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Operator
Good day and welcome to the Precision Optics Report's second quarter of fiscal year 2021 financial results. All participants will be in a listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one. Please note that this event is being recorded. I would now like to turn the conference over to Robert Bloom with Listen Partners. Please go ahead, sir.
Robert Bloom
All right. Thank you very much, Cole. And thank you all for joining us today to discuss the financial results of Precision Optics for the second quarter, fiscal year 2021, which ended December 31st, 2020. With us on the call representing the company today are Dr. Joe Forkey, Precision Optics Chief Executive Officer, Mr. Dan Hebiger, 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 the webcast as well as through 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 Section 21E of the Securities Exchange Act of 1934 is 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 our filings with the Securities Exchange Commission. All forward-looking statements contained during this conference call speak only of the date on which they are made. 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 of Precision Optics. Joe, please proceed.
Joe Forkey
Thank you, Robert. And thank you all for joining our call today to discuss our second quarter fiscal year 2021 financial results. Overall, the positive operating trends we saw in the first quarter continued into the second, as we reported another quarter of sequential revenue growth and significant year over year improvements in our adjusted EBITDA, all while continuing to work through the near term impact on some of our commercial projects from COVID-19 that we've discussed in recent quarters. On today's call, I will start with a summary of a few key events of the quarter, followed by the overall status of our production programs, as well as our product pipeline, all in the context of our overall strategic plans to support ongoing growth. Finally, I'll recap our financial results and provide some context to items on both the income statement and the balance sheet before opening the call up for any questions. As I mentioned at the onset, I'm pleased with the performance during the second quarter, which exhibited a continuation of the trends we saw in Q1, particularly with regard to revenues, which were slightly increased quarter over quarter. As we discussed last quarter, we are continuing to work through the short-term negative impacts the pandemic has had on certain production projects, including our cardiac otoscopy and defense products. However, the ramp in other areas of our operations has done a nice job replacing this near-term revenue disruption in order to keep overall revenues close to where they were a year ago pre-COVID. It is our hope and expectation that once the programs that were impacted by COVID return to normal, revenue levels will more clearly demonstrate the positive progress the company has made even during the difficult last 12 months. In general, despite the pandemic, we have continued to make progress in the major areas of our strategic plan, which include the following. Growing our sales capabilities and capacity. Investing in our technical resources and developing our own intellectual property. Investing in and updating our production capabilities, for example, to address the single-use market. and augmenting our own skills and programs via external partnerships or acquisitions. We have made progress along these efforts despite COVID and believe we are very well positioned with several prospective drivers of future growth. The status of our major production programs was predominantly the same in Q2 as it was in Q1. Our cardiac and otoscopy products continued to be impacted by reductions in sales and a buildup of inventory due to the effects of COVID. As we discussed for the last few quarters, we slowed down production to help our customer of the cardiac product better align their inventory levels due to lower sales caused by the pandemic. We maintained those reduced levels through this month, but now we are ramping back up again to pre-COVID levels through the end of June. As we continue to work with both our cardiac and otoscopy customers to get through COVID disruptions, production levels for these products will be variable from quarter to quarter. However, both programs have recently seen some early indications of recovery, and while the timing and extent of future order requirements are difficult to predict, both of these customers provide essential procedures, and both believe the long-term prospects for their product remains positive. In our commercial defense program, based on recent discussions with our customer, we anticipate a substantial reorder in the next couple months. At our customer's request, we have already pre-purchased the raw material for their products in order to guarantee the supply and to reduce the lead time for their next production order. As I mentioned previously, our relationship with this customer remains very good, and we have been introduced by this group to a number of other projects giving us confidence that significant opportunities exist for future growth with this customer and in the defense sector in general. In what we hope is the final step before full-scale production is initiated, we began pre-commercialization runs for some of the products in our multi-camera colonoscope project. Some work for this pre-production order was completed in the second quarter, and some will be done in the third quarter. Our customer has told us that all technical issues have been successfully addressed with the FDA and they expect final 510 clearance soon. The customer is finalizing their go-to-market strategy and we expect the full production order soon after they receive clearance. Finally, the volumes of our traditional products, including complex endocouplers, specialized endoscopes, custom spinal surgery products, along with the components supplied by our Ross Optical Division, all remained stable in Q2. All told, from our production programs, we reported revenue of about $1.9 million during the second quarter, compared to $2.2 million in the first quarter. As we look to the third quarter, we believe we will see an uptick in our cardiac program, offset by a decline in our otoscopy program, which should even itself out when compared to the second quarter. Looking out to the fourth quarter, Given our expected ramp in the defense program, coupled with the continued increased level of our cardiac program and the potential transition from pipeline to commercial level production of the colonoscope program, we anticipate ending the fiscal year with strong production revenue levels. The second quarter was a very strong quarter for the engineering segment of our business. In fact, the engineering revenue through the first six months of fiscal 2021 has already surpassed that from all of fiscal 2020. This is a clear result of the strategic investments we have made over the last couple years. First, to enhance our sales and marketing resources in order to identify and capture more engineering pipeline projects. And second, to increase our technical capabilities to be able to execute on a larger number of pipeline projects simultaneously. As I'll discuss in a moment, This has also led to an increase in company-owned intellectual property developed in areas associated with these highly technical projects, which has helped to move forward another of our strategic goals. Engineering revenue is commonly a leading indicator of our future production opportunities. The more projects in the pipeline, the more opportunities we have to bring high-value, long-term production orders into our revenue forecast. One feeds the other. and the strength of our engineering portfolio is one of the sources of our optimism regarding overall future corporate growth. Let me comment briefly on a couple of the projects in the pipeline. First, as I mentioned already, our multi-camera colonoscope program is very close to final FDA clearance. It is our expectation that we will receive an order within the next few months, and we can officially move it from our pipeline to our production projects. Second, the relatively new pipeline project with the large defense aerospace company that we discussed the last two quarters continues to move forward. In the first and second quarters of fiscal 2021, we delivered initial prototypes and worked closely with this customer to address normal engineering issues that arise during a prototype stage production effort for parts like these that are technically very challenging. These prototypes have now been deployed. And while I cannot go into details due to confidentiality, all indications are that the prototypes performed very well. We continue to feel really good about the productivity and tone of the interactions we have had with this customer and believe we are well positioned to be a part of this program going forward. We expect to hear from this customer regarding production orders before the end of our fiscal year. As we have discussed on earlier calls, the medical device industry is undergoing a fundamental change as traditional endoscopes are being replaced by new designs with CMOS sensors in the distal tip. Many of these are being designed for single use. We continue to see this market expand rapidly as the rate of introduction of product-enabling image sensors by OmniVision, the market leader in medical sensor fabrication, continues to increase. We have a very good working relationship with OmniVision, and they have shared with us their product roadmap, which shows a sustained and increasing rate of new product introduction for the next couple years. These new sensors support smaller and higher resolution performance, which allows their use in more and more endoscopic and medical device applications. A number of large medical device companies, most notably Boston Scientific, have now committed publicly to pursuing single-use versions of endoscopes and related medical devices for use in many different surgical disciplines. Given our recent investments in sales and marketing, as well as technical capabilities targeted to this area, we are well positioned to take advantage of this market expansion and are beginning to see benefits already. Today, we have two active single-use projects in our engineering pipeline, and three others in our sales funnel being pursued jointly by our sales and marketing and technical sales teams. Currently, the most significant of these projects is the single-use ophthalmology program that we have discussed on earlier calls. This program is moving along nicely with regulatory filing still targeted for mid-2021 and a potential commercial launch in early 2022. Our experience over the last two years in this program and others has led to advances in IT development. We currently have three new patents pending and have developed a wealth of corporate know-how, all of which will position us well as we pursue other opportunities in this expanding segment of the medical device market. During the second quarter, we were notified by two customers who had put engineering projects with us on hold for various reasons about a year ago that both would be active again starting early in 2021. These projects, one in the area of robotic urological surgery, the other in the otoscopy space, come back into our pipeline with engineering work already partially completed and with the prospect of moving to production on an accelerated time frame. All told, the number of engineering pipeline projects is greater today than any time in the recent past, and our sales team continues to pursue additional opportunities. Consistent with our strategic plans, we continue to expand our engineering team, which is extremely busy and doing a great job executing on pipeline projects to move them to long-term production as quickly as possible. All of this activity validates our recent strategic investments and gives us confidence in the prospects for future growth. I'll now spend a few minutes summarizing and commenting on some key elements of the income statement and balance sheet. On the top line, revenue during the second quarter was $2.8 million, a slight sequential increase from the first quarter and relatively flat compared to last year's second quarter, which had record revenues. The breakdown was $1.9 million of production revenue during Q2 of fiscal 2021, which compared to $2.2 million in the previous quarter and $2.3 million in the second quarter a year ago. As I mentioned already, the primary driver here was a decrease in production orders for the cardiac otoscopy and defense programs, offset by improvements sequentially in the initial pre-commercialization orders for our colonoscope program. Engineering services revenue was $847,000 during the second quarter, which was a 44% increase from the previous quarter and a 77% increase compared to the second quarter a year ago. Some of this relates to timing of revenue recognition, which we have discussed on previous calls. However, the vast majority is due to a consistent level of higher demand for engineering services and our larger pipeline overall. Our gross margin was 31% for the second quarter compared to 35% in the previous quarter and 33% in the second quarter a year ago. Included in the second quarter cost of goods sold were certain costs associated with our single-use engineering pipeline programs that were greater than was originally budgeted, but were also closely related to intellectual property development in this area. Consistent with our strategic goal to increase such corporate IP, we absorbed these costs, leading to a reduction in gross margin. Without this investment, gross margins would have been approximately 35%. Clearly, there is still room for improvement, much of which will come from better utilization of manufacturing overhead through a rebound in growth in production revenue. Our near-term goal continues to be to get back to the 40% plus gross margin range. Operating expenses were $1.1 million during the second quarter of fiscal 2021, down approximately $400,000 as compared to $1.5 million during the second quarter a year ago, and up approximately $100,000 compared to the most recent first quarter of fiscal 2021. The reduction in operating expenses year over year continues to come from overall careful management of all operating costs, as well as limitations in certain activities, particularly in the area of sales and marketing travel due to COVID-19. The slight increase quarter over quarter was due almost entirely to timing of certain stock-based compensation expenses. We expect the level of operating expenses to be relatively consistent for the next couple of quarters. All told, on the net income line, we reported a gap net loss of $213,000 during the second quarter, including $157,000 of stock-based compensation. Backing out the stock-based compensation, as well as depreciation, amortization, and interest, our adjusted EBITDA for the quarter was a loss of just $20,000. as compared to an adjusted EBITDA loss of $254,000 in the second quarter a year ago. This improvement was due to our ability to maintain revenue levels even in the midst of the pandemic, while simultaneously significantly reducing operating expenses. Turning now to our balance sheet. Our cash balance at December 31, 2020, was $816,000, which compared to $901,000 at the end of September. This reduction in cash was accompanied by a decrease in working capital of approximately $42,000. The main change here was a $193,000 decrease in inventory, offset by about a $114,000 decrease in accrued compensation and a decrease of $54,000 in customer advances. We continue to show a liability for $809,000 on the balance sheet, which is labeled note payable to bank. That entry relates to the PPP loan we received in May of 2020. We expect that the loan will be forgiven based on the criteria of the program, but until it is, it will continue to show up as a liability. We believe our cash balance at the end of the second quarter continues to position us well to execute on our plan, but as always, we are prepared to take steps to reduce expenses if necessary. Before I take questions, let me recap briefly. COVID-19 has put pressure on many surgical procedures, and some of our production programs have not escaped impact. However, the fact that our revenue has remained steady and our engineering portfolio has expanded significantly should be positive indicators to our investors that our business is fundamentally well-positioned for future growth. The markets we are addressing are strong overall and are expected to emerge from the pandemic with significant growth rates. We are beginning to see signs of progress toward a return to normal surgical volumes, and when that occurs, we expect to be at significantly higher revenue levels when historical and new programs combine. We have done a great job of expanding our pipeline and advancing key projects even in the midst of COVID disruptions. We have a number of projects in what we believe are the final stages of pre-commercialization in the pipeline that is larger than at any point in our company's recent history. I believe the strategy we laid out to invest in sales and marketing, invest in engineering and grow our IP portfolio, invest in manufacturing advancements, and continue to explore partnerships and strategic transactions is beginning to yield benefits. While there are still challenges to be overcome, particularly relating to the impacts from COVID-19, I am pleased with the progress being made in the business to position us well in both the near and long terms. One final note, I will once again be available for virtual one-on-one meetings at the upcoming Litham Partners Spring 2021 Investor Conference which will be held on March 30th and April 1st. As usual, please contact Robert Bloom for additional information. And now I'd be happy to take any questions.
Operator
We will now begin the question and answer session. To ask a question, you may press star then one on your touch-tone phone. If you're using a speaker phone, please pick up your handset before pressing the keys. To withdraw your question, please press star then two. And at this time, we'll pause momentarily to assemble the roster. And again, if you'd like to ask a question, please press star then 1. Our first question today will come from Rick Teller. Please go ahead.
Rick Teller
Yeah, hi, Joe. I was looking over the Ross Optical website, and they... In their blog, they had a little article earlier in the month on optics for LIDAR. LIDAR has gotten a lot of publicity of late for its possible applications in autonomous vehicles and helping manage drones and other military things. I'm just wondering, certainly automotive is a market that you've never had any involvement in before. I'm just curious how you would get into that industry. So that's one question. And I don't know the technicalities of LIDAR, but to what extent the products that you have that would work for that, are they relatively proprietary or just where, where do you stand in that?
Joe Forkey
Yeah, that's a great question, Rick. So, so I think one of the things that we have to be very careful of here as still as a small company is to make sure that we maintain our focus on the things that we do best. And so I, Maybe taking the end of your question first, what I would say is that we don't see automotive per se as an area where we want to develop entire devices like we do for medical and like we do for defense. And the reason is because we have limited resources and we want to be very focused both in terms of sales and marketing and in terms of using our technical resources to advance our pipeline projects as efficiently as possible. That having been said, one of the benefits that comes from the Ross Optical Division is that the products that they supply are very general in nature. And so... even without specializing in some of the things that you need for the automotive industry to build entire devices, you can still, we can still participate in the growth of that industry and the growth of the use of optics in that industry by supplying the optics and by supplying subassemblies in some limited engineering services to some of the companies that will take the components or take the LiDAR assemblies that we build and then they will market them to the end user in the automotive space. So I guess, you know, to summarize what I would say is we don't have any plans to become LIDAR experts, but we do see LIDAR as a place where some of the components and subassemblies that have broad applicability across many industries can be used, and so we see that as a potential growth area for the Ross Optical Division.
Rick Teller
Okay, good. I was just curious about that. Thank you.
Operator
Yeah, sure. And our next question will come from David Smith with Berkeley Street Partners. Please go ahead.
Rick Teller
Hi, Joe. Thanks for the call today. Two questions. How would the revenue be recognized on the new projects that you hope to start working on, say, in the next few quarters in terms of the timing, how it might improve the gross margin and then the rev rec. So I know you've mentioned you'd spent about 400 basis points of the gross margin impact for the investment, but would that be an ongoing quarterly thing in terms of an impact on the gross margin? So two questions, revenue recognition on the projects and then also the gross margin investment.
Joe Forkey
Yeah, so there's a lot underneath those questions. So let me see if I can summarize in a fairly succinct way. So first off, on the gross margin question, we'll take the second one first. This was an investment really in one of our engineering pipeline programs. And it arose because the program went in a direction that required some additional work, and we had quoted this in a fixed price arrangement. And so it made sense for us to continue down that path, again, because of the IP that was associated with it and the long-term potential for the program. One of the things we have done to try and avoid those kinds of surprises is to quote more of our engineering pipeline projects on a time and materials basis. So That doesn't mean that we will do that in every single case. Our ability to negotiate with our customers a reasonable approach to the IP ownership is a critical part of our sort of business model with engineering programs, and that can get tied up in terms of the way that we structure the programs. But generally, we're moving in a direction of doing more projects on a time and materials basis so that we don't get caught with these kinds of things in these programs, which are in some ways a little less predictable than production programs. So the short answer to your gross margin question is that we do not expect that to continue indefinitely. The particular program we're working on will go a couple more quarters, so there may be a little bit of up and down, but quoting things on a time and materials basis I think in the long run will help to reduce that impact. In terms of the revenue recognition question, There are really two pieces here. I'm not sure which you were getting at, but I'll answer both of them. From the standpoint of the increase in the engineering pipeline, again, because we're doing more with time and materials, that helps to smooth out a little bit some of the revenue recognition bumps that you can get from engineering programs that rely on milestones before you can invoice and recognize revenue. If you're doing things on a time and materials basis, As long as you spent the hours in a particular quarter, you can invoice there. So we think that will smooth out some of the bumps in revenue recognition from the engineering. And because the level of engineering is growing so significantly, we think that will help to sort of smooth out the revenue recognition issues with engineering. In terms of the production programs, the programs that are going into production, predicting the production revenue is really tricky now because of the ongoing impact, as I talked about in my comments, the ongoing impact on our existing production programs of the pandemic, where, you know, the timing of the resumption of specific procedures is very difficult to predict. So there's going to be some lumpiness with those programs, but the new programs coming in I think are going to ramp more smoothly. They may ramp more slowly than they would have if they were going into production outside of COVID, but I still think they're going to ramp more smoothly. There are one or two defense programs that we've talked about, and those, generally speaking, once they start in production, I think will not be impacted by COVID. The COVID impact on the defense side of things is that sort of across the board, business and government and industry has all sort of slowed down So the timing of receiving those orders has been a little slower than we anticipated. But once we get those orders, those will continue to grow without the lumpiness that we expect from the medical device side of things.
Rick Teller
Okay. Sorry about that multi-part question.
Joe Forkey
No, that's okay. Did I answer it?
Rick Teller
You did. That was very helpful. There was a lot there I didn't quite realize when I started to ask that, especially about the production revenue recognition.
Joe Forkey
Yeah, no, it's a good question.
Rick Teller
The other question I had, though, was on the payroll protection plan, that forgiveness. What's the timing expected on that, do you think? You used to have a pretty good, maybe it was a couple million, $3 or $5 million revolver. Do you still have that in terms of liquidity capabilities?
Joe Forkey
We don't know. We don't have a revolving line of credit and have not for some time. Okay. In terms of the PPP, I'm going to let Dan answer that question because he's been looking at it.
Dan
In terms of the PPP, some of the forgiveness applications were put on hold as the second round of funding went out. The banks were more focused on that. I expect to be submitting that application within the next, I would say, four to six weeks. There's a new application that's coming out actually today. It came out on the 16th from what I understand from our bank. So we'll be processing that in the near term.
Rick Teller
Okay, thank you. And then given your cash position, you don't feel you need a revolver at this point. Is that maybe the correct assumption?
Joe Forkey
So The short answer is I don't think we need it. The longer answer is we're talking with folks about putting a line of credit in place. We have to look at what the right timing is given our financial performance and given the orders that are coming in and who the orders are coming from, you know, all those sorts of things. We would like to get a line of credit in place. I think it's a useful thing to have, but it's not something that we need essentially right now.
Rick Teller
Okay, thank you.
Operator
Sure. And again, if you'd like to ask a question, please press star then one. Our next question will come from Scott Fruchter. Please go ahead.
Scott Fruchter
Hey, how's it going? And congratulations on a terrific quarter. I think the way that you guys have navigated the pandemic and continuing to win engineering contracts is definitely a testament to just good management of the business. Thanks very much. Yeah, sure. I definitely see, I appreciate your comments around how the medical device industry is shifting towards consumables and single use. I think it's definitely bullish for where you guys are positioned. I have just two quick questions. The first is just around kind of whether or not Precision Optics has ambitions to list on a primary exchange at some point. And apologies if that's asked and answered in prior calls. our fund is kind of new to precision.
Joe Forkey
Yeah, so the answer to that is very simple and straightforward. It's yes. But I will add that we think it's important to uplist at the right time. And I think we want to be very careful not to rush it. The last thing we want to do is get on one of the other exchanges and then not meet every single one of their criteria and have to scramble to try and make sure that we do. So the short answer is yes, but we're going to be very deliberate in doing that and do it at the right time.
Scott Fruchter
Got it. Thanks for that, Culler. And just as a follow-up, just looking at kind of how revenue flows from engineering into production, it's very easy on our end, our analysts, to kind of model out kind of what net present value looks like on some of these contracts. But I guess where I'm having a bit more trouble or lack of transparency for us on our end is trying to better understand how Precision Optics plans to grow in the future. Is growth by acquisition a stated objective of the company? It seems like Ross Optical really worked out well for you guys. Is that something you're looking to replicate?
Joe Forkey
Yeah, so I think there's two comments to be made there. The first one is that our primary focus is on organic growth. We believe that as a technology company that has some really great technology and a really great team, that we can continue to grow organically independent of acquisitions. However, the Ross Optical transaction has been quite successful. I would say, by any measure, both from the financial standpoint and from the standpoint of the incorporation of the various parties, the employees working together, the ability to attract opportunities that I think neither of the companies could have attracted independently. And we also have recognized for some time now that the optics industry in general is pretty fragmented. So I guess what I would say is that finding other acquisitions is not the only way that we see towards future growth. And so we're very interested in continuing to look at acquisition opportunities, but I would say that we would be focused on doing them on an opportunistic basis. The last thing we want to do is force an acquisition because that can be more detrimental than it can be helpful. I would also add that we did see a pretty strong reduction in the amount of conversations in the industry around acquisitions, just like we saw a reduction in conversations about business in general back towards the beginning of the pandemic. I think that's recovered a little bit now, and we are hearing from more folks, and we are engaging with them and having the conversations, and if and when we find the right acquisition target, we won't hesitate to do another one if it looks positive, but we won't force the issue because we do have the opportunity for organic growth as well.
Operator
And there are no further questions at this time. I'd like to turn the conference back over to Joe for any closing remarks. Great. Thank you, Operator.
Joe Forkey
Thanks, everyone, for joining us on the call today. I look forward to speaking with many of you again during the one-on-one meetings and I hope we can all visit face-to-face again in the near future. I hope you all have a great evening and stay safe. Thanks.
Operator
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect your lines at this time.
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