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 three months ended September 30, 2020 and with our audited consolidated financial statements for the year ended June 30, 2020 included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on September 24, 2020.

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, 2020 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. We selectively execute 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.

As Ross Optical Industries of El Paso, Texas we also operate as a supplier of custom optical components and assemblies for military and defense, medical and various other industrial applications. All products sold by us under the Ross Optical name include a custom or catalog optic, which is sourced through our 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 our in-house coating department.

Approximately 60% of our business during the three months ended September 30, 2020 is from the design and manufacture of high-quality medical devices. Approximately 9% of our revenue during the same period is from the design, manufacture and resale of optical products for military and defense, and 31% is from other industrial, non-medical products. Our proprietary medical instrumentation line and unique custom 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.

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 websites 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 social media posts on our Ross Optical LinkedIn page (www.linkedin.com/company/ross-optical-industries/) and Twitter feed (http://twitter.com/rossoptical).









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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 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.

Our largest customer during the three months ended September 30, 2020 accounted for 11.3% of our sales and represented production revenue for an ENT scanning device incorporating our Microprecision™ technologies as an enabling design feature. During the fiscal quarter ended September 30, 2020 we had revenue from another one-hundred fifty-eight customers, and none of those customers accounted for more than 10% of our total sales.

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.





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, 2020 filed with the Securities and Exchange Commission on September 24, 2020.





Results of Operations

Our total revenues for the quarter ended September 30, 2020, were $2,757,901, as compared to $2,514,984 for the same period in the prior year, an increase of $242,917, or 9.7%. We believe sales to certain customers were negatively impacted by the COVID-19 pandemic during the quarter ended September 30, 2020, however, the mix of engineering service, production and component sales were similar between the first quarter of fiscal year 2021 and the same quarter of the prior fiscal year. Engineering revenue during the quarter ended September 30, 2020 increased approximately $180,000 compared to the same fiscal quarter of the prior year due to the addition of projects with two new customers, which was partially offset by a typical and anticipated reduction in revenue to a customer progressing through the development stage. Production revenue had a slight increase in quarter-over-quarter revenue due to an increase in production revenue for the ENT scanning device product, which was partially offset by a reduction in production revenue for the cardiovascular product, which both incorporate our Microprecision™ CMOS technology.









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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 could continue 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 continued to operate as essential businesses, we took 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. We have had supply disruptions and customer delays that 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 impacts both 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.

Gross profit for the quarter ended September 30, 2020 was $975,178, compared to $974,117 for the same period in the prior year, reflecting an increase of $1,061. Gross profit for the quarter ended September 30, 2020 as a percentage of our revenues was 35.4%, a decrease from the gross profit percentage of 38.7% 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, 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.

Our gross margin on individual engineering projects 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, unanticipated cost over-runs, design challenges and changes, start-up production activities or other customer imposed project changes or delays. Our decrease in gross margin from 38.7% to 35.4% during the fiscal quarter ending September 30, 2019 compared to 2020 was primarily the result of a gross margin decrease in one engineering project due to cost over-runs, plus a decrease in production revenue gross margin resulting from two production products. One production product with a lower gross margin experienced an increase in quarter-over-quarter sales during the quarter ended September 30, 2020, while another production product with a higher gross margin experienced a decrease in quarter-over-quarter sales. The remainder of our production, engineering and component revenues resulted in margins within our targeted range with reasonably expected fluctuations.

Research and development expenses were $151,576 for the quarter ended September 30, 2020, compared to a similar amount of $152,154 for the same period in the prior year. 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 September 30, 2020 we achieved an increased amount of engineering revenue by utilizing a similar amount of engineering labor as compared to the same quarter of the prior year. Consequently, a similar amount of engineering resources were consumed in internal research and development activities during the quarters ended September 30, 2020 and 2019, respectively.

Selling, general and administrative expenses were $822,002 for the quarter ended September 30, 2020, compared to $907,845 for the same period in the prior year, a decrease of $85,843, or 9.5%. The decrease in the quarter ended September 30, 2020, compared to the same quarter of the prior fiscal year was due to decreased recruiting, shareholder relations, stock compensation and administrative travel costs offset by increases in consulting, professional accounting and insurance expenses.

Liquidity and Capital Resources

We have sustained recurring net losses for several years. During the year ended June 30, 2020 we incurred a net loss of 1,426,150 and used cash in operating activities of $592,492. During the three months ended September 30, 2020 we had net income of $793 and used cash in operating activities of $172,636. At September 30, 2020 cash was $900,510, accounts receivables were $1,585,001 and current liabilities were $2,875,003, including $206,665 of customer advances received for future order deliveries.









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Although our sales levels have increased and our financial performance has shown signs of periodic improvement during certain recent 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 lower 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 projects have the potential to generate increasing revenues and profitable financial results.

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 that are forgivable provided the loan proceeds are used for eligible purposes, including payroll, benefits, rent and utilities. The unsecured loan, which is in the form of a note dated May 6, 2020 and recorded as a current liability in accompanying financial statements, matures on May 6, 2022 and bears interest at a rate of 1% per annum, payable monthly commencing on December 6, 2020. While we currently believe that our use of the loan proceeds meets the conditions for forgiveness of the loan, we have begun the forgiveness application process and we cannot yet be assured that our $808,962 PPP loan will be eligible for forgiveness, in whole or in part.

Capital equipment expenditures and additional patent costs during the three months ended September 30, 2020 were $40,609. 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, 2020 of approximately $656,850, plus a $74,119 commitment remaining under three capital lease obligations for the acquisition of equipment and $109,156 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.

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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