Earnings Call Transcript - POCI Q4 2024

Operator, Operator

Good afternoon, and welcome to the Precision Optics Fourth Quarter and Fiscal Year 2024 Financial Results Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Robert Blum with Lytham Partners. Please go ahead.

Robert Blum, Presenter

Thank you very much, Gary, and everyone joining the call today. As the operator mentioned on today's call, we will discuss Precision Optics' fourth quarter and fiscal year 2024 financial results for the period ending June 30th, 2024. With us on the call representing the company today is Dr. Joe Forkey, Precision Optics’ Chief Executive Officer, and Mr. Wayne Coll, the company's Chief Financial Officer. At the conclusion of today's prepared remarks, we'll open the call for a question-and-answer session. Before we begin with prepared remarks, we submit for the record the following statements. 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. They 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 the company's filings with the Securities and Exchange Commission. All forward-looking statements contained during this conference call speak only of the date in 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.

Joe Forkey, CEO

Thank you, Robert, and thank you all for joining our call today to discuss our fourth quarter and fiscal year 2024 results. As most of you know, on August 14th, we pre-announced revenue expectations for the year to be in a range of $18.5 million to $18.9 million. Our final revenue numbers that we reported today were $19.1 million for the year and $4.7 million for the fourth quarter. These revenue levels were slightly above the range we pre-announced in August, but somewhat lower than we anticipated at the time of our last conference call in May. These lower levels were driven by specific delays in a few key programs in the latter half of the fourth quarter. I will explain the causes of these delays in more detail in a minute, but let me emphasize right from the top, the customer relationships in each case remain strong and the market potential of each product is intact. So our long-term outlook for these programs and overall business growth remains high. We always have a lot to cover on our Q4 calls since we have just about completed our Q1 and have a preview of Q2. Let me first take a step back and discuss some of the challenges and successes of fiscal year 2024. As we communicated over the past year, when we exited our record-setting fiscal 2023, we were facing the loss or pullback of a few significant programs that were not moving forward in fiscal 2024. This included two production products and two product development programs that were discontinued, one defense/aerospace program that was redesigned by our customer, and our longtime spinal surgery product for which our customer had built up excess inventory that they need to burn through before placing additional orders. These programs represented approximately $5.6 million in revenue in fiscal 2023. In addition, our Ross Optical division saw a sharp drop in revenue caused by an overall slowdown in the optics components industry starting in the first quarter of fiscal 2024. This represented a year-over-year reduction in revenue of approximately $1.5 million. All told, these situations had us starting fiscal 2024 with a reduction of over $7 million in fiscal 2023-based business. While this certainly made for a challenging fiscal 2024, we succeeded in rebuilding the revenue base by moving a number of programs from our product development pipeline into production and successfully bringing on new programs into our product development pipeline. This progress was punctuated by the record-breaking $9 million production order that we announced in May and record product development revenue with this segment of our business growing by nearly 24% year-over-year. I am happy to report that we are starting fiscal 2025 in a much stronger position. Of all programs that contributed significantly to our fiscal 2024 revenue, we have only one which contributed about $400,000 that will not continue into fiscal 2025. So, this year, we are building on a strong base of business that will allow us to reach record levels of revenue in fiscal 2025. While the first quarter of fiscal 2025 will still have suppressed revenue levels due to some specific ramp-up challenges, we expect to see a step increase in revenue beginning in the second quarter. Beyond the recovery of top-line revenue during fiscal 2024, we also continued to strengthen our team and invest in operational infrastructure to support a larger business. To support the ongoing increase in interest from the medical device market and our product development capabilities, we have added engineering talent and begun a rollout of our new platform product that draws on our many years of experience in developing new digital imaging systems. This effort, along with management of our overall sales and marketing team, is now being led by our new VP of Sales and Marketing, Clay Schwabe. Clay has extensive experience in the medical device space with previous positions in smaller growing companies as well as some of the industry's largest, Boston Scientific and Medtronic. Clay has taken over management of sales and marketing from our former Senior Vice President, Jeff DiRubio, who managed our team for more than 10 years. I want to take this opportunity to recognize the critical role Jeff has played in our company, helping us to increase sales by over 700% during his tenure. With significant growth expected in production, we have also updated the infrastructure of our manufacturing team and implemented a new ERP system. As part of the integration of the Lighthouse Imaging business, we made the decision last year to consolidate all optical systems manufacturing in our Massachusetts location while maintaining an office in Maine to house our engineering and digital imaging center of excellence. We now have all but one of our production programs running in Massachusetts, and we expect this final product to transition in the next couple of months. We have updated our management structure in this area, moving some folks from Maine to Massachusetts, redefining roles for some senior employees, and hiring additional resources, particularly manufacturing engineering. All told, we are well positioned to support the growth we expect during fiscal 2025 and beyond. Let me take a few minutes now to discuss in more detail what happened with the programs that impacted revenue in the latter part of Q4 and in Q1 and where we see things going in Q2 of fiscal 2025 and beyond. We manage our business in four separate revenue streams, product development, optical systems production, Ross Optical, and our micro-optics laboratory. At the micro-optics lab, we started Q4 coming off a particularly strong revenue contribution of $1.2 million in Q3 from a highly complex optical assembly we have manufactured for a top-tier defense customer for many years. In April, we announced the follow-on order from this customer. Given the nature of the production process, this order starts with lower revenue rates that grow larger as we move through the order. Q4 revenue from this program was therefore about $260,000, almost $1 million lower than that of Q3. For the first and second quarters of fiscal 2025, we expect revenue of approximately $360,000 and $370,000 for this order. Within optical systems production, we expected and achieved significant revenue growth from Q3 to Q4 from three programs. Two of these are programs that transitioned from our product development pipeline to production in the last 12 months. And the third is our otoscopy program, which has continued to recover from the complete shutdown during the pandemic. The output from these three production programs nearly doubled, increasing from approximately $500,000 in Q3 to nearly $1 million in Q4. All three were running well in the early part of the fourth quarter, and we expected they would continue to ramp through Q4 and beyond. While all indicators still point to significant increases in these programs in the next couple of quarters, we've experienced some challenges as they have ramped up. The first of these is our new defense/aerospace program that went into production in the second quarter of fiscal 2024. We had been ramping steadily until the middle of Q4 when we began to saturate the existing production line. Duplicating tools and fixtures and training additional operators took longer than expected during Q4, but we resolved these issues and continued shipping in Q1. In August of this year, however, our customer identified a potential specification failure, later determined to be the measurement technique used in acceptance testing by our customer and not a problem with the product itself. This is an indication of the extremely tight tolerances we are building to, tolerances that can only be measured with some of the most sophisticated measuring equipment available today. Unfortunately, the customer ordered a temporary production stop during the investigation, which reduced Q1 revenue by approximately $0.5 million. The good news, however, is that we restarted production on the line last week and fully expect this product to contribute to revenue at a higher level of approximately $850,000 starting in Q2. Importantly, our customer had the confidence to give us new follow-on orders for deliveries later this year, even while production was stopped during Q1. The second new program that went into production last year but stalled a bit in Q4 was the robotic laparoscopy product. Production began in January, and while we have delivered a significant number of units, we have also experienced variable yield from lot to lot. This resulted in lower shipments than expected both in Q4 and in Q1. Originally, we believed we would improve yield with experience, but we recently began a more thorough review of the build process to identify the root cause of the variable yield. Based on preliminary findings, we are confident we will be able to increase yields in Q2 and beyond. We restarted deliveries of the otoscopy product a little over a year ago. While restarting the line, we experienced some supply chain and yield issues, which were largely resolved by the fourth quarter of fiscal 2024, and we recognized approximately $400,000 in revenue that quarter. However, our customer requested we reduce shipments in the first quarter to match their demand as they were dealing with the discontinuation of an electronic component that has now been replaced. As a result, we were not able to deliver all of the units we produced in Q1. We expect shipments to be more regular in Q2 and beyond at a run rate of approximately $250,000 per quarter, with expectations that this may increase significantly by the end of fiscal '25, depending on market penetration. The overall impact of the challenges in these three programs reduced our Q4 revenue by approximately $0.5 million and will negatively impact Q1 revenue by approximately $900,000, resulting in expected Q1 revenue between $4.2 million and $4.4 million. The other major program that just transitioned from product development to production in the last few months is the record $9 million production order for a single-use endoscopic imaging assembly that we announced in May. When we received this order, we anticipated fiscal 2025 revenue would be approximately $2.2 million. With our customer already increasing their demand and pulling in their forecasts, we have been ramping up deliveries. We are now delivering at a rate of approximately $600,000 per quarter and are currently standing up a second production line to achieve our updated estimate of $3.6 million in revenue for fiscal 2025. Based on the strong market dynamics of our customers' end-use market, we expect that demand could continue to grow in the future. We hope to be able to provide more details on this program soon. This order provides the impetus for ongoing POC investments in single-use endoscope manufacturing at scale with high technical performance and at price points consistent with the single-use endoscope market. This will ultimately result in an efficient manufacturing platform that will provide ongoing strategic advantage. In summary, we are exiting Q1 with the optical systems production programs in far better shape and running at production levels supporting expectations that will contribute at much higher levels for Q2 and beyond. As we start fiscal 2025, our product development pipeline is as robust as ever, and we continue to add new opportunities on a regular basis. This is a strong indicator of the overall strength of the medical device imaging market, which is growing at 5% to 10% per year, and the even stronger single-use segment, which is growing 2 to 3 times faster. We are continuing to recruit for engineering talent, as we believe we have more opportunities than we can support with the existing team. As I mentioned on our last call, we have now developed a concept to provide an existing family of baseline designs to new customers coming into our product development pipeline. We call this our platform product because the baseline designs, which draw from our many years of experience, act as a starting point for POC's design of a customer's new product. Customers may choose from a pre-existing set of hardware and software components that then can be engineered specifically to their specification. This platform gives us a competitive advantage in the marketplace as these well-qualified baseline systems can offer an accelerated path to market and reduce development risk to our customers. Financially, this provides a high-margin offering that will utilize fewer engineering resources to entice customers into development programs. The limited launch of this product to a few select customers has been very well received, and we already have three new customers based on this approach. We expect to proceed with a more formal launch in the coming months. Ultimately, we believe this approach will help us to become the provider of choice for next-generation medical device digital imaging systems. Finally, our Ross Optical division is still feeling the impact of the industry-wide slowdown in optical component sales, although we are just now beginning to see some customers who have delayed deliveries for many months starting to accept product and to place follow-on orders. This is consistent with the general attitude in the industry that business will begin to pick up again in the beginning of calendar 2025. We are increasing our marketing budget for Ross Optical in order to accelerate and hopefully magnify its rebound in fiscal 2025. To summarize, we believe production issues that depressed Q4 and Q1 revenue from three ongoing programs are largely resolved. We expect production deliveries against the $9 million order for the single-use endoscope imaging assembly to continue to ramp. We expect product development pipeline revenue to continue at near-record levels, and we expect our Ross Optical division to continue at similar or slightly higher revenue rates compared to recent quarters. Taken together, these expectations support our strong confidence that we will see a sharp increase in revenue in Q2 with record quarterly revenues before the end of fiscal 2025.

Wayne Coll, CFO

Thank you, Joe. Let me expand on some of Joe's comments on the financial results, starting with revenue. For the year, revenue was $19.1 million, a decrease of $1.9 million from last year. Last year's results included $600,000 of one-time technology license revenue. Excluding this, fiscal 2024 revenue was down 6.6% compared to fiscal 2023. This is a significant accomplishment as we started the year with a loss of previous year programs and revenue representing about $7 million or 34% of fiscal 2023 revenue. A major contributor to that recovery was the product development or engineering pipeline segment of our business, which posted revenue at a record level of $8.3 million, representing a year-over-year increase of 24%. Looking specifically at the fourth quarter, revenue was $4.7 million compared to $5 million last year, a decrease of 6%. Joe has already commented on the key drivers here. With the pullback in revenue for the year, we saw less absorption of certain fixed costs in production, which impacted our overall gross margins. Lower revenues related specifically to Ross Optical reduced revenue by $1.5 million and gross margin by $1 million. For the year, gross margins were 30% compared to 38% last year. Excluding the license revenue, last year's gross margins would have been in the mid-35% range. For the fourth quarter of fiscal 2024, gross margins were 22% compared to 39% in last year's fourth quarter. The fourth quarter was particularly impacted by the ramp-up challenges Joe summarized, which led not only to lower revenue but also significantly reduced gross margin. We also recognized unfavorable charges to COGS in the fourth quarter resulting from one-time adjustments in the carrying value of our raw materials inventories. We do expect gross margin to recover quickly as production processes stabilize and revenues increase. Operating expenses for the year were $8.5 million compared to $8.4 million last year. And for Q4, they were $2.4 million compared to $2.5 million last year. There are also a few costs in Q4 that were new compared to a year ago. First, as Joe mentioned, we have put a focus on recruiting this past year. And during the fourth quarter, we had approximately $200,000 in one-time personnel-related expenses. Beyond this specific expense, there's the cost of new people, engineers especially, getting up to speed and achieving target utilization. These are investments in our long-term growth. Second, with the anticipated rollout of our new platform product, we incurred significant internal R&D expenses that were higher compared to earlier quarters and years, but also represent a strong investment in the platform product that we believe will have positive sales impacts in the near term. Third, with the increase in production volume, we have been exploring the possible expansion of our manufacturing facilities. We have not yet concluded on how best to balance our growth needs with investment costs, but we did incur approximately $50,000 in expenses in this area during the fourth quarter. As a result of the lower revenue, our net loss was $3 million during fiscal 2024 compared to a $145,000 loss last year. For the fourth quarter, the net loss was $1.4 million compared to a $96,000 loss in last year's fourth quarter. Adjusted EBITDA, which excludes stock-based compensation, interest expense, depreciation, and amortization was negative $1.6 million in fiscal 2024 compared to a positive adjusted EBITDA of $491,000 last year. For the fourth quarter, we had $1.1 million negative adjusted EBITDA compared to negative $410,000 last year. Again, the biggest driver here was the lower revenue and largely fixed manufacturing and operating expenses, along with one-time operating expenses that hit in the fourth quarter. As we look to achieve our goals for the upcoming year, we expect adjusted EBITDA breakeven quarterly revenue levels to be approximately $5.5 million, which is aligned with our revenue expectations for the second quarter and beyond. Our cash balance at June 30, 2024, was $405,000. After the close of the year, this past August, we completed a $1.4 million registered direct offering of common stock, which included participation from directors and officers to supplement our working capital. As we alluded to earlier, we are evaluating alternatives for the consolidation, expansion, and relocation of our physical facilities to support the growth and efficiencies that are key in our drive to scale. We believe the long-term financial model of the production business is very attractive and results in a high return on invested capital. This is supported by the high degree of recurring revenue as a result of our single-use focus, as well as the high likelihood of strong customer retention as our technologies are embedded in the products and will have been included in FDA submissions of our customers. Based on our growth expectations, we will, over time, invest in both physical capacity as well as methods for manufacturing efficiencies. We are confident the attractiveness of the business model will afford us multiple financing alternatives for appropriate investments.

Joe Forkey, CEO

Thank you, Wayne. To summarize, fiscal 2024 was certainly a challenging year. And while we made substantial progress rebuilding our revenue base during the year, revenue in the fourth quarter came in a bit lower than our initial expectations. This was caused by a few program delays that impacted fourth quarter revenue by about $500,000 to $600,000. Some of these issues will also impact first quarter fiscal 2025 revenue, which we expect to be in the range of $4.2 million to $4.4 million. But as of today, most of these issues have been resolved. We now have strong visibility and confidence that with our production single-use programs starting to grow in Q2, the re-ramp of our defense/aerospace program that was put on a temporary hold starting up again last week, coupled with a number of other growing programs, we will see significantly higher revenues in Q2 and record quarterly revenues before the end of fiscal 2025. This should also improve profitability due to the leverage of fixed costs in our business model. All in all, we are very optimistic that we will see substantial growth both in top line and bottom line performance in fiscal 2025. Before I turn it over to questions, I want to mention that we will be participating in the Lytham Partners Fall 2024 Investor Conference tomorrow. If you would like to schedule a one-on-one meeting, please reach out to Robert Blum to coordinate. To all of you on the call, I thank you for your continued support of Precision Optics. We'd be happy to take any questions at this time.

Operator, Operator

We are very optimistic that we will see substantial growth both in top line and bottom line performance in fiscal 2025. Before I turn it over to questions, I want to mention that we will be participating in the Lytham Partners Fall 2024 Investor Conference tomorrow. If you would like to schedule a one-on-one meeting, please reach out to Robert Blum to coordinate. To all of you on the call, I thank you for your continued support of Precision Optics. We'd be happy to take any questions at this time.

Robert Blum, Presenter

All right. Hey, Gary. This is Robert Blum. While we wait to see if anyone joins the live call, I have some webcast submissions here. So, Joe and Wayne, let's go through a couple of these. The first question is regarding a previously mentioned $1.2 million defense order that was expected to be completed by August '24. Was it completed, and have we had any follow-up discussions or orders?

Joe Forkey, CEO

Yeah. So, that was the new defense/aerospace program that we commented on during the comments here. This is the program that was put on hold by the customer for almost a couple of months. And so because of that hold, it reduced the time that it will take to finish the orders that this question is referring to. The good news, as I mentioned in the script here, was that the customer has allowed us to restart shipping. And so we're quite confident that this program is going to contribute significantly to Q2 and beyond. As for the second part of the question, the customer has given us new orders. In fact, this is one of the things I mentioned in my remarks. The customer gave us new orders even while they had us on a production hold because they were confident that we would be able to sort out with them what the issues were. So, the answer to the question is we have not finished the deliveries, but that's because our customer put us on hold. We expect to finish the deliveries now in the next quarter. And we do have follow-on orders that will continue after that.

Robert Blum, Presenter

Our next question is about your contribution margin on the various programs. Can you explain what you believe that margin is and whether you have a target for it?

Joe Forkey, CEO

I'm going to let Wayne answer this one.

Wayne Coll, CFO

Depending on the lines of business, the margin can vary significantly. For example, the defense and aerospace projects we work on in the micro-optics lab have some of the highest margins, exceeding 50%. In contrast, the margins for manufacturing, particularly for our single-use products, are currently around 30%. The Ross Optical business, when fully utilized, also approaches nearly 50% margins, but lower revenues result in a reduced margin profile. On the product development side, margins usually fall within the low to mid-40s, factoring in labor costs, non-recurring engineering revenues, and material revenues associated with that segment.

Robert Blum, Presenter

Okay, great. Next question here, and I know you touched on this a little bit, for the aerospace/defense program that was put on hold but is now back up and running, can you expand on what some of the factors were that forced the hold? Was any of this related to POC, or was this unrelated?

Joe Forkey, CEO

I can provide more details on this. The assembly we supply is used to transmit a laser beam, which requires specific measurements during production and inspections, as well as similar measurements from our customer at their facility. The measurement process is complex and needs sophisticated equipment. The measurements can be affected by tiny movements of components we assemble, as small as 10 microns, making it very sensitive. Initially, we took measurements here and shipped the product, but it took some time for our customers to conduct their measurements. When they did, they noticed discrepancies compared to our measurements, raising concerns about potential drift due to the sensitivity of the measurements to minute movements. They requested we halt production while we investigated the root cause together. Ultimately, we believe the issue wasn't due to the movement of the assembled parts but rather a sensitivity issue with the measurement devices used on both ends. We conducted troubleshooting, exchanged test measurements and assemblies to align our quality control processes, and based on this collaboration, both sides concluded it likely was a measurement issue. Consequently, our customers allowed us to resume production. As we did, we've augmented our measurements to further verify that our collective conclusion was accurate. Overall, there's no indication of issues with POC's production, but due to the sensitivity of the parts, it was ultimately a measurement error related to the devices used for these computations.

Robert Blum, Presenter

Okay, great. Our next question here is for the single-use program, you mentioned revenue expectations have increased. Can you provide any commentary on the dynamics leading to the increase?

Joe Forkey, CEO

Certainly. With non-disclosure agreements in effect, we can only share limited details about our current situation. However, I can provide some general insights that should clarify the matter. The single-use product we are developing for our customer is intended to replace an existing product they currently sell. This new product has recently received FDA clearance and is now available in the market. The market risk for this new product is relatively low because it is essentially taking sales away from their existing product, allowing them to expand in a market where they have already been successful. Once the product was launched, although it began with a limited release, feedback from surgeons confirmed the expected benefits, leading to increased delivery expectations from their marketing team. This, in turn, affects us positively, as they are requesting more products from us at a faster rate. This is a promising trend, and we believe there are ample opportunities for continued growth as they expand their market presence and receive more favorable feedback.

Robert Blum, Presenter

Okay, we have a few questions regarding the platform that I'll address together. Will the new product you are developing and offering alter the company's model by raising R&D expenses and boosting gross margins? Currently, you can charge R&D costs for customized client products, but in the future, clients will use your platform, which is less customized, meaning you'll bear the R&D expenses yourself. How will this impact gross margins, R&D expenses, and profitability? Additionally, how does this platform facilitate the transition for companies from an entry-level stage to a more established client pipeline? I know I covered a lot, so I can clarify any of these points if necessary.

Joe Forkey, CEO

I understand your question, and it's a great one. I want to clarify our platform product. As I mentioned earlier, we plan to enhance our marketing and officially launch it in the upcoming months. This will clarify many aspects as we share more information with the market. The main point is that we need to conduct some internal research and development to kickstart the platform product. However, much of the R&D work has already been completed over the past several years while developing various products for our clients. A key aspect of our business model is our ability to use the intellectual property created during product development. While we cannot replicate our customers' products for their competitors, we have identified common core design elements across all our products. We are now taking these core elements and reconfiguring them to quickly provide an initial prototype to our customers, almost as if it's off the shelf. There are also modular components from other products that we can incorporate, similar to Lego blocks that enhance the baseline design. Currently, we are incurring some R&D costs to unify our various designs into a common baseline. This process will not alter our overall business model, as we will continue to customize for our clients. However, it will enable us to present a higher level base design than before, leading to faster time to market. There will still be a need to customize the baseline design to fit our customers’ requirements and select which modular components to add. We expect that each customer will require a few unique custom features. Therefore, this does not eliminate the time and materials charges we apply during the product development process; rather, it speeds it up and allows us to charge for the baseline design that will be consistent across customers. From a margin perspective, since we can charge for this baseline design after the initial R&D phase, it should slightly improve our gross margins in product development. This approach will continue to attract customers to our product development pipeline while enhancing our competitive edge due to reduced time to market and risk associated with starting from scratch. I hope I addressed your inquiries, and I'm here for any follow-up questions.

Robert Blum, Presenter

All right, great. Well, I show no additional questions here, Joe. So, I will turn it over to you for any closing remarks.

Joe Forkey, CEO

Okay. Thank you, Robert. Thank you, everyone, for joining us on the call today. I look forward to speaking to all of you soon. Thanks very much. Have a good evening.

Operator, Operator

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