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 and nine months ended March
31, 2018 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. During the last ten to fifteen years, we 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 demanded smaller and more enhanced imaging systems for minimally invasive surgery.
Over the last two years, our customers have engaged our unique engineering services to develop their custom imaging and illumination
devices using our 3D endoscope and proprietary Microprecision™ technologies and know-how. Ultimately, those engineering projects
provide us with prototype development and manufacturing service orders as our customers test and deliver their custom products
to market.
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 is 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 nine months ended March 31, 2018,
approximately 67% of our sales were made to seven customers. Of these, four were medium to large, international, medical device
companies, and one was a large defense contractor. Each of these customers has been our customer for numerous years. The other
two customers were early-stage companies developing endoscopic products that incorporate our unique design capabilities. Sales
to these seven customers included 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
March 31, 2018, were $735,597, as compared to $983,186 for the same period in the prior year, a decrease of $247,589, or 25.2%.
Engineering service revenues decreased during the quarter ended March 31, 2018 compared to the same quarter of the prior year by
53% and production revenues increased 9% during the quarter ended March 31, 2018 compared to the same quarter of the prior year.
The majority of our revenues are derived from engineering design and manufacturing services related to products marketed or under
development by our customers. Therefore, our revenues are subject to fluctuations on a product by product basis from period to
period. The increase in production revenue during the quarter ended March 31, 2018 when compared to the same quarter of the prior
year resulted primarily from an increase in sales of a traditional product to two long-standing customers. Engineering service
revenue during the quarter ended March 31, 2018, when compared to the same quarter of the prior year included a similar number
and size of projects, but decreased revenue recognized in the current quarter due to the stage of completion of the projects at
March 31, 2018. We expect revenue recognized in the fourth quarter of fiscal 2018 to result from engineering services performed
during the third quarter on projects in process at March 31, 2018. We believe most engineering design projects have the potential
to generate production revenues when our customers achieve commercialization of the products under design.
Our total revenues for the nine months
ended March 31, 2018 were $2,577,116, as compared to $2,434,324 for the same period in the prior year, an increase of $142,792,
or 5.9%. The increase in total revenues for the nine-month period ended March 31, 2018 compared to the same period of the prior
year resulted from a decrease in engineering service revenue of 6% and an increase in production revenues of 15% during the current
quarter. The engineering revenue decrease during the nine months ended March 31, 2018 compared to the same period of the prior
year resulted primarily from revenue not yet recognized at March 31, 2018 due to the stage of completion of on-going projects.
Production revenues increased during the nine months ended March 31, 2018 compared to the same period of the prior year due to
the addition of an optical component project plus increases in various traditional device product sales to long-standing customers.
Management expects increases in production
revenues in future fiscal quarters as customer engineering projects transition to customer production orders. We have now received
production orders from two customers totaling approximately $2,000,000 which we expect to begin to fulfill in the fourth quarter
of fiscal year 2018 and continuing into the next two fiscal years.
Gross profit for the quarter ended March
31, 2018 was $236,153, compared to $278,124 for the same period in the prior year, reflecting a decrease of $41,971, or 15.1%.
Gross profit for the quarter ended March 31, 2018 as a percentage of our revenues was 32.1%, an increase from the gross profit
percentage of 28.3% for the same period in the prior year. Gross profit for the nine months ended March 31, 2018 was $923,117,
as compared to $593,582 for the same period in the prior year, which reflects an increase of $329,535 or 55.5%. Gross profit for
the nine months ended March 31, 2018 as a percentage of our revenues was 35.8%, an increase from the gross profit percentage
of 24.4% 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 and nine month periods ended
March 31, 2018 resulted from current project mix, increased engineering and production activity absorbing a higher percentage of
fixed manufacturing costs, and lower fixed compensation expense during a large portion of the nine months ended March 31, 2018.
Management expects compensation costs to increase since new hires for similar positions have now been made. Additionally, targeted
or better margins were realized on most engineering and production projects during the quarters ended December 31, 2017 and March
31, 2018, including the larger revenue projects in each category, due to experience related efficiencies in producing traditional
products and engineering development activities associated with Microprecision™ technologies. Product mix and start-up production
activities on products transitioning from engineering to production could result in lower future gross profit margins.
Research and development expenses were
$126,365 for the quarter ended March 31, 2018, compared to $122,313 for the same period in the prior year, a slight increase of
$4,052, or 3.3%. Research and development expenses were $334,823 for the nine months ended March 31, 2018, compared to $358,520
for the same period in the prior year, a decrease of $23,697, or 6.6%. The decrease in research and development expenses during
the nine months ended March 31, 2018, compared to the same period of the prior year, resulted from a temporary reduction in engineering
department staffing and a higher percentage of available engineering resources being 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 $388,611 for the quarter ended March 31, 2018, compared to $318,581 for the same period in the prior year, an increase of
$70,030, or 22.0%, resulting primarily from an increase in the reserve for doubtful accounts receivable relating to one specific
customer and charged to bad debt expense during the quarter ended March 31, 2018. Selling, general and administrative expenses
were $955,230 for the nine months ended March 31, 2018, compared to $1,003,590 for the same period in the prior year, a decrease
of $48,360, or 4.8%. The decrease in nine months ended March 31, 2018, compared to the same period in the prior year was primarily
due to reduced stock-based compensation expense relating to stock options and stock accrued for consulting services, plus reduced
wages resulting from the retirement of a sales person in January 2017 and a temporarily vacated administrative position which has
since been filled. The expense reductions during the nine month period ended March 31, 2018 were partially offset by increased
sales commissions and a $113,750 increase in the reserve for doubtful accounts receivable relating to one specific customer, $25,000
of which was charged to bad debt expense in the quarter ended December 31, 2017 and $88,750 charged in the quarter ended March
31, 2018.
No income tax provision was recorded in
the quarter and nine-month periods ended March 31, 2018 and 2017 because of the losses generated in those periods.
Liquidity and Capital Resources
We have sustained recurring net losses
for several years. During the quarter and nine-month periods ended March 31, 2018, we incurred net losses of $279,271 and $368,382,
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 March 31, 2018,
cash and cash equivalents were $201,897, accounts receivable were $579,165, and current liabilities were $1,589,311. Our working
capital was $404,801 and $479,604 at March 31, 2018 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 sustained 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 March 31, 2018 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 quarterly
sales revenues do not increase and maintain near or above cash breakeven levels during 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 stockholders, and debt financing, if available, may involve restrictive
covenants that could restrict our operations or finances. Financing, if necessary, may not be available in amounts or on terms
acceptable to us, if at all. If we cannot raise funds on acceptable terms, achieve positive cash flow, or continue to sufficiently
manage our working capital, we may not be able to continue to conduct operations, develop new products, grow periodic revenues
or market share, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements, any
of which would negatively impact our business, operating results, financial condition, and ability to continue as a going concern.
Capital equipment and patent application
related expenditures during the nine months ended March 31, 2018 and 2017 were $17,189 and $33,567, respectively. Future capital
equipment and patent application expenditures will depend upon future sales and success of on-going research and development efforts.
We have contractual cash commitments related
to open purchase orders as of March 31, 2018 of approximately $674,413, including a $25,713 commitment remaining under a five-year
capital lease obligation for the acquisition of equipment (see Note 3. Capital Lease Obligation). The increase in contractual cash
commitments at March 31, 2018 compared to commitments of $388,000 at December 31, 2017, is the result of our entering into increased
vendor purchase agreements related to anticipated sales from two customer production orders received in the recent quarter totaling
approximately $2,000,000 of expected revenue in the next two fiscal years. 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 March 31, 2018, 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 March 31, 2018.
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 March 31, 2018, 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.