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Operator
Good afternoon and welcome to the Precision Optics third quarter 2021 financial results call. All participants will be in 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 on your touchtone phone. To withdraw your question, please press star then two. Please note, this event is being recorded. I would now like to turn the conference over to Robert Bloom with Lithum Partners. Please go ahead.
Robert Bloom
All right. Thank you very much, Eileen, and thank all of you for joining us today to discuss the financial results of Precision Optics for the third quarter of fiscal year 2021, ended March 31, 2021. With us on the call representing the company today are Dr. Joe Forkey, Precision Optics Chief Executive Officer, and Dan Habegger, 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 both through 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 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 27A, the Securities Act of 1933 is amended, and 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 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 at filings with the Securities Exchange Commission. All forward-looking statements contained during this conference call speak only of the date in which they were made and are based on management's assumptions and estimates as of such date. The company does not undertake any obligation to publicly update any forward-looking statements, whether the 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.
Eileen
Thank you, Robert, and thank you all for joining our call today to discuss our third quarter fiscal year 2021 financial results. To lay out the agenda for today's call, I will first summarize a few key events of the quarter, including some brief commentary on the numbers and put it into the context of the strategic plans we have discussed on earlier calls. I'll then talk a bit about the status of our commercialized programs and pipeline projects, including some industry trends we are seeing around single-use products and how Precision Optics is positioned to address this segment of the industry. Then I'll wrap up with a recap of the financial results and, as always, take any questions. At a high level, the third quarter results were in line with the expectations we anticipated on our call back in February. We continue to see reduced revenue levels from products that were in production prior to the start of the pandemic, even as there are strong indications that we have moved beyond the immediate acute impact and are starting to climb back to pre-pandemic levels of production. We also continue to benefit from an extremely strong and robust engineering pipeline that has helped to cushion the impact on revenues due to lower production levels. Because the timing of revenue from engineering is more choppy, in part due to limited predictability of design timelines, but also due to discrete milestone requirements for revenue recognition, the extent to which the higher engineering revenue offsets the lower production revenue can vary significantly from quarter to quarter, even as our overall business level continues to increase. In Q3, we saw an uptick in production volumes for our cardiac program, offset by a decline in our otoscopy program. Overall, production revenues were $1.9 million in Q3, essentially flat compared to the previous quarter, but down about $250,000 compared to Q3 of a year ago, a clear impact of COVID-19. On the engineering side, we continued the strong positive trends we have seen in recent quarters with revenues increasing 162% year over year, but due to timing of discrete phases of work, down 35% quarter over quarter. As a point of reference, our year-to-date engineering revenue at the end of Q3 of nearly $2.0 million has already far surpassed the $1.4 million of engineering revenue for all of fiscal 2020. This is due in large part to three of the four areas of strategic investment we have talked about in many of our recent calls. Increase in our sales resource has led to the identification of more opportunities. Increase in our technical capabilities, including generation of IP, as well as technology development and high volume production processes, has made us a more attractive partner for new projects and has led to the conversion of more of the sales opportunities into revenue bearing engineering pipeline projects. We also continue to pursue our fourth strategic area of focus, which is to explore possible strategic transactions to increase the overall size of the business and benefit from economies of scale. and to augment our existing capabilities and enhance our portfolio of offerings to our customers. While discussions with potential partners slowed to a virtual halt during the early days of the pandemic, we are now back talking to many potential partners on a near continuous basis. As I have commented before, we cannot run the business assuming a strategic transaction will occur at any particular time. but we still believe there are significant opportunities in an industry that is highly fragmented and would benefit from consolidation. I will touch more on our new business pipeline in a moment, but one thing is clear. The market opportunity for micro-optic and 3D-enabled devices and components in the medical and defense and aerospace industries continues to be robust. We are seeing large established industry players and well-funded startup companies looking for enabling technology partners such as Precision Optics that can make next generation products a reality. This gives me great optimism in our strategy and in the future of Precision Optics. The status of our major production programs was predominantly unchanged from what we reported back in February. We saw an uptick in production volumes during Q3 for our cardiac program, following a prolonged slowdown in production volume throughout much of the past 12 months, with volumes now back to where they were pre-COVID. These elevated levels will continue through the end of the fiscal year. The end market for this product has begun to recover, but it will take some time for it to return to pre-COVID levels worldwide. We are in close communication with our customer and will continue to monitor the recovery and adjust our shipments to help them better align their inventory levels with sales while continuing to support the ongoing operation of our production line. As we stated last quarter, we held back on increasing inventory of components for our otoscopy product, pending better end market visibility for the product as our customer works through the impact of the pandemic. While the market is beginning to show some early signs of recovery, the timing and extent of future order requirements are difficult to predict. Our relationship with this customer remains very strong, however. They have recently brought us in on another program they are developing to evaluate how we might be able to help them. While the size of this new program is not of the same magnitude as our main project, it validates the strong partnership we have developed. At the end of the day, we believe the long-term prospects for their products remain very positive, and that our position as their sole supplier is solid. We look forward to working closely with them to make their product a success for both of our companies. In our production defense program, based on recent discussions with our customer, we continue to anticipate a substantial reorder very soon. 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. We continue to wait anxiously for final FDA 510 clearance for our customer developing a multi-camera colonoscope, which is enabled by the custom micro cameras we provide. In recent discussions, our customer has reiterated their belief that they are on track for 510 clearance, although they expressed frustration at the slower than usual pace of FDA interactions, a consequence they and others attribute to the agency's prioritization of COVID-related applications. Despite the delays, our customer has a robust go-to-market plan with a Salesforce demo systems and console production facility in place. We are confident that soon after they receive clearance, we will see additional production orders for our cameras. 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 during the quarter. All told, from our production programs, we reported revenue of about $1.9 million during the third quarter, compared to $1.9 million in the second quarter sequentially, and $2.2 million in the year-ago third quarter. As we look to the fourth quarter, we see all of our current commercialized products running at relatively stable rates. Let's turn now to our engineering developments and pipeline, which is as large and robust as it has been at any time in recent history. As I mentioned already, this increase has been driven largely by the strategic investments we have made in sales and marketing engineering, and unique production capabilities over the last couple of years. It is also the result of the ongoing growth of end market opportunities for micro optic and 3d enabled devices and components in the medical and defense and aerospace industries. One of the main parts of the medical device market that we have discussed before, and that continues to grow and expand is the single use endoscope market. It has been five years now since Boston Scientific launched LithiView, essentially the first single-use endoscope offered by a major medical device company. Their success over the following few years with this product and other single-use products has now led to a major expansion in the single-use endoscope market in general, as more and more large medical device companies, as well as well-funded startups, now consider a single-use option for nearly every new procedure in many existing procedures. Along with the increase in market demand, the increased availability of small CMOS sensors, off-the-shelf electronics modules, and software packages have also helped to accelerate market adoption of single-use products. Anticipating this market growth, we have been pursuing customer engagements as well as internal research and development in the optics and integration technology needed for these devices. Engagements with customers have been motivated, obviously, by a desire to capture engineering and production revenue, but also to gain experience, know-how, and IP related to the unique requirements of single-use endoscopes. These types of endoscopes require design approaches as well as manufacturing tools and procedures that are primarily focused on low material costs and or low manufacturing touch time, while still satisfying safety, efficacy, and regulatory requirements. This is a change in mindset from design and manufacturing approaches used historically for medical endoscopes intended to be re-sterilized and reused hundreds or even thousands of times. The capability we have developed in this area is significant and unique enough that we are having good success not only in attracting new customers for single-use endoscopes, but also in doing so with order terms that allow us to maintain ownership or access to IP and know-how developed during our engagements. A good example of the type of important know-how in this area is the ability to design a product and associated assembly procedures so that they can be built using automation. Through our hands-on experience with these types of products, we have learned that in many cases, the return on investment for moving to full automation is not justified until volumes get to the 30,000 to 50,000 units per year level. Many of our customers launched their products with initial volume expectations of 10,000 units per year and some uncertainty in the anticipated rate of adoption. To bridge this gap, we have developed design and production approaches, including unique fixtures, that result in very low manufacturing touch time at volumes of 10,000 units per year, even without automation. These approaches can be used at initial lower volumes with the transition to more automation as volumes increase and sales forecasts become more certain. Because there may be common subassemblies for many different single-use endoscopes, we are also mindful of the possibility of aggregating the needs of multiple customers to get to a level of POC subassembly production that would warrant the use of fully automated systems. As an aside, this represents a product strategy for POC, the sale of a consistent product, be it finished scope or sub-assembly, to multiple users. In this context, all of our partners will benefit from POC's productization efforts as we will drive down their costs and support the business case for their own single-use products. As many of you are aware, the number of projects that are moving through our engineering group not only increases engineering revenue in the near term, but also increases the pipeline of candidates for long-term commercial production. As I just explained, we make a concerted effort to preserve ownership of the intellectual property in key areas associated with these highly technical projects. The strength of our engineering portfolio is one of the sources of our optimism regarding overall corporate growth. And to reiterate the numbers behind this, Our engineering revenue for Q3 was up 162% compared to the same quarter last year and year to date revenue has already far surpassed that from all of last year. Let me comment briefly now on just a couple of the specific projects in the pipeline. The project with the large defense aerospace company that we discussed the last few quarters continues to move forward. We have 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. The initial prototypes have now been deployed and we have been told that an order for a final set of prototypes is imminent. If all goes well with the next round of prototypes, this project could move to production early in fiscal 2022. Within our ophthalmology program, we have moved from the design stage to the validation stage. As a reminder, this is a single-use disposable device and the one farthest down the development path in which precision optics components are embedded. The project is moving along nicely with regulatory filings still targeted for later this calendar year and a potential commercial launch in early 2022. There have been some increased costs within this program. largely surrounding our desire to advance IP development, where we currently have three new patents pending and have developed a wealth of corporate know-how. This is a great example of the general approach we take with these single-use programs that I described a minute ago, and we believe that the added investment in this case will position us well as we pursue other opportunities in this expanding single-use endoscope market. It may be helpful to note we have incurred these additional costs in costs of goods sold as they related to the delivery of this project, despite the future benefit we may receive through the development of intellectual property. Other projects in our engineering pipeline include an augmented reality system for use in abdominal surgery with a well-funded startup, and a second otoscopy-related project with a large medical device company. both of which continue to move forward nicely. We also have multiple additional projects, many for single-use endoscopes, that are currently in initial proof of concept and early prototype stages with a number of significant customers. 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 third quarter was $2.5 million, a slight increase from the third quarter of last year and down slightly on a sequential basis. The breakdown was $1.9 million of production revenue during Q3 of fiscal 2021, which compared to $1.9 million in the previous sequential quarter and $2.2 million in the third quarter a year ago. As I mentioned already, the primary driver here was the decrease in production orders for the otoscopy and defense programs, offset by improvements sequentially in the cardiac program. Engineering services revenue was $550,000 during the third quarter, which was a 162% increase from the third quarter of a year ago and down about $300,000 from the second quarter. The change sequentially relates to timing of revenue recognition, which we have discussed on previous calls. However, the overall upward trend we have achieved this fiscal year is due to a consistent level of higher demand for engineering services and our larger pipeline overall. Our gross margin was 33% for the third quarter, compared to 31% in the previous quarter and 34% in the third quarter a year ago. We continue to make what I believe are important investments in our single-use engineering pipeline programs, which are included in the cost of goods sold, leading to a reduction in reported gross margin. Without these added costs, gross margins would have been approximately 38%. Clearly, there is still room for improvement, much of which will come from more complete 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 third quarter of fiscal 2021, down approximately $200,000 compared to the third quarter a year ago, and roughly flat compared to the most recent second 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. We expect operating expenses to be relatively consistent for the next few quarters. I am sure most of you will notice the PPP loan forgiveness that we received during the quarter. That forgiveness is recognized as other income on the income statement in the amount of $809,000. The offset to the income statement entry is the removal of this amount as a liability on the balance sheet. We are pleased to have utilized the loan in the manner in which it was designed to maintain payroll during the difficulties faced over the past year. All told, on the net income line, we reported a gap net income of $552,000 during the third quarter. Excluding the PPP forgiveness, net income would have been a loss of $257,000. Backing out the $97,000 of stock-based compensation, as well as depreciation, amortization, and interest, our adjusted EBITDA for the quarter was a loss of $136,000. as compared to an adjusted EBITDA loss of $360,000 in the third quarter a year ago, an improvement of approximately $225,000. Adjusted EBITDA for the nine months ended March 31st, 2021 was a loss of just under $50,000. Given the challenges of the last nine months, I think the team has done a tremendous job managing through the pandemic and setting the stage for growth in the future. Turning now to our balance sheet. Our cash balance at March 31st, 2021 was $782,000, which was down only $34,000 compared to the balance of $816,000 at the end of December. It's important to note that we did make a $167,000 earn out payment during the quarter to the previous owners of Ross Optical. The oncoming team at Ross Optical has done a great job, and we were pleased to be able to make this payment. We believe our cash balance at the end of the third 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 the major elements of our strategic plan that we have discussed the last few quarters. Number one, growing our sales capabilities and capacity. Number two, investing in our technical resources and developing our own intellectual property. Number three, investing in and updating our production capabilities, for example, to address the single-use market. And fourth, augmenting our own skills and programs via external partnerships or acquisitions. Overall, I am pleased with the progress made along these efforts. Precision Optics has created a strong position in micro-optics and 3D robotics, particularly within the medical device and defense and aerospace markets. We have created an end-to-end solution that allows visionary companies to leverage our capabilities to bring to market next-generation applications that they would otherwise be unable to accomplish on their own. Due to the proactive measures taken to increase investment in sales and marketing and research and development, our pipeline is as robust as it has ever been. We have a number of projects approaching near-term commercialization from which we anticipate production orders soon. While there continue to be some near-term disruptions to certain surgical procedures due to the pandemic, the markets we are addressing are strong overall and are expected to emerge with significant growth rates. Operationally, we have managed the business efficiently, and I believe we are well positioned to see growth resume as the surgical markets return to normal and our pipeline of projects turn into long-term production contracts. One final note. I will once again be available for virtual one-on-one meetings at the upcoming Lithium Partners Summer 2021 Investor Conference, which will be held June 14th to June 16th. As usual, please contact Robert Bloom for additional information. I thank you for your attention, and I'd be happy to take any questions now.
Operator
We will now begin the question and answer session. To ask a question, you may press star then 1 on your touchtone phone. If you are using a speaker phone, please pick up your handset before pressing the keys. To withdraw your question, please press star then 2.
Robert Bloom
Hey, Joe and Dan, maybe while we're waiting to see if anyone would like to ask a question, I want to jump in on two topics here in particular. The first one here, you went into some good detail as it relates to the IP surrounding single use, but any additional color that can be added there on some of the specific applications? Yeah, sure.
Eileen
So I guess I would think of intellectual property related to single use really related to anything that we're working on. as really falling into two categories. One is patentable innovations. So these are things that we believe are novel and innovative. And importantly, that we believe someone else, when looking at our final work product, the finished device, would be able to reverse engineer. So anything that falls in that category we would put in the category of patentable IP. There are other things that have to do with the way that we do things, the way that we manufacture things, the particular way we design tools and fixtures that we would prefer to keep secret that we would consider as trade secrets or corporate know-how. And both of these are pretty important for the single-use market in particular. So I commented on or referred to the fact that for one program, the outcome was a pretty significant amount of corporate know-how and also three very specific patent applications. Without going into too much detail and taking too much time, I'll just give you a flavor of this. The three patents that we have applied for deal with very specific ways that we put together optical fiber applications. And in some cases, it has to do with the way that we put illumination fiber into these single-use endoscopes. And what we've discovered and come up with is a very efficient way of doing this so that we don't have to spend as much time polishing the ends of the fibers, grinding and polishing the ends of the fibers. Traditionally, with reusable devices, manufacturers would take anywhere from, you know, three to five to ten minutes to polish the ends of the fibers on these endoscopes where the fibers are emitting light. And one of the things that's really important is to change the mindset of the people who are working on designing these projects because even two or three minutes, can have a big impact on the overall cost of single-use scopes. So we've come up with ways to manage the fiber in a completely different way of processing it so that we save that time. Similarly, we have another patent that deals with the way that you hold, again, an illumination fiber that's used for transmitting laser power to ablate tissue. While we're using this certain geometry that helps to reduce the cost of the mechanical components that hold this fiber, we're doing this for a particular application where certain parts of the body need to be ablated. It can be used across the board in any place that you'd want to ablate tissue, which is a large fraction of the number of places you'd like to use endoscopes. So those are the kinds of things that we're talking about when we talk about patentable IP. The trade secret or know-how IP comes more in the area of understanding and figuring out creative ways to design the product with an eye towards the manufacturing process and with an eye towards the particular kinds of fixtures that we've made before that, again, may only save a minute or two of time, but when you're talking about trying to drive the cost of these single-use devices down as low as possible, saving a minute or two of time on 15 or 20 different procedures that sort of stack together to build the entire device can very quickly turn into 20 or 30 minutes, which can be a significant change in the touch time and the overall cost of the devices. So those are sort of the two categories and a couple of examples of the kinds of things that we've been doing with the IP around single use.
Robert Bloom
All right, that's helpful, Joe. Thank you. The other area I wanted to touch on here a bit, and again, you went into, I think, some good detail as it relates to the end markets for single use and some of the growth that's happening in those markets. Anything you can expand on a bit further as it relates to the aerospace and defense markets and the applications where it is that you... are providing products to the programs.
Eileen
Yeah, sure. Yeah, thanks for that question, Robert. So one of the difficulties we have with the defense aerospace market is that many times our customers choose not to or legally are unable to tell us what the final product is that our pieces are going into. But we have talked enough with folks in the industry and we've been involved with enough programs that we have a general sense of the place where our products fit inside of the overall defense and aerospace industry. And in particular, we understand, even if we don't know what all of the end products are, we have a pretty good understanding of some of the motivating factors that will drive our customers to the particular capabilities that we have, which, remember, have to do an awful lot with making small optics. And for POC in Massachusetts, historical POC, small optics means a millimeter or smaller, maybe two or three millimeters or smaller. But even the small optics that Ross Optical works on, which I would say are 10 or 12 millimeters or smaller, still fall into the category of optics that are on the smaller side and optomechanical and electro optical systems that are on the smaller side of, of what you would look at. If you looked at the full range of optical devices that can be used for communication or imaging or targeting or transmission of, of, uh, laser signals, those sorts of things. So the, the, the main motivation here is, or the main question is, um, are there places in the defense aerospace industry where smaller size optics are important? And so, again, without going into too much detail, there are some aspects of things that are done in defense and aerospace that fit very well with the idea that you'd like to have smaller sizes. So with aerospace, it's very clear. Anything you put on a plane or a launch vehicle or a satellite, there's a cost to lifting the weight of whatever it is that you're moving. And there's a cost in the overall size of those systems. And so there's a clear motivation for the system designers to go to smaller size on aerospace systems where there's a fuel cost and therefore a dollar cost to making anything any larger than it needs to be. And on the flip side, there's a savings in any case that you can make things smaller. In the defense industry in general, there's, again, a desire to make things wherever you can smaller. And there's even an acronym that's become fairly popular in the defense industry now called SWAP, which stands for size, weight, and power. And it refers to a reduction in size, weight, and power. So power, of course, is in the electronic side of things. But size and weight speaks very directly to the ability to design and manufacture optical systems, optomechanical systems, and electro-optical systems with smaller size and therefore smaller weight. And that's exactly the space that POC has been working in for a long time and that Ross Optical is expert in sourcing components for. So really it comes down to the fact that both in defense and in aerospace, in a very general way, Again, without knowing all of the end uses, in a very general way, there's a strong desire to reduce the size of systems, and that fits very well with the core competencies of POC.
Robert Bloom
All right. Thank you for that, Joe. Eileen, I don't know if there are questions, but if you want to prompt one more time, and then we can sit the same questions. I'll turn it over to you.
Operator
And if you do have further questions, please press star and then 1 to join our queue. Seeing no further questions, I would like to turn the call back over to management for any closing remarks.
Eileen
Thank you, Eileen. And thanks, everyone, for joining us on the call today. I look forward to speaking with many of you again during our virtual one-on-one meetings in June. And I look forward to the day when we can all visit face-to-face again in the near future. Thank you, everyone. Have a good evening and stay safe.
Operator
The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.
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