Business context and reporting period
Precision Optics Corporation, Inc. designs and manufactures optical components and medical instruments, including endoscopes and micro-optics. This unaudited Form 10-Q covers the three months ended September 30, 2011, the first quarter of fiscal 2012, and compares results with the same quarter of fiscal 2011.
Financial performance and liquidity
| Metric | Quarter ended September 30, 2011 | Comparable 2010 quarter |
|---|---|---|
| Revenue | $504,749 | $683,902 |
| Gross profit (margin) | $139,294 (27.6%) | $352,237 (51.5%) |
| Operating loss | $(263,202) | $(142,976) |
| Net income (loss) | $1,998,441 | $(157,846) |
| Cash used in operating activities | $(694,580) | $(158,381) |
Reported net income included a $2,276,286 gain on the sale of patents; it did not reflect profitable operations. The patent sale generated net cash proceeds of $2,463,171, driving investing cash flow and the increase in cash.
At September 30, 2011, cash was $1,788,473, current assets $2,765,488, and current liabilities $2,007,067, implying working capital of $758,421. The balance sheet reported total assets of $2,822,876 and stockholders’ equity of $815,809. Current liabilities included $795,833 of 10% secured convertible notes, comprising $600,000 principal and $195,833 accrued interest. No default was reported. The notes were subsequently extended to December 15, 2011; holders could convert principal into common shares.
Material changes versus the prior comparable period
- Revenue declined $179,153, or 26.2%, primarily due to lower unit sales of micro-optics, prisms, and a surgical visualization system.
- Gross profit fell $212,943 as lower sales volume and a less favorable product mix reduced the margin to 27.6% from 51.5%.
- Research and development expense decreased 33.5% to $151,190, mainly due to lower labor and material costs, partly offset by lower customer reimbursements. Selling, general and administrative expense declined 9.4% to $253,356.
- Operating loss widened despite lower operating expenses, while net results swung to income primarily because of the patent-sale gain.
- Cash increased from $19,556 at June 30 to $1,788,473 at September 30, principally from patent-sale proceeds, despite operating cash use.
Outlook, commentary, and risks
Management said operating losses are expected to continue through fiscal 2012 and until sales reach breakeven and profitable levels. It aims to increase sales of existing and newly developed products, including Lenslock endoscopes, sub-millimeter micro-precision optics, and handheld stereo endoscopes. Management said customer discussions could lead to revenue growth but noted that order timing is unpredictable and detailed growth is difficult to forecast. No quantified revenue or earnings guidance was provided.
The July 2011 sale to Intuitive Surgical transferred issued, unexpired patents and pending patent applications; Precision Optics retained a royalty-free worldwide license for uses outside medical robotics, subject to exceptions. The filing says the proceeds provide cash for working capital and could fund retirement of the notes if necessary. In October 2011, 245,326 shares were issued to settle $674,645 of deferred compensation and consulting liabilities, rather than paying those amounts in cash.
Risks include recurring operating losses and cash burn, dependence on unpredictable customer orders, competition from larger and better-resourced companies, and lengthy, costly product development and regulatory requirements. The company reported two material weaknesses in internal control over financial reporting: inadequate segregation of accounting duties due to limited staff and inventory valuation controls. Management reported remediation efforts were ongoing and could not guarantee successful remediation. Management also stated that risk factors were not materially changed from the June 30, 2011 Form 10-K.
Important facts for investors to verify
- Whether the company can convert its product pipeline and customer discussions into sustained revenue growth and reach operating breakeven.
- Cash burn and liquidity after the patent-sale proceeds, and the company’s ability to meet or refinance the $795,833 note obligation due December 15, 2011.
- The effect of the patent transfer on future product rights and commercial opportunities, including the scope of the retained license.
- Completion and accounting treatment of the October share issuance settling $674,645 of liabilities, and resulting dilution; the filing reports 1,245,339 shares outstanding on November 14, 2011.
- Progress in remediating the disclosed material weaknesses, particularly inventory valuation and segregation of duties.