timely basis. But let me let Wayne talk about this in more detail.

Thanks, Joe. Yes, I think my answer is similar. An integrated system will allow us to collect better information, more quickly and productively so we can run the business more efficiently, and it's really going to help us to scale with our existing headcount.

Alright. Perfect. Sounds good. I think the last question here is how are you planning to manage sort of the significant growth in production you are expecting, and do you have the resources that you need?

Yes. And so, that's a question we've been asking ourselves for quite some time. Of course, we've seen that this production ramp is coming for a little while now. In terms of planning for it, we've planned on a number of fronts. So we did do a bit of a sort of a mini reorganization of the company a few months ago, in order to get people into the positions that we thought would be most effective as the production starts to grow. The last of those positions that we came out of this restructuring reorganization was a senior director of operations for production, and that role has been filled by someone internally just about a week or two ago. So we've been working for some time to make sure that the organizational arrangement is ideally suited to the production that we see coming. In terms of the resources beyond that, there is obviously the direct labor resources that we'll need. And while we can sort of pre-position those folks, we can't do too much of that, because I have people sitting around and not being productive. So the direct labor for the assembly work and production work, we're pretty confident we can bring in when and as we need them for the growth that we see. The other sort of critical piece of resources is one that I alluded to in our comments, and that is our production facilities. While we're able to satisfy the requirements that we have today, we do believe that over the next few quarters, depending on exactly when various programs start to hit, that we likely will outgrow the facilities that we have. So there are a couple of different ways that we could expand, and one of those ways of course, is to look at a new facility. So we are looking at all potential ways of satisfying the facility requirements. And as we move forward, as the new programs come online, we'll be ready to have new facility capabilities as we need them in the most efficient way possible.

Alright, fantastic. That's all the questions we have here. Andrea, I'm going to go ahead and turn it back over to you if there's any additional questions, or to close the call out.

There appear to be no questions on the line at this time, I will turn the conference over to management for any closing remarks.

Thank you, Andrea, and thanks, everyone, for joining us on the call today. I look forward to speaking with everyone soon. Have a good night, and stay safe.

The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect.