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, 2020 and with our audited consolidated financial statements for the year ended June 30, 2019 included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on September 26, 2019.

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, 2019 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 a developer and manufacturer of advanced optical instruments since 1982. 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. For 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.

Effective June 1, 2019 we acquired the operating assets of Ross Optical Industries, Inc. of El Paso, Texas, which we began operating as a division of our Company beginning on that date. The accompanying financial statements include the results of operations of the Ross Optical division for the entire nine and three-month periods ended March 31, 2020 and the assets and liabilities of the division as of June 30, 2019 and March 31, 2020. The acquisition of the assets of Ross Optical Industries effective June 1, 2019 expands our optics components and assemblies business. All products supplied by Ross Optical include a custom or catalog optic, which is sourced through Ross Optical's extensive domestic and worldwide network of optical fabrication companies. Most systems make use of optical lenses, prisms, mirrors and windows and range from individual optical components to complex mechano-optical assemblies. Products often include thin film optical coatings that are applied using the in-house coating department. Approximately 75% of Ross Optical revenues are from customers in the United States, 8% from Western Europe and 7% from Canada during the nine months ended March 31, 2020. Ross Optical's sales are mostly resale of specialized optical components with the remainder being assemblies. Ross Optical does not perform revenue generating engineering services or internal research and development. The majority of Ross Optical sales are for industrial applications with the remainder split between military and medical device products.

The Management Discussion and Analysis which follows is based on the financial condition and results of operations of our Company including the operating results for the three- and nine-month periods ended March 31, 2020 and the balance sheet as of June 30, 2019 and March 31, 2020 of our new division Ross Optical.

Our business is the design and manufacture of high-quality medical devices. Approximately 12% of our revenue in the nine months ended March 31, 2020 is from the design, manufacture and resale of optical products for military and defense and 31% is from other industrial, non-medical products. Our medical instrumentation line and unique design and manufacturing capabilities include traditional endoscopes and endocouplers as well as other custom imaging and illumination products for use in minimally invasive surgical procedures. We design and manufacture 3D endoscopes and very small Microprecision™ lenses, assemblies and complete medical devices to meet the surgical community's continuing demand for smaller, disposable, and more enhanced imaging systems for minimally invasive surgery.









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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 websites are www.poci.com and www.rossoptical.com. Information on our website is not intended to be integrated into this report. Investors and others should note that we announce material financial information using our company websites (www.poci.com; www.rossoptical.com), our investor relations website, SEC filings, press releases, public conference calls and webcasts. Information about Precision Optics, our business, and our results of operations may also be announced by posts on the following social media channels:





    ·   Ross Optical's LinkedIn page
        (www.linkedin.com/company/ross-optical-industries/)
    ·   Ross Optical's Twitter feed (http://twitter.com/rossoptical)

The information that we post on these social media channels could be deemed to be material information. Therefore, we encourage investors, the media, and others interested in Precision Optics to review the information that we post on these social media channels. These social media channels may be updated from time to time on Precision Optics' investor relations website. The information on, or accessible through, our websites and social media channels is not incorporated by reference in this Quarterly Report on Form 10-Q.

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. Over the years and through the acquisition of the Ross Optical division in June 2019, we have developed extensive experience collaborating with other optical specialists worldwide.

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, illumination, single-use endoscopes and 3D endoscopes.

The Ross Optical division sales are primarily optical components and assemblies for industrial applications in addition to medical and military uses. By combining the unique capabilities of our Company with the Ross Optical division we believe there are opportunities for expanded sales of each division products and services throughout the combined customer base. Additionally, we believe Ross' expanded worldwide vendor relationships will benefit our traditional efforts to source materials at competitive prices for our development projects and manufacturing activities.

For the nine months ended March 31, 2020, approximately 23% of our sales were made to our three largest customers representing 10%, 7% and 7% of our total sales, respectively. No other customer accounted for more than 4% our total sales during the nine months ended March 31, 2020. Our three largest customers during the quarter ended March 31, 2020 are all in the medical device industry. One represents engineering service revenue for an early-stage company, and the other two represent production revenue for companies commercializing a cardiovascular endoscope and an ENT scanning device. Each of these three products incorporates our Microprecision™ technologies as enabling design features. In addition to the three largest customers, we made sales to two hundred ninety-three other customers during the nine-month period ended March 31, 2020.

Current sales and marketing activities are intended to broaden awareness of the benefits of our new technology platforms and our successful application of these new technologies to medical device projects requiring surgery-grade visualization from sub-millimeter sized devices and 3D endoscopy, including single-use products and assemblies. 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 and 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. Our Ross Optical division markets through existing customers and trade shows, in addition to proactive online marketing strategies executed primarily through its website. We believe there are opportunities to expand the reach of sales activities of our business and that of our new division, Ross Optical, through the gradual integration of some of the sales and marketing resources of the two operations.









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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, 2019 filed with the Securities and Exchange Commission on September 26, 2019.





Results of Operations

Our total revenues for the quarter ended March 31, 2020, were $2,374,584, as compared to $1,386,454 for the same period in the prior year, an increase of $988,130, or 71.3%. Revenues increased during the quarter ended March 31, 2020 compared to the same quarter of the prior year primarily due to the revenues of the Ross Optical division, which were $1,212,805 for the quarter ended March 31, 2020. Our non-Ross revenues decreased by $224,675 during the quarter ended March 31, 2020 from their levels in the same period of the prior year. While the overall sales were negatively impacted by the COVID-19 pandemic, the mix of engineering service, production and component sales were similar between the quarters.

The COVID-19 world-wide pandemic that began during the quarter ended March 31, 2020 and the domestic and international impact of policy decisions being made in major countries around the world has had, and is expected to have, an adverse impact on our sources of supply, current and future orders from our customers, collection of amounts owed to us from our customers, our internal operating procedures, and our overall financial condition. While we and many of our medical device and defense contracting customers continue to operate as essential businesses, we have taken various actions to augment our operating and human resource policies and procedures to guard against the potential health hazards of COVID-19. These augmented procedures can have a negative impact on our operational efficiencies. We source various components from overseas suppliers throughout Asia, including China. During the quarter ended March 31, 2020, certain suppliers from China accelerated shipments to our Ross division in anticipation of pending shutdowns, which had a beneficial effect on our Ross sales. On the other hand, we also had supply disruptions and customer delays during the quarter causing the decrease in non-Ross sales mentioned above, which we believe were the result of the COVID-19 pandemic and related economic slow-down. We continue to communicate as closely as possible with our suppliers and customers to maintain a current perspective on the future effects of COVID-19 on our business. Given the uncertainty surrounding the continuation of economic slow-downs domestically and abroad, we cannot predict with certainty at this time what the future impact of COVID-19 and resulting business and economic policies in the US and abroad will be on our up-coming quarterly fiscal operating results.

Our total revenues for the nine months ended March 31, 2020 were $7,686,330, as compared to $4,423,763 for the same period in the prior year, an increase of $3,262,567, or 73.8%. Revenues increased during the nine months ended March 31, 2020 compared to the same period of the prior year primarily due to the revenues of the Ross Optical division, which were $3,454,493 for the nine months ended March 31, 2020. Our non-Ross revenues decreased by $191,926 during the nine months ended March 31, 2020 from their levels in the same period of the prior year primarily as a result of the COVID-19 pandemic effects on the quarter ended March 31, 2020 as described above. While the overall sales were negatively impacted by the COVID-19 pandemic, the mix of engineering service, production and component sales were similar during the quarters.









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Gross profit for the quarter ended March 31, 2020 was $817,019, compared to $455,936 for the same period in the prior year, reflecting an increase of $361,083, or 79.2%. Gross profit for the quarter ended March 31, 2020 as a percentage of our revenues was 34.4%, an increase from the gross profit percentage of 32.9% for the same period in the prior year. Gross profit for the nine months ended March 31, 2020 was $2,709,075, as compared to $1,274,165 for the same period in the prior year, which reflects an increase of $1,434,910 or 112.6%. Gross profit for the nine months ended March 31, 2020 as a percentage of our revenues was 35.2%, an increase from the gross profit percentage of 28.8% 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, the costs of engineering services, production start-up costs, challenges in connection with new products, the effects of COVID-19 pandemic policy decisions on various economies and our suppliers and customers, as well as the effects on production efficiencies due to the augmented policies we have incorporated into our operations as a result of the COVID-19 pandemic.

The increase in gross profit dollars and gross profit percentage during the quarter and nine-month period ended March 31, 2020 compared to the same periods of the prior year was primarily due to the inclusion of the Ross Optical division revenue at a higher gross margin percentage than we realize on non-Ross revenues. Ross Optical division revenues generated a gross margin percentage of 48-50% while non-Ross revenue margin was 24.0% for the nine months ended March 31, 2020. The non-Ross gross margin is dependent on a number of factors and is expected to fluctuate from quarter to quarter based on the nature and status of engineering projects. Specifically, periodic margins are impacted by revenue volume, facility utilization, product sales mix, and unanticipated cost over-runs associated with engineering projects, start-up production activities of new products, and the effects of COVID-19 pandemic policy decisions on various economies and our suppliers and customers as well as the effects on production efficiencies of the augmented policies we have incorporated into our operations as a result of the COVID-19 pandemic. During the quarter ended March 31, 2020, a non-Ross engineering service project experienced cost over-runs that negatively impacted gross margins during the period and due to timing of milestone deliverables generated no revenue. The project negatively impacted the consolidated gross margin percentage by 3.3% during the quarter ended March 31, 2020. The cost over-runs resulted from design challenges and issues we are addressing and that we believe will only cause a temporary decrease in total 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 $319,875 for the quarter ended March 31, 2020, compared to $121,640 for the same period in the prior year, an increase of $198,235, or 163.0%. Research and development expenses were $700,605 for the nine months ended March 31, 2020, compared to $347,851 for the same period in the prior year, an increase of $352,754, or 101.4%. In-house research and development and certain internal functions not directly related to customer engagements are classified as research and development expenses with the majority of our engineering, research and development activities being consumed in revenue generating engagements with our customers for the development of their products. During the quarter ended March 31, 2020 we had a larger staff of engineering personnel and a greater amount of our engineering personnel time was consumed in internal research and development activities; the product of which we believe will benefit various engineering design projects involving specialized fixturing and illumination features.

Selling, general and administrative expenses were $962,591 for the quarter ended March 31, 2020, compared to $414,475 for the same period in the prior year, an increase of $548,116, or 132.2%. The increase in the quarter ended March 31, 2020, compared to the same quarter of the prior fiscal year was due to the addition of $320,888 of selling, general and administrative expenses incurred by our Ross Optical division. Non-Ross selling, general and administrative expenses reflect a $42,508 increase in stock-based compensation and service fees in the quarter ended March 31, 2020 compared to the same period of the prior year, and increases of $184,720 in compensation to existing and newly hired employees, advertising, tradeshows and professional fees.

Selling, general and administrative expenses were $3,111,397 for the nine months ended March 31, 2020, compared to $1,430,880 for the same period in the prior year, an increase of $1,680,517, or 117.4%. The increase in the nine months ended March 31, 2020, compared to the same nine-month period of the prior fiscal year was due to the addition of $919,930 of selling, general and administrative expenses incurred by our Ross Optical division. Non-Ross selling, general and administrative expenses reflect a $2,505 decrease in stock-based compensation and service fees in the nine months ended March 31, 2020 compared to the same period of the prior year, and increases of $763,092 driven by higher compensation to existing and newly hired employees, advertising, tradeshows and professional fees.





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Liquidity and Capital Resources

We have sustained recurring net losses for several years. During the year ended June 30, 2019 and the nine months ended March 31, 2020 we incurred net losses of $614,871 and $1,103,065, respectively. As a result of our acquisition of the Ross Optical division, our revenue, gross margin and components of our working capital have increased. At March 31, 2020 cash was $632,131, accounts receivables were $1,479,077 and current liabilities were $2,454,280, including $310,525 of customer advances received for future order deliveries.

Although our financial performance has improved during the last few fiscal quarters, our operating expenses have also increased and we continue to experience pricing pressure from our customers and challenges in engineering projects and production orders that result in cost over-runs and depressed gross margins. Consequently, critical to our ability to maintain our financial condition is achieving and maintaining a level of quarterly revenues that generate break even or better financial performance as well as timely collection of accounts receivable from our customers. We believe profitable operating results can be achieved through a combination of revenue levels, realized gross margins and controlling operating expense increases, all of which are subject to periodic fluctuations resulting from sales mix and the stage of completion of varying engineering service projects as they progress towards and into production level revenues.

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 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.

Although we believe the fundamentals of our operations, business plans and opportunities can generate profitable financial results, the effects of the COVID-19 pandemic have resulted in a reduced level of sales in the quarter ended March 31, 2020 and an increase in our net loss. To enhance our financial condition and our ability to manage future uncertainties resulting from COVID-19 and its effects, in April 2020 we entered into agreements with accredited investors for the sale of 200,000 shares of our common stock at $1.25 per share which generated $250,000 of proceeds available for general working capital purposes.

On May 6, 2020, we received loan proceeds in the amount of $808,962 under the Paycheck Protection Program, or PPP, from Bank of America. The PPP, established as part of the Coronavirus Aid, Relief and Economic Security Act, or CARES Act, provides for loans to qualifying businesses for amounts up to 2.5 times of the average monthly payroll expenses of the qualifying business. The loans and accrued interest are forgivable after eight weeks as long as we use the loan proceeds for eligible purposes, including payroll, benefits, rent and utilities, and we maintain our payroll levels. The amount of loan forgiveness will be reduced if we terminate employees or reduce salaries during the eight-week period.

The unsecured loan, which is in the form of a note dated May 6, 2020, matures on May 6, 2022 and bears interest at a rate of 1% per annum, payable monthly commencing on December 6, 2020. The note may be prepaid at any time prior to maturity with no prepayment penalties. We intend to use the loan amount for eligible purposes, such as payroll expenses. While we currently believe that our use of the loan proceeds will meet the conditions for forgiveness of the loan, we cannot assure you that it will be eligible for forgiveness, in whole or in part.

Capital equipment expenditures and additional patent costs during the nine months ended March 31, 2020 were $142,833 and we acquired an additional $113,213 of manufacturing equipment under two capitalized leases during the quarter ended March 31, 2020. 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 March 31, 2020 of approximately $830,402, plus a $108,437 commitment remaining under three capital lease obligations for the acquisition of equipment and $139,791 commitment remaining under a three-year facility lease relating the Ross Optical division in El Paso, Texas (see Note 3. Lease Obligations). We have no other contractual cash commitments since other leased facilities are currently on a month-to-month basis.









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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.

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