Item 2. Management’s Discussion and Analysis of Financial
Condition and Results of Operations.
The following discussion of our financial
condition and results of operations should be read in conjunction with the unaudited condensed consolidated financial statements
and notes to those statements included elsewhere in this Quarterly Report on Form 10-Q for the quarter ended September 30, 2017
and with our audited consolidated financial statements for the year ended June 30, 2017 included in our Annual Report on Form 10-K,
filed with the Securities and Exchange Commission on September 28, 2017.
This Quarterly Report on Form 10-Q
contains forward-looking statements. When used in this report, the words “anticipate,” “suggest,” “estimate,”
“plan,” “project,” “continue,” “ongoing,” “potential,” “expect,”
“predict,” “believe,” “intend,” “may,” “will,” “should,”
“could,” “would” and similar expressions are intended to identify forward-looking statements. You should
not place undue reliance on these forward-looking statements. Our actual results could differ materially from those anticipated
in the forward-looking statements for many reasons, including the risks described in this report, the risks described in our Annual
Report on Form 10-K for the year ended June 30, 2017 and other reports we file with the Securities and Exchange Commission. Although
we believe the expectations reflected in the forward-looking statements are reasonable, they relate only
to events as of the date on which the statements are made. We do not intend to update any of the forward-looking statements
after the date of this report to conform these statements to actual results or to changes in our expectations, except as required
by law.
Overview
We have been developing and
manufacturing advanced optical instruments since 1982. Today, the vast majority of our business is the design and manufacture
of high-quality medical devices and less than 10% of our business is the design and manufacture of military and
industrial products. Our medical instrumentation line includes traditional endoscopes and endocouplers as well as other
custom imaging and illumination products for use in minimally invasive surgical procedures. Much of our recent development
efforts have been targeted at the development of next generation endoscopes. Over the last ten years, we have funded internal
research and development programs to develop next generation capabilities for designing and manufacturing 3D endoscopes and
very small Microprecision™ lenses, anticipating future requirements as the surgical community continues to demand
smaller and more enhanced imaging systems for minimally invasive surgery.
Our unique proprietary technology in the
areas of micro optical lenses and prisms, micro medical fiber and CMOS based cameras, and custom design of medical grade instruments,
combined with recent developments in the areas of 3D displays, has allowed us to begin commercialization of related product and
service offerings to a widening group of customers addressing various medical device, defense and aerospace applications. Thus,
a portion of our revenues are now derived from engineering and design services we performed for our customers to incorporate our
technologies and capabilities into their medical device products. We believe that new products based on these technologies provide
enhanced imaging for existing surgical procedures and can enable development of many new medical device products and related medical
procedures.
We are registered to the ISO 9001:2008
and ISO 13485:2003 Quality Standards and comply with the FDA Good Manufacturing Practices and the European Union Medical Device
Directive for CE marking of our medical products. Our internet website is www.poci.com. Information on our website is not intended
to be integrated into this report.
The markets in which we do business are
highly competitive and include both foreign and domestic competitors. Many of our competitors are larger and have substantially
greater resources than we do. Furthermore, other domestic or foreign companies, some with greater financial resources than we have,
may seek to produce products or services that compete with ours. We routinely outsource specialized production efforts as required
to obtain the most cost effective production.
We believe that competition for sales of
our medical products and services, which have been principally sold to original equipment manufacturers, or OEM, customers, is
based on our ability to design and produce technical features, performance, engineering service and production scheduling, on-time
delivery, quality control and product reliability, and competitive pricing.
We believe that our future success depends
to a large degree on our ability to develop new optical products and services to enhance the performance characteristics and methods
of manufacture of existing products. Accordingly, we expect to continue to seek and obtain product-related design and development
contracts with customers and to selectively invest our own funds on research and development, particularly in the areas of Microprecision™
optics, micro medical cameras and 3D endoscopes.
For the quarter ended September 30, 2017,
approximately 81% of our sales were made to seven customers. Of these, four are medium to large, international, medical device
companies and one is a large defense contractor. Each of these customers has been our customers for numerous years. The other two
customers are early-stage companies developing endoscopic products that incorporate our unique design capabilities. Sales to these
seven customers include both products we developed over five years ago and products we are currently developing which rely heavily
on our unique, proprietary Microprecision™ lens technology and optical visualization system expertise.
Current sales and marketing activities
are intended to broaden awareness of the benefits of our new technology platforms, which we believe are ready for general application
to medical device projects requiring surgery-grade visualization from sub-millimeter sized devices and 3D endoscopy. We market
directly to established medical device companies primarily in the United States that we believe could benefit from our advanced
endoscopy visualization systems. Through this direct marketing, referrals, attendance at trade shows including Medical Design and
Manufacturing West and MD&M East, and periodically a presence in online professional association websites, we have expanded
our on-going pipeline of projects to significant medical device companies as well as well-funded emerging technology companies.
We expect our customer pipeline to continue to expand as development projects transition to production orders and new customer
projects enter the development phase.
General
This management’s discussion and
analysis of financial condition and results of operations is based upon our unaudited consolidated financial statements, which
have been prepared without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. The preparation
of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses. We base our estimates on historical experience and on various other assumptions that are believed
to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of
assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different
assumptions or conditions.
There have been no significant changes
in our critical accounting policies as disclosed in the Notes to our Financial Statements contained in our Annual Report on Form 10-K
for the year ended June 30, 2017 filed with the Securities and Exchange Commission on September 28, 2017.
Results of Operations
Our total revenues for the quarter ended
September 30, 2017, were $1,028,746, as compared to $849,548 for the same period in the prior year, an increase of $179,198, or
21.1%. Revenues increased during the quarter ended September 30, 2017 compared to the same quarter of the prior year in the engineering
services and production categories by 22% and 20%, respectively. The majority of our revenues are derived from engineering design
and manufacturing services related to products marketed or under development by our OEM customers. Therefore, our revenues are
subject to fluctuations on a product by product basis from period to period. Production revenue during the quarter ended September
30, 2017 when compared to the same quarter of the prior year included a reduction in sales of a traditional product, offset by
a larger increase in sales of optical components to a defense contractor customer. Engineering service revenue during the quarter
ended September 30, 2017 when compared to the same quarter of the prior year included a large reduction of sales to one customer,
which was offset by a larger increase in engineering and design revenues from numerous customers developing new products. We believe
each of these engineering design projects have the potential to generate production revenues when our customers achieve commercialization
of the products currently under design.
Gross profit for the quarter ended September
30, 2017 was $386,742, compared to $167,051 for the same period in the prior year, reflecting an increase of $219,691, or 131.5%.
Gross profit for the quarter ended September 30, 2017 as a percentage of our revenues was 37.6%, an increase from the gross profit
percentage of 19.7% for the same period in the prior year. Quarterly gross profit and gross profit percentage depend on a number
of factors, including overall sales volume, facility utilization, product sales mix, and the costs of engineering services and
initial production in connection with new products. The improvement in our gross profit performance during the quarter ended September
30, 2017 resulted from increased revenues absorbing a higher percentage of fixed manufacturing costs, stable gross margins throughout
all production projects during the quarter ended September 30, 2017, and targeted or better margins on seven different engineering
projects which accounted for 81% of engineering revenue during the same quarter.
Research and development expenses were
$118,427 for the quarter ended September 30, 2017, compared to $116,992 for the same period in the prior year, an increase of $1,435,
or 1.2%. The vast majority of our engineering, research and development activities are consumed in revenue generating engagements
with our customers for the development of their products. In-house research and development and certain internal functions not
directly related to customer engagements are classified as research and development expenses.
Selling, general and administrative expenses
were $296,584 for the quarter ended September 30, 2017, compared to $343,782 for the same period in the prior year, a decrease
of $47,198, or 13.7%. The decrease in the quarter ended September 30, 2017, compared to the same periods in the prior year was
primarily due to reduced stock based compensation expense of $50,819 relating to stock options and stock accrued for consulting
services, plus reduced wages resulting from the retirement of a sales person in January 2017. The expense reductions were partially
offset by a $25,000 increase in the reserve for doubtful accounts receivable relating to one specific customer.
No income tax provision was recorded in
the quarters ended September 30, 2017 and 2016 because of the losses generated in those periods.
Liquidity and Capital Resources
We have sustained recurring net losses
for several years. During the quarters ended September 30, 2017 and 2016, we incurred net losses of $28,785 and $293,408, respectively.
We also incurred net losses of $1,006,457 and $1,034,765 during the fiscal years ended June 30, 2017 and 2016, respectively, and
used cash in operating activities of $667,434 and $876,298 during the same fiscal periods, respectively. As of September 30, 2017,
cash and cash equivalents were $194,714, accounts receivable were $613,961, and current liabilities were $1,096,876. Our working
capital consisted of $730,478 and $479,604 at September 30, 2017 and June 30, 2017, respectively.
We have traditionally funded working capital
needs through product sales, management of working capital components of our business, and by cash received from public and private
offerings of our common stock, warrants to purchase shares of our common stock or convertible notes. We have incurred quarter to
quarter operating losses during our efforts to develop current products including Microprecision™ optical elements, micro
medical camera assemblies and 3D endoscopes. Our management believes that the opportunities represented by these products have
the potential to generate sales increases to achieve breakeven and profitable results. However, our current financial condition
may raise doubt regarding our ability to continue as a going concern, as referenced by the Report of our Independent Registered
Public Accounting Firm on our financial statements for the year ended June 30, 2017, included in our Annual Report on Form 10-K.
We recognize that the working capital described
above and our cash and accounts receivable as of September 30, 2017 is low considering the level of cash historically used in our
operations at our current sales levels. Our accounts receivable and cash balances are subject to significant fluctuations based
on the timing and amount of customer billings and accounts receivable collections as well as the terms of vendor payment obligations.
If we are unable to increase quarterly sales revenues to near cash breakeven in the next six to nine months, we may be required
to obtain cash for operations from non-working capital sources, which may not be available, in which case we would have to significantly
decrease or cease operations.
The sale of additional equity or convertible
debt securities would result in additional dilution to our current stockholders, and debt financing, if available, may involve
restrictive covenants that could restrict our operations or finances. Financing may not be available in amounts or on terms acceptable
to us, if at all. If we are unable to secure additional capital, we may be required to curtail our research and development initiatives
and take additional measures to reduce costs in order to conserve our cash in amounts sufficient to sustain operations and meet
our obligations.
Capital equipment expenditures during the
quarters ended September 30, 2017 and 2016 were $0 and $3,500, respectively. Future capital equipment expenditures will be dependent
upon future sales and success of on-going research and development efforts.
We have contractual cash commitments related
to open purchase orders as of September 30, 2017 of approximately $235,000, including a $29,909 commitment remaining under a five-year
capital lease obligation for the acquisition of equipment (see Note 3. Capital Lease Obligation). We have no other contractual
cash commitments since leased facilities are currently on a month-to-month basis.
Off-Balance Sheet Arrangements
We currently have no off-balance sheet
arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes
in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Item 4. Controls and Procedures.
Management’s Evaluation of Disclosure Controls and
Procedures
Our Chief Executive Officer and our Chief
Financial Officer evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by
this Quarterly Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have
concluded that our disclosure controls and procedures, including internal control over financial reporting, were not effective,
as of September 30, 2017, to ensure the information we are required to disclose in reports that we file or submit under the Securities
Exchange Act of 1934, as amended (i) is recorded, processed, summarized, and reported within the time periods specified in Securities
and Exchange Commission rules and forms, and (ii) is accumulated and communicated to our management, including our Chief Executive
Officer and our Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Our disclosure
controls and procedures are intended to be designed to provide reasonable assurance that such information is accumulated and communicated
to our management. Based on this evaluation, our management concluded that our internal control over financial reporting was not
effective as of September 30, 2017.
The following is a description of two material
weaknesses in our internal control over financial reporting:
Segregation of Duties
: As previously
disclosed in our Annual Reports on Form 10-K for the fiscal years ended June 30, 2008-2017, our management identified a control
deficiency during the 2008 fiscal year because we lacked sufficient staff to segregate accounting duties. We believe the control
deficiency resulted primarily because we have the equivalent of one and one-half persons performing all accounting-related on-site
duties. As a result, we did not maintain adequate segregation of duties within our critical financial reporting applications, the
related modules and financial reporting processes. This control deficiency could result in a misstatement of balance sheet and
income statement accounts in our interim or annual consolidated financial statements that would not be detected. Accordingly, management
has determined that this control deficiency constitutes a material weakness. During the period beginning with fiscal year 2008
through June 30, 2017, no audit adjustments resulting from this condition were required.
To address and remediate the material weakness
in internal control over financial reporting described above, beginning with the quarter ended September 30, 2008, we instituted
a procedure whereby our Chief Executive Officer, our Chief Financial Officer and other members of our Board of Directors perform
a higher level review of the quarterly and annual reports on Form 10-Q and Form 10-K prior to filing.
We believe that the step outlined above
strengthens our internal control over financial reporting and mitigates the material weakness described above. As part of our assessment
of internal control over financial reporting for the fiscal year ended June 30, 2017, our management has evaluated this additional
control and has determined that it is operating effectively.
Inventory Valuation
: As previously
disclosed in our Annual Report on Form 10-K for the fiscal year ended June 30, 2017, we reported a material weakness with respect
to the valuation of our inventories. Specifically, the amounts used to value our inventory at June 30, 2009 with respect to overhead
rates and purchased items were often inconsistent with the supporting documentation, due to year-to-year changes in overhead rates
and costs of purchased items that were not properly reflected in inventory valuation. Accordingly, management had determined that
this control deficiency constituted a material weakness as of June 30, 2009. Audit adjustments of approximately $58,000 and $41,000
to our audited financial statements as of June 30, 2011 and June 30, 2017, respectively, were necessary as a result of this condition.
Changes in Internal Control over
Financial Reporting
There was no change in our internal control
over financial reporting that occurred during the first quarter of our fiscal year covered by this Quarterly Report on Form 10-Q
that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
To address and remediate the material weakness
in internal control over financial reporting described above, beginning in the quarter ended September 30, 2009 and continuing
through the quarter ended September 30, 2017, we implemented processes to improve our inventory controls and documentation surrounding
inventory valuation for overhead rates, and performed procedures to ensure that the pricing of inventory items was consistent with
the supporting documentation. We believe that the step outlined above strengthens our internal control over financial reporting
and mitigates the material weakness described above.
We intend to continue to remediate material
weaknesses and enhance our internal controls but cannot guarantee that our efforts will result in remediation of our material weaknesses
or that new issues will not be exposed in this process.