Earnings Call Transcript - POCI Q3 2022

Operator, Operator

Good day and welcome to the Precision Optics Reports Third Quarter of Fiscal Year 2022 Financial Results. All participants will be in a 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, Investor Relations

All right. Thank you very much, Sara, and thank all of you for joining us as we discuss Precision Optics' third quarter fiscal year 2022 financial results for the period ended March 31, 2022. With us on the call representing the company today are Dr. Joe Forkey, Precision Optics' Chief Executive Officer, and Dan Habhegger, 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. 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 were included in today's press release. 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 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 Exchange Commission. All forward-looking statements contained during this conference call speak only as 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. So, with that said, let me turn the call over to Dr. Joe Forkey, Chief Executive Officer, Precision Optics. Joe, please proceed.

Joseph Forkey, CEO

Thank you, Robert, and thank you all for joining our call today to discuss our third quarter fiscal year 2022 financial results. As you can see from the results in the press release that we issued after the close, the third quarter was really a watershed for us as a number of initiatives we have been working on all came together to provide nice improvements in nearly every key business metric. Revenue of $4.7 million was up 89% year-over-year and excluding the effect of the Lighthouse acquisition, organic revenue was up 37% year-over-year. Sequentially, revenues were up 19% compared to the second quarter, including Lighthouse results in both quarters. Consolidated gross margins were 37%, which is the highest level since the September 2019 quarter and excluding Lighthouse, the historical business gross margins were over 40%. This has been a key corporate goal over the last few years and we are very pleased with the operating performance we have achieved to meet this benchmark. Importantly, on the bottom-line, we reported a positive adjusted EBITDA of $218,000, which is a new modern-day record for the company. In addition to these great financial results, we also made progress on a number of other key initiatives, including the advancement of our intents to uplift our stock onto the NASDAQ Capital Market Exchange. We successfully received approval from shareholders at our annual meeting to effect the reverse split if needed, and we have had a number of productive discussions with the Exchange regarding other factors that are required for listing. We are working through the final details of the qualification with NASDAQ and hope to have additional updates for you on this in the near future. All told, I am very pleased with operational progress since our last conference call, as the vision we have talked about for some time is beginning to come to fruition. I'd like to comment on a few specifics now, particularly those key drivers that are accelerating revenues and improving margins. Then I will provide some insight into what the rest of the fiscal year could look like, as some projects continue to ramp and as we recently announced yet another pipeline project that has moved into production. As we've talked about in earlier calls, we have a number of projects that recently transitioned from our engineering pipeline into production and others, which were in production previously, that were negatively impacted by the pandemic but are now beginning to recover. These increases significantly impacted our production revenue, which was $3.1 million for the quarter. This is $850,000 or 38% higher than last quarter's production revenue and is $1.2 million higher than last year's third quarter. Lighthouse contributed about $250,000 to production revenue. So, even excluding Lighthouse, the increase year-over-year was $950,000, which is a 50% increase in our organic production revenue. The key drivers here were the increase in production orders for our spinal product from a major longtime customer, which we announced in March, as well as record revenue from our Optical Components division. The new defense aerospace production contract that we announced in February also contributed to Q3 production revenue, with initial deliveries of approximately $100,000 shipping at the very end of March. Expanding on that a bit more, our announcement on the defense aerospace contract was that we received initial production orders for approximately $1.5 million, deliveries of which we expected to extend from approximately March through September. We also announced that our expectation was that this was the beginning of ongoing orders that would continue at a run rate of approximately $3 million per year and that there are opportunities to expand the number of products we are providing. Consistent with that interpretation, I am pleased to report today that we have now received our first follow-on order for this application for approximately $800,000, which will cover deliveries nominally from October through the end of the calendar year. We continue to work with this customer on additional products, some of which are going through prototype testing now. All-in-all, we expect this customer's programs will likely represent revenue of several million dollars annually to Precision Optics. While we are not yet at the stage of having smooth, consistent quarterly delivery volumes, we expect the future quarterly run rate to be significantly higher than the $100,000 we shipped in the last few days of Q3. As we reported in our March 2022 press release, we received multiple production orders of our spinal surgery product totaling approximately $2.5 million from one of our existing large medical device customers. We have supplied this product to this customer for more than 10 years. Due to the impact of pandemic-related restrictions on elective surgeries, fiscal year 2021 orders dropped significantly. But now with the relaxation of these restrictions, we have seen a significant rebound in orders for this product. We expect to deliver approximately $1.5 million through the end of fiscal 2022 with approximately $0.5 million in each of Q3 and Q4 and an additional $1.3 million in fiscal year 2023. This is a great example of the value to our company of medical device products once they transferred to production. With very little ongoing investment, this product has continued to contribute to production revenue and now more than 10 years out from initial production, volumes are growing substantially. Because of regulatory requirements and an aversion to risk associated with changing suppliers, these types of products tend to stay with us once they transition to production, often contributing to ongoing revenue for 10 years or more. Two additional programs are currently transitioning to production, the first of which we announced just last week. This product is a highly complex optical and electronic otoscope used for imaging in the ENT space and we are currently delivering against a $600,000 initial production order that will continue for the next nine to 12 months. This product came to us through the Lighthouse acquisition where it was in the Lighthouse development pipeline along with four or five other projects slated to transfer to production in the next 12 months. Production of this product represents the first successful transfer of a Lighthouse pipeline product since the acquisition and is a great indicator of the likely success of the other programs nearing production. The second product that is transitioning to production now is the multiple camera colonoscope. On our last call, I reported that our customer for this product had finally received 510(k) clearance from the FDA. They have now indicated that they are finalizing their go-to-market plans and expect to release an order to us in early summer, which should help provide for continued revenue growth heading into the next fiscal year. In addition to these few specific programs, we also continue to see a nice recovery of other mature products that were delayed due to the pandemic. For instance, the order we reported during the November earnings call for the defense product that was delayed due to the pandemic is back to pre-pandemic levels and was a contributor to year-over-year revenue growth. Our other production programs including our otoscopy and cardiac devices, while not back to pre-pandemic levels, appear to be achieving improved market pull-through which we believe will lead to a continuation and increase in production orders as we enter fiscal 2023. Transitioning to our engineering pipeline, I'll start with the same comment I've made the last couple earnings calls, which is that our pipeline in the volume of new opportunities, especially as a combined company, continues to be as large as it has been any time in the past, despite the fact that we have had multiple products transition to production in the last few months. What this means in part is that we are able to replenish our engineering pipeline as soon as programs transition into production. The demand for our services and products in both the medical device and defense aerospace markets continues to be strong. And with the combination of technical expertise augmented through the acquisition of Lighthouse, our offering is even more attractive to potential customers. I'm really excited to report that we recently received the development program from the first customer we engaged with as an integrated company. We spoke with this customer soon after the acquisition, began dedicated discussions about their project in December, and received an order for the first stages of the development program in April. After talking with their VP of Operations, I am completely convinced that neither Precision Optics nor Lighthouse would have received this order prior to the merger because this program requires both the heavy-duty optical and electronics expertise that our combined company can now provide. This is a great validation of the reasons for which we made this acquisition and it's a strong indicator of the business opportunities before us. From a revenue standpoint, engineering revenue was $1.5 million this quarter compared to $550,000 in Q3 of last year, and compared to $1.6 million last quarter. The slight quarter-over-quarter reduction in engineering revenue is largely due to the timing mismatch of the transition of some projects to production and initiation of invoicing for new engineering programs. This revenue level of $1.5 million to $1.6 million is pretty much our capacity at the moment, given the current size of our technical team. We are actively recruiting additional engineers, which will allow us to increase both the size of the engineering pipeline, as well as the speed with which we can move specific projects to production. And while the labor market is tight, we have been successful in bringing on some very good additional talent. While engineering revenue can fluctuate from quarter-to-quarter, mainly due to timing of specific programs, stages, and milestones, we expect that with the strong demand in the market, we will be able to increase engineering revenues overall as we continue to grow our technical staff. Beyond the product I've already mentioned that are recently transitioned to production, there are approximately five additional engineering pipeline programs which are a mix of pre-acquisition Precision Optics and Lighthouse opportunities that are likely to move to production in the next 12 months. These projects include two different arthroscopy products, an ophthalmic scanning device, an application for robotic laparoscopy and our single-use ophthalmoscope. As I've stated in the past, the single-use ophthalmoscope project continues to move forward with urgency on the part of our customer as they continue working through a few gating items with their suppliers. We continue to believe a production order will come in late calendar 2022. As I've stated before, this project has added importance to Precision Optics since it is our first single-use product. The experience and understanding we are gaining about the business requirements for single-use products, as well as the tangible intellectual property and intangible know-how will allow us to better develop a long-term strategy to address the large and rapidly growing single-use segment of the medical device market. The complexity here is not only technical in nature, it also involves the creation of a supply chain in partnership with the customer to develop the product at an end-market price point that can support single-use economics. We believe success in this endeavor will lead to many future opportunities. The other engineering pipeline projects targeted for production in the next year are moving along nicely. Beyond these five projects, there are numerous others that continue to advance as well. Our goal remains for each one of these pipeline projects to contribute on the order of $1 million of revenue in the first year of production, and many have the potential to grow to much larger production levels over time. As I've said in the past, the key to our long-term growth is a large and robust pipeline and with the merger of Precision Optics and Lighthouse, our pipeline is as large as it has ever been and is filled with high-quality programs with a high likelihood of transitioning to production. As we look to the fourth quarter of this fiscal year and beyond, we believe the strong positive trends of the last couple of quarters will continue. Nearly all of the contributors to our record revenues of the third quarter should continue with additional revenue coming from the programs that recently transitioned to production. While individual programs may experience ups and downs in delivery schedules, the clear overall trend is in the direction of ongoing continued revenue growth. Let me talk a bit now about some of the financial highlights. On the topline, as I've already mentioned, total revenue during the third quarter of fiscal year 2022 was $4.7 million, an increase of 89% year-over-year and 19% sequentially. Production revenue was $3.1 million, while engineering revenue was $1.5 million. Excluding Lighthouse, total organic revenue was up 37% year-over-year. Our gross margin was 37% for the third quarter compared to 29% in the sequential second quarter and 33% in the third quarter a year ago. Excluding Lighthouse, gross margins would have been above 40% during the quarter, representing a key milestone for the company. As engineering pipeline programs that came to us with the acquisition of Lighthouse continued to transition into production and more fully absorb overhead at Lighthouse, we expect overall gross margin to continue to improve. Based on their production program schedule, Lighthouse will outgrow their production capacity, and we are building a plan to deal with that when it occurs. The improvement in gross margin in the third quarter was driven by a number of factors which we have commented on in previous calls. First, many of our production costs are fixed and so growth in revenue delivers higher margins. Second, the cost overruns on our single-use engineering program have largely been corrected, so that this program and virtually all other engineering programs are contributing margins in line with targets. And finally, the resumption of growth in some of our longstanding production programs, which have high margins, but whose volumes were impacted by the pandemic. These products are coming back online with mature production processes that have already been through inefficiencies that sometimes accompany initial production runs of new products. Overall, the results of the third quarter clearly demonstrate the ability of our business model to achieve gross margins in the 40% range and higher. As new programs move into our engineering pipeline and others transition to initial production, we may see some fluctuations in gross margins. But the overall expectation is that gross margins will continue to trend towards our target of 40% and higher. Operating expenses in the third quarter were $1.8 million. On a cash basis, excluding depreciation and amortization, as well as stock-based compensation, operating expenses were approximately $1.5 million compared to approximately $1.2 million in the second quarter and $1.0 million in the third quarter a year ago. The year-over-year change is partly due to the inclusion of Lighthouse expenses, but also to the ramping back up of certain sales and marketing initiatives, such as trade shows, that had been reduced during the pandemic. The quarter-over-quarter increase was largely due to integration expenses, higher research and development expenses, as well as higher sales and marketing costs. We are making investments in our business that reflect the level of scale and maturity we are reaching. Additional talent to our HR and accounting functions, for example, reflects our size in volumes as well as our headcount in physical footprint as we now have locations in Massachusetts, Texas, and Maine. We are no longer three small companies. We are adding process as part of our integration to leverage our talents and market reach. All told, on the net income line, we reported a GAAP net loss of $114,000 during the third quarter with an adjusted EBITDA profit of $218,000. Adjusted EBITDA excludes stock-based compensation, interest, expense, depreciation, and amortization. We are pleased that we continue to invest in the business and yet are still seeing the leverage in our model flow through to adjusted EBITDA. With the expectation for continued growth in revenue in the fourth quarter and beyond, we also expect to achieve greater adjusted EBITDA. Turning now to our balance sheet, I'll highlight just a couple of items. Our cash balance at March 31, 2022 was $832,000. Accounts receivable increased substantially during the quarter due to the increase in revenue, but also due to an issue with terms for one customer which has now been substantially resolved. Inventory and accounts payable also increased in the period. We expect this to continue as production revenues returned to pre-pandemic levels, and we move more development projects to production. Before I take questions, I always like to recap the major elements of our strategic plan that we put in place a couple years ago. First, we have actively worked to grow our sales, capabilities, and capacity. This has resulted in the large increase of our engineering pipeline and strong year-over-year and quarter-over-quarter growth in revenue. Second, we have invested in our technical resources and worked to further develop our own intellectual property. Through targeted recruitment over the last couple of years, as well as the addition of the Lighthouse technical team, we have taken a significant jump forward in our technical capabilities. As I mentioned above, we continue to recruit and invest in our technical team. So we can continue to increase the size of our engineering pipeline and the rate at which we execute on particular programs. Third, we continue to invest in and update our production capabilities, both in personnel and in facilities as we respond to the strong growth in production revenues coming from new projects moving into production, as well as those recovering from pandemic-related slowdowns. And fourth, we have augmented our own skills and programs via external partnerships or acquisitions. Clearly, the acquisition of Lighthouse was a significant event that combines two of the industry's leaders in medical optics and digital imaging. And while our main focus today is the complete and successful integration of Precision Optics and Lighthouse activities, we continue to see opportunities in the industry for additional transactions in the future. Overall, I am extremely pleased with the current progress of Precision Optics as well as our position for future growth. With strong organic revenue growth, improvements in gross margins, the positive results of the Lighthouse acquisition and a general turnaround in the macro environment with pandemic-delayed elective surgeries coming back online, I believe we are well positioned for ongoing future growth. One final note, we will be participating in the Lithium Summer 2022 Investor Conference on June 22nd and 23rd. I look forward to speaking with many of you then, but as always in the meantime, please don't hesitate to reach out to Robert Blum or me to schedule a call. I thank you all for your attention and I'd be happy now to take any questions.

Operator, Operator

Thank you. We will now begin the question-and-answer session.

Robert Blum, Investor Relations

Sara, while we wait to see if anyone likes to ask questions, I've got a couple here for you.

Joseph Forkey, CEO

Sure.

Robert Blum, Investor Relations

Let's discuss capacity. As you mentioned, there has been an increase in revenue, along with expectations for further growth. Could you clarify your manufacturing capacity to satisfy the demands from the various projects we have?

Joseph Forkey, CEO

Yes, sure. So, capacity is certainly something that we pay very close attention to while we're going through this growth mode, for sure. It depends a little bit on the location. But in general, I think we have a ways to go before we will reach capacity in terms of our facilities. We're always hiring new people and while the labor market is tight, we've been successful in attracting people, both from the technical side as well as the administrative and the assembly and technician side. From a facility standpoint, which I think is probably the most relevant in terms of potential costs, we're looking pretty carefully. In Texas, I think we have quite a bit of room to go before we saturate that facility. In Maine, we're actively looking right now at other potential facility solutions because as I mentioned in our comments today, we do expect that the group at Lighthouse in Maine will outgrow their facility, as some of these programs in the next 12 months go into production. So, we're actively looking for space there and having some success. In Massachusetts, we're actually in a pretty good place because we're far enough outside of Boston, that there's a fairly good amount of the kinds of production facilities that we need. We actually have one large facility near us that we have been able to use as a bit of a flex space and in fact, we opened a new 2,500 square foot space there just in the last year to help support the single-use project that I've talked about a number of times. So, in that case, in Massachusetts, we can flex that up pretty easily up and down as we need to. So, the main place that we're looking at right now is Maine. But as I say, we're on top of that and looking at it carefully, and we're well prepared for the needs that will come.

Robert Blum, Investor Relations

Okay. Are you seeing any sort of supply chain issues out there that might impact some of the various production projects that you have ongoing?

Joseph Forkey, CEO

Yes, supply chain is a concern and we are actively addressing it. There are challenges such as longer shipment times and backorders for electronic components lasting over a year. Our team has effectively tackled these issues on a case-by-case basis. For example, the Lighthouse group heavily relies on electronic components and has been significantly affected. They've managed to redesign components quickly when replacements are needed. Additionally, with our customers' support, we have placed long-term orders for certain components well ahead of production to prevent potential delays caused by lower-cost electronics items. Another area of concern is glass supply. Many of our products require specific types of glass, some of which are sourced from Eastern Europe. Due to the war in Ukraine affecting energy supplies, there are reports of production reductions in Germany for some glass types we use. Our team is carefully monitoring these specific issues to ensure we have adequate materials available. In summary, while supply chain challenges exist, our team is doing an excellent job managing them and will continue to do so.

Robert Blum, Investor Relations

All right, maybe one more here. Regarding aerospace and defense projects, you've seen some recent success. Typically, these projects aren't included in your pipeline, which mainly consists of medical device-related work. Has there been an increase or a shift in focus on aerospace defense lately, either with existing customers or new ones?

Joseph Forkey, CEO

Yes, there is. We often discuss our work in medical devices due to our recent success and larger presence in that area, especially after acquiring Lighthouse, which is focused on medical devices. While our medical device projects dominate our pipeline, we are also actively exploring significant opportunities in the defense and aerospace sectors. We have a project that recently came online with an annual run rate of $3 million, and we are pursuing additional opportunities vigorously. There are a couple of promising projects in our pipeline. The combination of Precision Optics and Lighthouse enhances our capabilities, making us a more competitive supplier in defense and aerospace, just as it has in the medical device sector. Some existing defense customers have already expressed interest in our expanded capabilities. The recent $3 million defense aerospace project benefited from the merger of Ross Optical and Precision Optics a few years ago, and I believe we will create many new opportunities in the defense aerospace market thanks to the Lighthouse acquisition. There is a wealth of potential in this area for us.

Robert Blum, Investor Relations

All right, perfect. I'll leave it there. Sara, I'll turn it back over to you for instructions if there's any other questions.

Operator, Operator

Thank you. Showing no further questions, this concludes our question-and-answer session. I would like to turn the conference back over to management for any closing remarks.

Joseph Forkey, CEO

Thank you, Sarah. And thank you all for joining us on the call today. I look forward to speaking to all of you very soon. Thanks and have a good evening.

Operator, Operator

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