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Operator
Good afternoon, everyone, and welcome to the Precision Optics Report's third quarter fiscal year 2023 financial results conference call. All participants will be in a listen-only mode. Should you need assistance, please see 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 and one. To withdraw your questions, you may press star and two. Please also note today's event is being recorded. At this time, I would like to turn the floor over to Robert Bloom with Lithium Partners.
Robert Bloom
Sir, please go ahead. All right. Thank you very much. And as the operator indicated, thank you for joining us today to discuss Precision Optics third quarter fiscal year 2023 financial results for the period ended March 31, 2023. A couple of notes here 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 dial-in instructions. The details of both were included in today's press release. Also, 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 of the Securities Act of 1933 as amended and Section 21E of the Securities Exchange Act of 1934 as amended, and such forward-looking statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements describe future expectations, plans, results, or strategies and are generally preceded by words such as may, future, plan or planned, will or should, expected, anticipates, draft, eventually, or projected. Listeners are cautioned that such statements are subject to a multitude of risks and uncertainties that could cause future circumstances, events, or results to differ materially from those projected in the forward-looking statements, including the risk that actual results may differ materially from those projected in the forward-looking statements as a result of various factors and other risks identified in our filings with the Securities Exchange Commission. All forward-looking statements contained during this conference call speak only as of the date in which they were made and are based on management's assumptions and estimates as of such date. The company does not undertake any obligation to publicly update any forward-looking statements, whether as 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, Precision Optics. Joe, please proceed.
Joe Forkey
Thank you, Robert, and thank you all for joining our call today to discuss our third quarter fiscal year 2023 financial results. On the whole, I am pleased with the continued progress made during the quarter, with revenue up 9% compared to the same quarter a year ago, as we began a ramped-up production for a number of programs in the last 12 months. Looking specifically at our production revenue, we were up 17% compared to the same quarter a year ago, and up 2% sequentially. This is a new all-time record for production revenue. This increase has been driven by the maturing of a number of programs as they have moved from the development pipeline to production, as well as increases in existing production programs as they gain traction in their markets. With this kind of organic growth, combined with the increase in company size from our two recent acquisitions, it has become clear that to continue to operate effectively, we needed to enhance our executive management team. I'm really pleased that we were able to recruit Mahesh Lawande to join POC in the newly formed role of Chief Operating Officer. Mahesh has a really impressive resume, which is filled with experience ideally suited to helping us drive development speed, production volume, acquisition integration, and overall operational efficiency as we move forward. Bringing on Mahesh is an indication of our recognition that we have reached a stage as a company where we need to optimize our business model and drive an inherent level of profitability and consistency. We have also initiated the recruitment process for a permanent chief financial officer, and that process is moving along quickly. Our enhanced business model, where we apply our deep technical knowledge to support a customer from the early design phase all the way through mass manufacture, continues to show great signs of success. Not only does this model leverage our capabilities within micro-optics, 3D endoscopy, and digital imaging to bring new and innovative products to the market, it also creates long-term customer relationships where our technology becomes an integral part of these products, and we become a critical supplier to our customers. So as they grow, we grow with them. We are pleased to have another quarter with increasing production revenue since this is ultimately the driver of top-line growth. Equally important, however, is the size of our development pipeline, which is the source of future production programs and therefore the best indicator of long-term growth potential. Our product development pipeline is as large as it has ever been. In April, we announced the addition of another major development program to our portfolio, and we are now in discussions with customers pretty much continuously about other new significant programs. Whereas in years past, our largest development programs ran in the hundreds of thousands of dollars, you can see from the recent announcements we are consistently seeing programs now in the millions of dollars. This is due in large part to our expanded capabilities that allow us to develop a more complete product that is higher on the value chain. These new programs will backfill the projects that recently transitioned to production or that are currently in our so-called transfer phase, which is the development phase between finalizing product design and beginning long-term production. Today, we have four programs in transfer phase with production starts expected in the next three to 12 months. The exact timing of these production starts is difficult to predict, but we expect them to continue our recent trend of overall revenue growth. This gives us great optimism for the future. Recognizing that the engineering work we do is the core competency that allows us to attract customers, develop new technology, design and build next-generation products, and ultimately drive production revenue, we made the decision during the third quarter to continue development on a few programs that had run over budget and to share in the excess costs with our customers. We did this both to support our long-term relationships with these customers, but also to perfect technologies that we believe will be useful for future projects and will generally support our overall competitive position in the market. The cost overruns that we absorbed were caused by an underestimation of the amount of work that would be required to complete certain tasks during the development of these products. While it is always difficult to predict with certainty how much time will be required to invent new products and technologies, the issues we experienced in the third quarter were compounded by the process inefficiencies associated with having multiple POC sites working on the same projects. We have been working over the last few quarters to update our tools and procedures as we integrate our recent acquisitions. Driving completion of this process improvement is a clear near-term priority for Mahesh, our new COO. The cost overruns totaled approximately $200,000 during the third quarter, which is equivalent to approximately $300,000 in engineering revenue we could have charged customers. Excluding the impact of these costs, the third quarter would have looked very similar to the first and second quarters on a revenue, gross profit, and adjusted EBITDA basis, excluding the $600,000 of revenue associated with our licensing agreement in the second quarter. As we've talked about on previous calls, we are focused this year on both top line and bottom line growth. We still expect a solid 20% or more increase in top-line revenue for the year, and while the bottom line will show improvement, we recognize there are still opportunities to further increase profitability. As a company whose revenue has grown by multiples over the last several years, we recognize the need to demonstrate a level of operating profitability that supports additional investment in our capacity and capabilities. In this fiscal year, we made improvements in our gross margins, but we require a level of operational maturity to be more profitable more consistently. I believe we have talented people, new and existing, within POC capable of delivering this goal. All in all, with production revenue at record levels, a development pipeline as strong as it has ever been, an updated executive team in place, and strong interest from the marketplace, we believe we are well positioned to finish the fiscal year on a strong note and to move into fiscal 2024 with a great opportunity for ongoing growth in revenue and profitability. I'd like to spend a few minutes now on some specifics. We currently have half a dozen major programs contributing to production revenue, plus a large number of contributions from our Ross Optical Division that supply smaller orders to many customers. Production revenue during the third quarter was $3.7 million, an increase of about $70,000 from the sequential second quarter, or 2%, and up about $500,000, or 17%, from the third quarter a year ago. Again, this was a new record for quarterly production revenue. The key drivers during the quarter were our new defense aerospace production program, our historic defense program for which we received a significant follow-on order in December, our cardiac atrial fibrillation program with CardioFocus, our spinal program for a major long-time customer we have worked with for over 10 years, and two other legacy endoscope products, one from historic POC activities and one from our Lighthouse acquisitions. Our newer defense aerospace program contributed revenue during the third quarter of about $425,000. This is the tail end of two production orders that we have delivered against over the past year. As we talked about last quarter, we are currently working with this customer on a next generation redesign. This redesign will impact production during the fourth quarter, but we expect it to ramp back up in the first half of fiscal 2024. We are pleased with the overall development of this program to date and look forward to a long, profitable future with this customer. Our defense program that started production prior to the pandemic slowed down dramatically during the pandemic and since has recovered, is now in full swing with deliveries against the largest order we've received for this program to date. In December, we announced a $2.6 million order for this product. In the third quarter, we delivered approximately $263,000 against this order as we ramp up to a rate that we believe will be in the half-million-dollar range per quarter as we work through this order and anticipated follow-on orders. We also successfully executed against our $2.4 million order from a large medical device company for spinal surgery applications. We will have fourth quarter revenue associated with this restocking order, after which we expect a temporary slowdown while the customer delivers product to the market. We have worked with this customer for more than 10 years and fully expect to ramp production up again in the future. Production programs can ebb and flow based on timing and success of the product we produce in the market. I just referred to programs that will slow or pause for various reasons, such as design changes or inventory management. Concurrently, new programs will come online and we see a handful of programs currently going through our transfer phase that we expect will launch into production between Q1 and Q3 of fiscal 2024. Specifically, we are expecting initial production contracts for the single-use ophthalmic microendoscope, a laparoscope for robotic surgery, an ophthalmic scanning device, as well as the reinitiation of the otoscopy program, which went on hiatus during the pandemic. This last program is one for which we already received the new production order for $2.3 million, which we announced in January of this year. There was no revenue associated with this product in the third quarter, but we expect production to ramp in the fourth quarter and beyond to a steady level of approximately a half million dollars per quarter. On the whole, we expect total production revenue levels to remain steady over the next quarter or two and expect we will exceed our goal of 20% top-line growth for fiscal 2023. Based on customer expectations and timing of programs, including those that may temporarily slow and those coming online, we anticipate strong quarterly growth in production as we enter the new fiscal year. Our engineering revenue during the third quarter was $1.4 million, which was down about $300,000 from the sequential second quarter and down $250,000 from last year's third quarter. The primary reason for this is the cost overruns on certain programs for which we agreed to absorb the cost instead of billing it to our customers. Had we billed for this work, our engineering sales would have been right in line with the levels in recent quarters. I point this out because it's important to understand that our engineering group is running at a high utilization rate, despite what appears to be a pullback in revenue in the third quarter. There is no slowdown in what our development team is doing. And in fact, we are continually looking at ways to ramp up our engineering capacity to meet the constant inflow of inquiries from new and existing customers. As we discussed last quarter, we entered into a technology licensing and royalty agreement for the new single-use ophthalmic product we have jointly been developing with our customer for the last few years. This agreement was unique for Precision Optics in many ways, providing both us and our customer with a number of benefits. As you may recall, we are initially producing the product in our Gardner facility, and the customer may at some point in the future transfer production to their own or a third-party facility using tools and fixtures that we have designed and validated. In return, they have agreed to pay us royalties for an agreed upon period of time if and when production is moved out of a POC facility. We are, in effect, being paid a royalty not only for the IP and the product design, but also for the IP and know-how in the production process. Importantly, we maintain ownership and control of these technologies and have broad leeway to use these technologies on other products. As part of this agreement, we received a one-time payment of $600,000 upon execution of the agreement. This payment was recognized as revenue during the second fiscal quarter. During the third quarter, we recognized development revenue, which is independent of future royalties, of approximately $300,000 from this program. This program is one of the ones that is in transfer phase now, and we expect to begin production in Q2 or Q3 of fiscal 2024. This agreement is important because it not only paves the way for this first single-use program to launch into production, it also serves as a template for engaging with other potential customers in the single-use market, which we estimate is growing at a rate of 15% to 20% per year. Last week, we announced a $1.5 million follow-on development order for our single-use urology program. This follow-on order was approximately twice the size of our original development order and demonstrates the quick progress we are making on this product. It also is a great example of the programs we can attract with the expanded technical breadth we have due to the combined capabilities of both precision optics and lighthouse imaging. Between our single-use ophthalmology micro-endoscope and our single-use urology program, we have made great strides to position ourselves as leaders in this rapidly growing market, which presently has few competitive players when it comes to the unique capabilities we provide within micro-optics and digital imaging, particularly for programs that have customer design requirements that cut across multiple engineering disciplines. It has taken us some time to make the technological advancements to get to this point, and there will still be advancements yet to come, but I believe that we are in a great position to be a leader in this space. Let me comment now on some of the financial highlights of the third quarter. Revenue for the third quarter was approximately $5.0 million, which compares to $4.7 million in the same quarter a year ago, an increase of approximately 9%. Production revenue was a record $3.7 million, while engineering revenue was $1.4 million. Our gross margin was 34.4% for the third quarter, compared to 37.2% in the same quarter last year. As we talked about, the impact of the lost engineering revenue of about $300,000 associated with the costs we absorbed impacted gross margins by approximately 4%. Without the effect of these overruns, gross margin would have been approximately 38% during the third quarter, in line with our target of 40% gross margin. Operating expenses in the third quarter were $2.2 million compared to approximately $1.8 million in the previous year's third quarter and $2.0 million in the sequential second quarter. On a cash basis, excluding depreciation and amortization, as well as stock-based compensation, operating expenses were approximately $1.7 million, compared to approximately $1.5 million in the third quarter of last year and $1.7 million in the second quarter of this year. The year-over-year increase is mainly due to increases in sales and marketing expenses as the market has recovered from the pandemic, as well as increased corporate costs associated with our uplisting to NASDAQ. We continue to keep our operating expenses relatively stable while still making targeted investments, particularly in sales and marketing, to continue to grow the business. Net loss during the third quarter was $398,000 compared to a net loss of $114,000 in the third quarter of last year. Again, the biggest delta here is the engineering cost absorption along with non-cash stock-based compensation expenses. During the third quarter, we had a one-time pickup in other income of $143,000. This is related to a negotiated modification of our earn-out agreement with the sellers of Lighthouse Imaging, whereby we reduced the second-year maximum earn-out potential from $750,000 to $600,000, along with a modification of the earn-out targets. This modification reflects our desire to maintain the incentive for Lighthouse to push development programs through to production, while also recognizing that many of these programs have taken longer to get to production than Lighthouse anticipated. The earn-out structure was originally included in the acquisition transaction, in large part to take into account the difficulty in predicting the time it takes to develop new medical devices. We remain optimistic that many of the programs brought by Lighthouse will progress into production, but they are clearly taking longer than was forecasted. It's important to reiterate here that the main purpose of the acquisition was not to acquire a book of business with specific customers, but to combine the two technical teams to create a combined company that is better able to compete in the medical device marketplace particularly in the segment of the market that requires both optical and electronic technical expertise, a subset of which is the single-use market. As I mentioned on previous calls, there is no doubt that this goal of the acquisition has been completely successful, and we continue to attract new business that neither of the companies could have competed for independently. Adjusted EBITDA, which excludes stock-based compensation interest expense, depreciation, amortization, other income, and acquisition expenses was positive $9,000 for Q3 compared to $218,000 for the third quarter a year ago. Once again, the delta is largely the engineering cost absorption. Our cash balance at the end of the third quarter was slightly over $600,000, which was up a couple hundred thousand dollars from the end of the second quarter and about flat relative to the start of the fiscal year last June. Accounts receivable were down compared to the end of the second quarter as we have been successful in collecting some, although not all, of the overdue receivables we discussed last quarter. We will continue to manage cash aggressively as we accommodate the growth in the company's working capital needs. As we look to the fourth quarter of fiscal 2023 and beyond, We expect our run rate of overall production revenue to be steady or slightly higher compared to Q3, as some projects slow down or stop, but new projects come online. We expect Q4 to look more like Q3, absent the impact of the cost overruns we discussed. Overall, we expect solid revenue growth to exceed our target of 20% for this fiscal year. As we look into fiscal 2024, Based on the program traction we have and new programs coming into development, we expect to continue to aggressively grow revenue while improving our total business model to increase operating margins. We will continue to invest in sales and delivery capacity to take advantage of opportunities we see in the market. I thank you all for your continued support of Precision Optics, and I'd now be happy to take any questions.
Operator
Ladies and gentlemen, at this time, we'll begin the question and answer session. To ask a question, you may press star and then 1 on your touch-tone telephone. If you are using a speakerphone, we do ask that you please pick up the handset before pressing the keys. To withdraw your question, you may press star and 2. Once again, that is star and then 1 to join the question queue.
spk04
We'll pause momentarily to assemble the roster. Once again, if you would like to ask a question, please press star and one.
Robert Bloom
Hey, Joe, this is Robert Bloom here. While we wait to see if there's any questions that come in, a couple of topics I thought maybe you could expand on here for us. First, we've talked a lot about single use here. Maybe talk a little bit about the mix of single use versus traditional medical devices versus maybe some of the defense opportunities as a whole.
Joe Forkey
Yeah, sure, Robert. So it's true. A lot of what I talked about in the remarks today had to do with single use. This is a part of the minimally invasive surgical market that's growing quite dramatically because of the innovations in technology that now make single use imaging devices feasible, whereas they weren't feasible even five years ago or seven years ago. So there's a lot of excitement around single use. That part of the market is growing two to three times faster than the reusable part of the market. But it is true that many of our opportunities still exist in the reusable space. And in fact, three of the four programs that I talked about that are in our transfer phase right now are in the reusable space. So we still see that as a significant part of the market where we have significant opportunities. I think there's There's a little more excitement over the single-use part of the market because it's a new technology and we have a lot of customers coming to us. But basically what happens is when a new customer comes to us, they always want to know if we can make the product single-use. And then if we can't make it single-use, they very often will want to go to a reusable version. And the differentiator there, of course, is the complexity of the device and whether or not we can hit the financial requirements. requirements for a single-use product. It's also important, I think, for me to point out that we are still pretty heavily involved in expanding our presence in the defense aerospace market. We've talked a lot about a couple of new programs and one program that's come back online. The defense aerospace opportunities are really quite significant for us. Because it's sort of a new market for us, we've been in it sort of over the years, but it's a new focus for us. I think there are lots of opportunities for that part of our business to grow relatively quickly. Our efforts to start working more deliberately in the defense aerospace market is timed quite well with some movement that we see or with the change in attitude that we see in that marketplace. with a very strong interest in re-onshoring almost everything that's done for the defense aerospace market. Now, it's obviously true that a lot of that market already had great restrictions on exports. But given the current geopolitical environment, the requirements there are even stronger than they have been in the past. that also is contributing to the great opportunities that we see in defense aerospace. So all three of those areas, I think, are prime for us to expand. And I think just because we're starting from smaller amounts of revenue today in the single use and in the defense aerospace parts of our business, those will grow more quickly on a percentage basis. But really, all three of those markets, single use medical device, reusable medical device, and defense aerospace, are all prime markets for us to find significant growth in.
Robert Bloom
All right, that's perfect. Thank you for that caller there. Maybe one more question before, operator, I turn it back over. You've talked in the past about sort of the three original programs sort of production, you know, the defense, the autoscopy, the cardiac, sort of had some slowdowns during the pandemic. It looks like all three are sort of have come back with new production orders. Are we sort of done with the impact of the pandemic or are there still some sort of lingering effects, you know, specifically as it relates to your business, of course?
Joe Forkey
Yeah. It's an interesting question. The acute impacts, the acute effects of the pandemic I think are pretty clearly over. It's interesting that there do seem to be some sort of ongoing sort of residual effects. So everybody talked about the supply chain impact, you know, six months ago or a year ago, particularly with the electronics parts that we use. I think by and large, a lot of people have, including us, have designed our way out of the supply chain issues associated with electronic components. And as you pointed out, Robert, all three of the programs that were delayed because of the pandemic Now we're coming back online. The third of those was our otoscopy program that I mentioned in the prepared remarks is just going online in this quarter Q4. So we'll start to see that revenue from that product ramping back up to about half a million dollars per quarter. That one I think took the longest of any of the programs we were working on to come back online. The interesting thing is that there are still some residual I would call it sort of oscillations to the inventory buildups that happened. And so we are seeing a little bit, a couple of cases where our customers came back and said, build this whole bunch of inventory because the pandemic's over and now they find they have a little bit of excess and now they're going to sell that off a little bit and then come back. So there's a little bit of this sort of oscillation. The spinal surgery product is a good example of that where We've been filling a pretty significant order for the last year. Our customers told us they're going to take a little pause while they burn down some of their inventory, and then they'll come back. So there's a little bit of that that's still sort of happening out there. But by and large, I would say that the impacts of the pandemic are pretty much over.
Robert Bloom
All right, perfect, Joe. Thanks for that. Jamie, I'll turn it over to you in the event there are any additional questions.
Operator
Once again, if you would like to join the question queue, please press star and 1. And at this time, in showing no questions, I'd like to turn the floor back over to management for any closing remarks.
Joe Forkey
Thank you, Jamie. And thank you all for joining us today on the call. I look forward to speaking to all of you again soon. Thanks and have a good night.
Operator
Ladies and gentlemen, with that, we'll conclude today's conference call and presentation. We thank you for joining. You may now disconnect your lines.
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