Precision Optics Corporation, Inc. (POCI) Q2 2024 Earnings Report, Transcript and Summary

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. [Operator Instructions]. 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 thank you all for joining our call today to discuss our second quarter fiscal year 2024 financial results. Revenue for the second quarter was $4.8 million. As we anticipated and discussed on recent calls, this is down year-over-year due to timing differences between reorders for ongoing production, the exit of certain mature customer programs, and the introduction of new customer programs. Also consistent with our recent discussions, however, was the 12% quarter-over-quarter increase in second quarter revenue compared to the first quarter. This is in line with our expectations that as we continue to expand our engineering pipeline, and as new programs move from engineering to production, we will see higher overall revenues and profitability in the second half of the year, with record quarterly run rates expected by the end of the fiscal year. Production revenue for the quarter was $2.6 million, up 6% over first quarter production revenue -- an increased driven mainly by the introduction of a new defense aerospace program to production. Engineering revenue for the quarter was $2.3 million, up 33% compared to the same quarter a year ago, and up 19% sequentially. This increase in engineering revenue for the quarter was supported in part by the addition of two senior engineers who started during the second quarter. We continued to recruit aggressively to grow our technical team to take advantage of the high demand for our engineering services. Gross margins decreased from Q1 to Q2, resulting in an adjusted EBITDA loss relatively close to that of Q1, despite the increase in revenue in Q2. As Wayne will discuss in more detail, we understand the underlying causes of the reduced margin in the second quarter and are confident we have taken appropriate steps to recover gross margin in the second half of fiscal 2024. Overall, we continue to anticipate strong engineering revenues and growing production revenues for the remainder of the fiscal year. As we have pointed out before, our strong engineering pipeline is a good indicator of potential future production revenue. These anticipated increases in revenue, combined with the expected improvement in gross margin, supports our optimism for positive EBITDA in the second half of fiscal 2024 and beyond. I wanted to take a couple of minutes to talk about some of our major programs, quite a few that have moved or will move to production this year, that will drive the sequential revenue growth that we expect for the third and fourth quarters. I also want to put these programs into the context of the market segments that they are part of. This is important to justify our confidence, not only in the likely success of these new products, but also in the potential for us to capture new programs from the same market segments to support long-term growth. The otoscopy program that recently restarted production after a pandemic-induced hold; the new complex imaging subassembly used for robotic laparoscopy that will begin production in the third quarter; as well as other otoscopy, sinoscopy, and cystoscopy programs currently in our engineering pipeline, are good examples of endoscopes that utilize POC's proprietary digital imaging and micro-optics technology. The otoscopy program was restarted by us a few quarters ago, but has been limited by issues associated with one supplier's inability to restart their production of a highly complex critical component. We have worked with this supplier over the last six months and believe we have now resolved the underlying issues. With this supply chain issue resolved, we expect revenue from this customer to increase from a few hundred thousand dollars in the first half of the year, to over $600,000 in the second half of the year, with much of this coming in the fourth quarter. We believe this program will ultimately settle into a run rate of approximately $400,000 to $500,000 per quarter. The second program in this category is a high-level subassembly that we build for a robotic laparoscopy system. We announced the receipt of the first production order for this product in November, and transitioned the program from engineering to production during the second quarter. This product is expected to begin contributing to production revenue in the third quarter at a run rate of approximately $200,000 to $250,000 per quarter. Both of these programs are great examples of the migration over the last five to 10 years of complex endoscopes from designs utilizing more traditional technologies that incorporated rod lens relays or coherent fiber bundles and large cameras external to the endoscope system, to the use of small CMOS image sensors incorporated into the body of the endoscope itself. The combined capabilities of POC in the areas of optical design, particularly at small and micro sizes required for endoscopes, along with the electrical engineering capability required to design and manufacture digital imaging systems, positions us well to compete in the part of the medical device market that requires next-generation CMOS-based endoscopes. The overall endoscope market is fairly mature, with an annual growth rate of 5% to 10% and dominated by procedures such as colonoscopy, traditional non-robotic laparoscopy, and arthroscopy. The medical disciplines that POCs digital and micro-optics technology is ideally suited for are areas that historically were more difficult to approach endoscopically because of the extremely small sizes required for access to the relevant parts of the body. POC's technology is also well-suited for complex imaging products required for robotic systems that need custom complex optical, electronic, and mechanical interfaces, as well as the use of CMOS imagers embedded in the endoscope. Since the advances in CMOS sensors and micro-optics allow more innovation in these areas today, we believe that the overall growth rate of these segments of the market is considerably higher than that of endoscopy in general, and solidly in the double digits. The level of demand we have seen recently for new engineering programs in this area supports this conclusion. Today, we have more opportunities than we can satisfy with our current team. An additional segment of the endoscope market that requires the use of CMOS sensors and micro-optics is the area of single-use endoscopy. Two of the programs that are scheduled to move from our engineering pipeline to production in the latter half of this fiscal year fall into this category. As we have discussed in earlier calls, single-use endoscopes have many benefits over traditional reusable endoscopes, including ease of inventory control by the hospital; guarantee of brand new image quality for the surgeon in every procedure; and importantly, the virtual elimination of the possibility of cross-contamination from one patient to another. Over the last few years the number of inquiries we have received from customers for new single-use programs has grown dramatically, and we have a number of opportunities in this area that we are currently evaluating. This is consistent with overall market trends, which indicate single-use endoscopy is growing at annual growth rates between 15% and 20% -- significantly higher than that of the endoscopy market in general. We have discussed our two single-use programs on earlier calls, so I won't go into detail here, but I do want to provide a brief update. The first of these programs is for an ophthalmic application. This program has moved through the transfer phase, and is essentially ready for POC to start production. Due to delays in our customers' submission of their 510(k) to the FDA, we now expect production to begin in the fourth quarter of this fiscal year, or first quarter of fiscal 2025. We expect to continue production for a year or so after which we believe production may transfer to one of our customers' facilities. If production is transferred, we would then receive royalties on units manufactured and sold by our customer. The second of these programs -- the single-use cystoscope -- has moved in the opposite direction, with our customer pushing us to be ready to launch production in the fourth quarter of this fiscal year, more than six months earlier than we had previously expected. This program has been our largest engineering pipeline project for the last couple of quarters, and we expect that after it launches, it will quickly become our largest production program. This product is a replacement product for a reusable device within a larger robotic system. Therefore, we have good reason for optimism that this product may drive substantial growth for us in coming years. The experience our sales and engineering team that have gained through the support of these two single-use programs, combined with the strong and accelerating market growth, gives us confidence that single use products will continue to be a major source of ongoing growth for many years to come. In October, we announced the receipt of orders for a new defense aerospace program, which began production in the second quarter. Since that announcement, we have received follow-on orders to continue production at least through the fourth quarter of this fiscal year, and we are in discussions with the customer for additional orders to extend deliveries at least through an additional 12 months. This program contributed approximately $200,000 to second quarter production revenue, and we expect this program to ramp to approximately $0.5 million per quarter by the end of this fiscal year. Our historic defense aerospace program also contributed to second quarter revenue, and is expected to increase in revenue for the third quarter. Our customer for this program has indicated we should expect follow-on orders in the coming months to support a steady-state production rate on the order of $2 million per year. As we've discussed on recent calls, we have been investing significantly in our sales resources. I'm happy to report that in the second quarter, we added two new sales reps. And while our main focus today is still in the medical device market, both of these new reps have some experience in the defense aerospace market as well. Given our success with a few defense aerospace programs, we have initiated an effort to better understand the size and growth potential of different segments of this market, and to identify those areas in which POC's unique technology would have the greatest value. We have hired an outside consultant and created an internal working group to evaluate the most promising submarkets to consider. To expand further, while the overall growth rate of traditional optical targeting systems is in the 5% to 10% range, POC's capabilities are better suited to segments that are still developing, and that rely on next-generation technology. We have already identified three segments that require micro-optics and or high-precision alignment, some of which are represented by our current production programs. They are unmanned aerial vehicles or drones; directed energy weapons or laser weapons; and satellite communications, especially among satellite constellations. Each of these segments is expanding at double-digit annual growth rates, making them ideal targets for future POC sales and marketing efforts. While we are just starting to approach the defense aerospace market in a more deliberate way, it is already clear that there are opportunities for POC's unique capabilities.I look forward to providing more updates on this initiative on future calls. With a large number of programs anticipated to move to production in the next few quarters, we have begun to critically evaluate our manufacturing infrastructure. We are considering various approaches to satisfy our requirements for manufacturing space, including a search for a potential new facility that will allow us to further expand and optimize manufacturing capacity to support both our near-term and longer-term growth objectives. We are also carefully considering the need to refill the engineering pipeline as programs move to production. Our experience in the marketplace confirms our belief that POC's unique technologies are ideally suited to segments of the medical device market that are experiencing high growth rates. With our increasing understanding of the defense aerospace market, we believe there are more opportunities in that industry as well. By continuing to support and expand our sales resources, and given the high quality and quantity of potential new customers we have today, we are confident we will have plenty of opportunity to continue to grow our engineering pipeline even as programs move to production. At our size, the timing of specific programs moving in and out of production can cause some ups and downs in quarterly revenues, but the clear trend is toward increasing revenue in the remainder of fiscal 2024 and beyond. I'll now turn the call over to Wayne to review the financial results in more detail. I will then make a few closing comments before questions. Wayne?

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, 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. I will now turn the call back over to Joe for some final comments.

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 in Q4 of this year. With growth in revenue will come increase 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. [Operator Instructions]. 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.

Okay. So this huge growth in engineering -- this large growth in the engineering revenue, it's important for even larger revenues in the production side.

Exactly.

Okay. On that program, you mentioned, that you expect for it to be the largest program -- and I think that is going to be in the fourth quarter, it's going to start -- could you tell a non-medical professional exactly what it's going into?

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 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.

[Operator Instructions].

Andrea, this is Robert Blum here. Before -- while we see if there's any additional questions in the queue, Joe, a couple of questions here on this side. As you mentioned sort of the pursuit of more defense and aerospace projects, give us an idea of how long it sort of takes to A, win these opportunities, and B, sort of the conversion of them into revenue, maybe in comparison to the medical device side?

Yes. It's a great question. It's actually part of what we're looking at as we're digging into the various segments of the defense aerospace market. But I can use the two programs that we have running right now as good examples of sort of the extremes. And as you point out in comparison to medical device, let me just remind everyone, the medical device programs -- because of the regulatory requirements and because we're typically working on a program from the very conception stage -- typically take two or three years to get through the engineering process. Now in some cases, it will take even longer if it's a program that requires something more than a 510(k), or if there are multiple clinical trials that are required. But typically for a medical device program, we're looking at somewhere around two or three years to go through the engineering pipeline -- sometimes a little faster times, sometimes a little slower. Our experience with the defense aerospace programs is that it depends critically on just how far the program is pushing the technological limits of what people have done before. So this new program that I commented on, that came into production this year, is a program for which the customer came to us with a set of prints and a fairly welldefined design, and they came to us about a year ago. So this one took about a year for us to to develop the process, to build it, which is really the key technology that we're contributing year. It's the manufacturing process and the know-how that we have in the manufacturing process. So it took us about a year to put that process together, for their particular design that they came to us with, and then to run through a couple of rounds of prototypes to demonstrate that we could do it. That was sort of the fastest that I would expect one of these programs would take, is about a year. On the longer side, the historical defense aerospace program that we have that we've been producing for a number of years just before the pandemic started, that one actually took some three years or so. Maybe even four years to go through a few rounds of prototypes. In that case, the customer was asking us to do something that day, and we agreed was right on the edge of what was physically possible. And so, while we don't know exactly what it's used for, we know that it's used for a very advanced technological device, whatever it is, that's pushing the limits in terms of what can be done with the micro-optics that we're making. So in that case, while the customer had an initial design, we had to go through three or four design iterations to be able to satisfy both their requirements and what could be done from a physical standpoint. So I expect that what we're going to find as we dig into these segments that have higher growth rate because there's a lot of technological development that's going on, I think what we're going to find is that that range that we found for these two programs -- between one year or four years -- is probably the typical time line that we should expect for these 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 and 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.

All right. 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. So 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 in 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 so while we can sort of pre-positioned 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. And 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 a new facility capabilities as we need them in the most efficient way possible.

All right, 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.