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, 2018
and with our audited consolidated financial statements for the year ended June 30, 2018 included in our Annual Report on Form 10-K,
filed with the Securities and Exchange Commission on September 27, 2018.
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, 2018 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 majority of our business is the design and manufacture of high-quality medical
devices, and 10% to 20% 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 the surgical community’s
future demand for smaller and more enhanced imaging systems for minimally invasive surgery. Over the last few years demand for
these products has increased, and our engineering personnel resources and capabilities are now mostly consumed in revenue generating
optical design and development projects for our customers.
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 9001:2015
and ISO 13485:2016 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 and to expand the number and type of applications in medical device and defense industry use
of high quality, small size optical 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, 2018,
approximately 74% of our sales were made to seven customers. Of these, one represents engineering revenue with a start up medical
device company developing a 3D robotic system. Another is a large defense contracting company for micro optical components and
assembly services. Two additional customers are global medical device companies, one purchasing our traditional laryngoscope products
and the other purchasing a newly developed ENT scanning device incorporating our recently developed CMOS and Microprecision™
technologies. The remaining three customers are two established and one start-up medical device company purchasing a recently developed
fiberscope incorporating our Microprecision™ technologies, a traditional coupler product to a medical device reseller, and
optical components for a multi-use bedside endoscopy system. In addition to these seven customers, we performed engineering design,
development, production and assembly services for another twenty seven customers during the fiscal quarter ended September 30,
2018.
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, 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, 2018 filed with the Securities and Exchange Commission on September 27, 2018.
Results of Operations
Our total revenues for the quarter ended
September 30, 2018, were $1,559,458, as compared to $1,028,746 for the same period in the prior year, an increase of $530,712,
or 51.6%. Revenues increased during the quarter ended September 30, 2018 compared to the same quarter of the prior year in the
engineering services and production categories by 22% and 72%, 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.
The number and type of engineering service
revenue projects have been consistent over the past quarters and when comparing the current quarter ended September 30, 2018 to
the same quarter of the prior fiscal year. Projects range in type and include CMOS, Microprecision™, 3D and robotic visualization
and illumination systems, and we continue to believe that these engineering projects represent our pipeline of additional production
revenues as certain customer products progress through development and into commercialization. Engineering service revenue increased
during the quarter ended September 30, 2018 when compared to the same quarter of the prior year due primarily to a decrease caused
by one project transitioning to production revenue during fiscal year 2018, which was offset by a larger increase in engineering
service revenue from one new 3D robotic project in the quarter ended September 30, 2018.
The 72% increase in production revenue
during the quarter ended September 30, 2018 when compared to the same quarter of the prior year is due primarily to an increase
in the number of production projects and the recent transition of engineering projects to production. The decreases in two production
project revenues during the current quarter are considered to be normal fluctuations in orders from two on-going customers, and
were offset by larger increases from two production projects that recently transitioned from engineering to production orders.
Those products represent a fiberscope incorporating our Microprecision™ technology and an ENT scanning device incorporating
CMOS and Microprecision™ technologies. Revenues during the quarter ended September 30, 2018 were further increased compared
to the same quarter of the prior fiscal year by an increase in number of production projects from nineteen to twenty-six in the
quarter ended September 30, 2018.
Gross profit for the quarter ended September
30, 2018 was $462,507, compared to $386,742 for the same period in the prior year, reflecting an increase of $75,765, or 19.6%.
Gross profit for the quarter ended September 30, 2018 as a percentage of our revenues was 29.7%, a decrease from the gross profit
percentage of 37.6% 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. Although the higher level of revenues during the quarter ended September 30,
2018 when compared to the same quarter of the prior year absorbed a greater amount of fixed manufacturing costs thereby increasing
realized gross margin, two projects during the quarter encountered cost over-runs that resulted in the decreased gross margin as
a percentage of sales during the current quarter. The two projects represent 25% of total revenues for the quarter, one being a
production project impacting the current period gross margin percentage by an estimated 4.8% and one engineering service project
impacting the current gross margin percentage by an estimated 3.3%. The cost over-runs in each of these cases resulted from design
challenges and issues we are addressing and that we believe will only cause a temporary decrease in realized gross margins. The
remainder of our production and engineering jobs resulted in margins within our targeted range with reasonably expected fluctuations.
Research and development expenses were
$100,798 for the quarter ended September 30, 2018, compared to $118,427 for the same period in the prior year, a decrease of $17,629,
or 14.9%. 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 $660,489 for the quarter ended September 30, 2018, compared to $296,584 for the same period in the prior year, an increase
of $363,905, or 122.7%. The increase in the quarter ended September 30, 2018, compared to the same quarter of the prior fiscal
year was primarily due to increased non-cash stock-based compensation expense of $329,877 relating to stock option and common stock
awards. Operating expenses were further increased during the quarter ended September 30, 2018 when compared to the same quarter
of the prior fiscal year by increased compensation costs for additional engineering personnel, and existing personnel salaries
and sales commissions, which were partially offset by a reduction in bad debt expense related to one isolated customer in the prior
year. Excluding total non-cash stock-based compensation expense of $342,984 recognized in cost of goods sold and selling, general
and administrative expenses during the quarter ended September 30, 2018, non-GAAP net income would have been $43,699 in the quarter
ended September 30, 2018.
No income tax provision was recorded in
the quarters ended September 30, 2018 and 2017 because of the losses generated in those periods.
Liquidity and Capital Resources
Our financial performance has improved
during the last two fiscal quarters ended September 30, 2018 and June 30, 2018, due primarily to increased production orders, revenues
increased to $1,559,458 and $1,460,932 in the quarters ended September 30, 2018 and June 30, 2018, respectively. Excluding expenses
relating to non-cash stock-based compensation expense of $342,984 and $10,339 during the fiscal quarters ended September 30, 2018,
and June 30, 2018 respectively, and non-recurring bad debt expense of $113,750 relating to one isolated customer during the quarter
ended June 30, 2018, non-GAAP net income was $43,699 and $141,081 during the fiscal quarters ended September 30, 2018 and June
30, 2018, respectively. Despite the improved financial performance in the most recent two fiscal quarters, we have sustained recurring
net losses for several fiscal years. We incurred net losses of $351,390 and $1,006,457 during the fiscal years ended June 30, 2018
and 2017, respectively.
As of September 30, 2018, cash and cash
equivalents were $351,314, accounts receivable were $655,720, and current liabilities were $1,691,131, including $400,704 of customer
advance paid against open purchase orders from our customers. As reported on Form 8-K filed on October 18, 2018, we received $2,000,000
on October 16, 2018 from the sale of 1,600,000 shares of our common stock at $1.25 per share, which we intend to use for general
working capital purposes. Proceeds from this stock offering, combined with our recently improved financial performance, significantly
enhances our working capital position and financial condition. Critical to our ability to maintain our financial condition is achieving
a level of quarterly revenues at or greater than the levels achieved during the most recent two fiscal quarters. A return to lower
revenue levels experienced in recent fiscal years could result in the use of our cash and working capital and an overall decline
in our financial condition.
We have traditionally funded working capital
needs through product sales, management of working capital components of our business, cash received from public and private offerings
of our common stock, warrants to purchase shares of our common stock or convertible notes, and by customer advances paid against
purchase orders by our customers and recorded in the current liabilities section of the accompanying financial statements. Our
management believes that the opportunities represented by our current production projects and engineering pipeline of Microprecision™
optical elements, micro medical camera assemblies and 3D endoscope projects have the potential to generate increasing revenues
and profitable financial results.
Capital equipment expenditures during the
quarters ended September 30, 2018 and 2017 were $42,809 and $0, respectively. Future capital equipment expenditures will be dependent
upon the type and amount of future sales revenue and the needs of on-going research and development efforts.
We have contractual cash commitments related
to open purchase orders as of September 30, 2018 of approximately $545,000, including a $21,378 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, 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 September 30, 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, 2008-2018, 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, 2018, 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, 2018, 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, 2018, 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. Periodic fiscal year end audit adjustments of approximately
$50,000 have been 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, 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.